finance bob meinte am 20. Jan, 22:57:
About the risk-return trade-off
I´ve got a question about the statement about the risk-return relationship mentioned earlier (...that taking additional risk doesn´t provide any premium).Why should a "risky" investment in the fixed-income market provide a risk premium if the market values the securities efficiently?
In your calculations you have started with the actual YTM of the bonds, then you have taken out the risk factors (6% default and 50% recovery rate) and the result was a yield very close to that of a riskless treasury bond (3,78% to 4,18%).
Since I´m a fan of efficient markets I´d say that your calculation is rather another proof of the Efficient Markets Hypothesis than a puzzle.
However I´m worried about some mistakes in my conclusions too so please don´t hesitate to correct me!
HedgeFundGuy antwortete am 20. Jan, 23:05:
Well, you could be right, but only if credit risk is considered nonsystematic, or diversifiable. Most researchers think it is systematic and nondiversifiable.
stxx antwortete am 21. Jan, 01:28:
Another thing that is puzzling me: "If credit risk is not rewarded by the financial markets, why do investors not simply engage in an asset swap transaction and go short the B and long the AAA cash flow? With a large enough portfolio (to realize the 6% default prob.) I would have a free lunch (most likely)?"
finance bob antwortete am 21. Jan, 15:05:
Yeah that´s right. So if hedge funds (or other traders) have the possibility to exploit this free lunch then in the long-run bond prices should adjust so that the extra yield of a risky bond (=spread) exactly offsets the risk of default.(?)
HedgeFundGuy antwortete am 21. Jan, 16:26:
positive return, poor sharpe
I agree that the 3% return seems a reasonable estimate, but if you look at the annualized volatility of going long the AAA and short the B Index, you have an annualized stdev of about 8%. That means a sharpe of merely 3%/8%, or .38, which is not going to excite many investors.
