#### Now suppose the portfolio consists of $250,000 of 30-day Treasury bills. Every 30 days your bills mature,

Suppose you owned a portfolio consisting of $250,000 of long-term U.S. government bonds. a. Would your portfolio be riskless? Explain. b. Now suppose the portfolio consists of $250,000 of 30-day Treasury bills. Every 30 days your bills mature, and you will reinvest the principal ($250,000) in a new batch of bills. You plan to live on the investment income from your portfolio, and you want to maintain a constant standard of living. Is the T-bill portfolio truly riskless? Explain. c. What is the least risky security you can think of? Explain. Suppose you owned a portfolio consisting of $250,000 of long-term U.S. government bonds. a. Would your portfolio be riskless? Explain. b. Now suppose the portfolio consists of $250,000 of 30-day Treasury bills. Every 30 days your bills mature, and you will reinvest the principal ($250,000) in a new batch of bills. You plan to live on the investment income from your portfolio, and you want to maintain a constant standard of living. Is the T-bill portfolio truly riskless? Explain. c. What is the least risky security you can think of? Explain. Suppose you owned a portfolio consisting of $250,000 of long-term U.S. government bonds. a. Would your portfolio be riskless? Explain. b. Now suppose the portfolio consists of $250,000 of 30-day Treasury bills. Every 30 days your bills mature, and you will reinvest the principal ($250,000) in a new batch of bills. You plan to live on the investment income from your portfolio, and you want to maintain a constant standard of living. Is the T-bill portfolio truly riskless? Explain. c. What is the least risky security you can think of? Explain. |

part a

Explanation

All securities are subject to some level of risk due to interest rate changes and the rate of inflation In addition, as interest rates rise, the prices of bonds decline, which creates price risk. Reinvestment risk happens when the interest rate declines, the coupon payment received by the bondholder will not be able to reinvest at the same rate causing a loss.

Sample Response

An investment in long-term US government bonds is not a riskless investment due to the risk of inflation and reinvestment risk. Reinvestment risk will happen when bond holders reinvest coupons received at a lower interest rate.

part b

Explanation

If inflation averages 3% and treasury bills averaged 1%, then the account would be decreasing in value 2% per year despite ever seeing a physical drop in the value. Using the rule of 72 and a 3% inflation rate, the cost of living would double every 24 years (72/3). Therefore, if the investor's money also does not double, it would be impossible to maintain standard of living.

Sample Response

The treasury bill is not a riskless investment due to inflation. If an investor retires and invests all his/her money in US treasury bills, the money will always grow as the risk of default is zero. However, the rate of inflation has historically been higher than the rate of return on treasury bills. Thus, even though the investor's money is growing, it is losing purchasing power as inflation eats into the investment. Therefore, after several years go by, the investor will not be able to maintain his/her standard of living because prices will exceed the amount of income the investor receives.In addition, as interest rates rise, the prices of bonds decline, which creates price risk. Reinvestment risk happens when the interest rate declines, the coupon payment received by the bondholder will not be able to reinvest at the same rate causing a loss.

part c

Explanation

No investment is completely free of risk. Investment depends on an individual's degree of risk aversion and that the additional expected return may or may not compensate the investor for the risk of losing principal.

Sample Response

The lowest risk investment could be an inflation-linked bond as it is issued by the US government and adjusts for the rate of inflation. Therefore, this investment is free of default and protects against inflation.

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