Question

In: Finance

1. Define Current Yield and Yield to Maturity. Why do we need two return measures on...

1. Define Current Yield and Yield to Maturity. Why do we need two return measures on bonds?

2. Describe the assumptions we need to make for the constant-growth dividend discount model.

3. Why risk can be measured by variance/standard deviation?

4. Briefly describe the CAPM model. Why stock/portfolio's expected returns are associated with market risk premium?

Solutions

Expert Solution

1.

Current Yield is an investments annual income ( interest or dividends) dividend by the current price of the security.

Yield to maturity is the total return anticipated on a bond if held till the maturity.

We need these measures to ascertain whether the bond is overpriced or undervalued and hence whether the investor should buy or sell.

2. The assumptions made under this model are:

a. it assumes that the dividend are a suitable measure of valuation.

b. it assumes that the required return on equity(ke) and the growth rate of dividend(g) will be constant forever.

3. The standard deviation is a measure of risk that the investment will not meet the expected return in a given period. higher the standard deviation, higher is the risk associated with the security and vice-versa.

4. CAPM explains the relationship between the expected returns, systematic risk and the valuation of securities.

the formula is given by:

Rf + beta*(Rm - Rf)

CAPM is based on the premise that the risk of security is eliminated, when more and more securities are added in the portfolio.


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