Question

If the future cash flows from an investment are uncertain, then the investment is risky. As a result, if the cash flows are uncertain then there's also higher risk involved.

This means there is uncertainty about the future cash flows or that the future cash flows could be different from expected cash flows. The degree of uncertainty varies from investment to investment. This is all the essence of risk.

Discuss the impact of risk on both the stock and bond markets focusing on beta, the time value of money and ratings from the credit rating agencies.   

Answer 1

1) Beta :- It is a measure of systematic risk of a portfolio or stock as compared to the market. This is usually used for stocks and not for bonds. When the beta of the stock or portfolio is equal to 1 , then the risk of portfolio is same as in the market. But if the beta is higher than 1, then the portfolio risk is more than the market , so a higher return is required to compensate for the risk and vice versa.

2) Time value of Money :- It refers to present value of the future cash flows or future value of the present cash flows. This affect both the stock and bond market. If the time period is long, then the risk will be higher , so the discount rate used will be high and the present intrinsic value of both stock and bond will be low , making them less attractive.

3) Ratings from credit rating agencies

Credit rating agencies provide rating to the companies on the basis of their creditworthiness. If the rating provided is low, then the company is less worthy of making the payment. So the return required on it will be higher and vice versa. Credit ratings are basically used to see the likehood of default for the bond.

This rating indirectly affects the stock market. A company can get a lower rating , because it must have issued a large amount of bond. This affects credit worthiness of the company , and increases the cost of equity for new issuance. Thus, also increases the risk involves with equity along with bond.