Question

If an asset has unlimited down-side returns then its returns can be infinitely negative, so there’s no minimum return. If an asset has limited up-side returns then its returns have a maximum at some finite number.

Which one of the following statements about returns on debt and equity issued by a limited liability company is NOT correct? Assume a zero lower bound on risk free government bond yields.

Select one:

a. Debt has limited up-side returns.

b. Debt has limited down-side returns.

c. Equity has unlimited up-side returns.

d. Equity has unlimited down-side returns.

e. Equity and debt prices must be positive.

Answer 1

Option d is correct as the statement is not correct.

The statement 'Equity has unlimited down-side returns' is NOT correct. Equity has limited down-side returns. The downside return is limited to -100% not infinitely negative.

The other answer options are incorrect because they are correct statements:

• Yes, debt has limited up-side returns
• Yes, debt has limited down-side returns, -100%
• Yes, Equity has unlimited upside-returns.
• Yes, Equity and debt prices must be positive