Evaluate the risk and reward proposition for an investor considering purchasing a government versus corporate bond, indicating the key factors to be considered to determine the investor level of risk tolerance and the impact to his decision.
Risk- Reward Trade off
This is a trade off that an investor faces between the risk and return of an investment. The higher the risk the higher the return(reward) the investor gets and the lower the risk the lower the return.
Answer and Explanation:
An investor planning to invest in a government bond earns a risk free interest rate of return. A corporate bond has a higher risk involved and therefore for an investor to accept an investment in the corporate bond he must be compensated for taking up more risk. This results in more return higher than the return in government bond.
This extra return that is rewarded for taking extra risk is the risk premium. It is the return in excess of the risk free interest rate earned by investing in government bonds.
The risk tolerance of an investor is determined by factors like;
The liquidity of the investor.
The time horizon.
The Attitude of the investor towards risk.
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from Financial Accounting: Help and ReviewChapter 5 / Lesson 26