Question 8.1: Risk Taking SITUATION: You work for the treasurer of a large...
Risk Taking
SITUATION: You work for the treasurer of a large manufacturing corporation where earnings are down substantially for the year. The treasurer’s staff is convinced that interest rates are going to decline over the next three months, and they want to invest in fixed-income securities to make as much money as possible for the firm. The staff recommends investing in one of the following securities:
• Three-month T-bill
• Twenty-year corporate bond
• Twenty-year zero coupon Treasury bond
The treasurer asks you to answer the following questions about the staff’s plan: (1) What is the underlying strategy of the proposed plan? (2) Which investment should be selected if the plan were to be executed? (3) What should the treasurer do?
DECISION: First, the staff’s strategy is based on the negative relation between interest rates and bond prices. Thus, if interest rates decline, bond prices will rise, and the firm will earn a capital gain. Second, to maximize earnings, the treasurer should select bonds that will have the largest price swing for a given change in interest rates. Bond theorems 2 and 3 suggest that for a given change in interest rates, low-coupon, long-term bonds will have the largest price swing. Thus, the treasurer should invest in the 20-year zero coupon Treasury bond. With respect to the plan’s merits, the intentions are good, but the investment plan is pure folly. Generating “earnings” from risky financial investments is not the firm’s line of business or one of its core competencies. As was discussed in Chapter 1, the treasurer’s primary investment function is to invest idle cash in safe investments such as money market instruments that have very low default and interest rate risk.