Questions

1. Calculate the expected rate of return for each of the fnancial

assets listed in Table 1, and complete the expected return row for
Table 1. Based solely on the expected returns, which of the
investments appears the best and worst? Discuss the impact on
returns for eneral chanes in the economy for C!C, "orely, and
#$T.
Best% C!C
&orst% T'Bills
C!C and #$T are positively correlated to chanes in the economy
while "orley is neatively correlated.
(. Considerin ).*. Treasuries are uaranteed by the ).*.
overnment, answer the followin +uestions.
a. ,s the T'bill return independent of the state of the economy?
Brie-y explain.
.es, The Treasury redeems the bills at par no matter what the
state of the economy is.
Do T'bills promise completely ris/'free returns? #xplain.
0o,
they are exposed to reinvestment rate ris/ and in-ation ris/
b.Why do T-bond returns vary? Why are T-bond returns high when the
market returns are low?
Interest Rates changing, bonds become a better investment as the market is
low because of the reduced risk and fxed rates
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c.How would returns on corporate bonds that Filmore Enterprises
might issue compare with those for T-bonds? Would your answer be
dependent on the potential bond rating of Filmore Enterprises?
Filmores returns would be higher
6. Basin a decision solely on expected returns is appropriate only
for ris/'neutral individuals. *ince most people are ris/ averse, ris/
is an important consideration for the decision.
a. Two possible measures of ris/ are the standard deviation and
the coe7cient of variation. Calculate the standard deviation
and coe7cient of variation for C!C returns and complete the
related blan/s in Table 1.
*tandard deviation for cpc 18.9:; coe7cient of variation1.8<
:. *uppose investors create a ('stoc/ portfolio by investin =199,999
in C!C and =199,999 in "orely.
a. Calculate the expected return for each state of the economy,
and then compute the expected return for the portfolio.
Complete the related blan/ in Table (.
!ortfolio #xpected return% >.>; =1<,:99
b. Compute the standard deviation for the portfolio, and compare
it to the standard deviation of the individual stoc/s. Complete
the related blan/s in Table (.
*tandard Deviation :.16;
c. ,n eneral, how would ris/ be a?ected if you formed another
portfolio composed of C!C and #$T? #xplain how the correlation
coeffcient a?ects the level of diversifcation in the C!C'"orely
and the C!C'#$T portfolios.
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@is/ would be hiher , for a portfolio to be diversifed e?ectively the
stoc/s need to be neatively correlated. !ostively correlated
stoc/s will both tren up and down at the same time.

<. *uppose an investor has a portfolio consistin of Aust one
randomly'selected stoc/. &hat happens to the ris/ as the investor
adds more and more randomly'selected stoc/s to the portfolio?
,llustrate your answer with a raph showin Bportfolio standard
deviationC on the vertical axis and Bnumber of stoc/sC on the
horiDontal axis.
@educes ris/ Ecompany'specifc ris/F but each stoc/ added has less of
a ris/ reducin e?ect as the last
8. $nswer the followin +uestions relatin to diversifcation.
a. &hat implication does diversifcation have for investors?
Diversifcation @educes the ris/ of the portfolio so havin a well'
diversifed portfolio is less ris/y.
b. ,f an investor decides to hold a 1'stoc/ portfolio and as a result
is exposed to more ris/ than diversifed investors, could the
non'diversifed investor expect to be compensated for all his or
her ris/? That is, could the investor earn a ris/ premium lare
enouh to compensate for that part of the total ris/ that
diversifcation could have eliminated? 0o, if a stoc/ produced
returns this hih the price of the stoc/ would o up and returns
would o down as everyone else also invested in it.
c. #xplain the di?erence between total ris/, diversifable ris/, and
mar/et ris/. Diversifable ris/ is the investment ris/ which can
be reduced by diversifcation, mar/et ris/ is the ris/ associated
with any investment in a iven mar/et and total ris/ is the
combination of the two ris/s.
d. 4ow miht the desire for diversifcation of individual retirement
funds a?ect the structure of ).*. investments?
0o idea
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>. Chane Table 1 by substitutin .ear 1 throuh .ear < for the states
of the economy.
a. !lot the characteristic lines for C!C, "orely, and T'bills showin
the returns on the index Ethe mar/etF on the G'axis and the
returns on the asset on the .'axis. #stimate Eby visual
inspectionF the slope for each line. ,f you are usin the
spreadsheet model, compute the slope coe7cients. 4ow do
these compare to the betas provided in Table 1?
TheyHre the same.
b. &hat is the sinifcance of the distance between the plot points
and the reression line, that is, the errors?
0o idea
c. &hat do betas measure, and how are they used in ris/
analysis? Betas measure the volatility of a stoc/ next to the
mar/et
d. Develop a chart depictin the beta and expected return for
each security, determined from the data provided by the
investment ban/ers. Does the ris/ and return relationship
appear reasonable relative to the mar/et?
.es
19. The *"I miht shift in response to various economic chanes. $
chane in the *"I a?ects security prices and rates of return.
a. *uppose investors raised their expectations for in-ation by :
percentae points over current estimates as re-ected in the
<.(; T'bond rate. #xplain the e?ect this would have on the
*"I and on the returns re+uired on hih' versus low'ris/
securities
T4# #0T,@# *"I ,* *4,JT#D )!&$@D E!$@$II#I TK T4# B$*# C$*#
*"IF
b. Disreard Luestion 19a and assume that investorsH ris/
aversion increased enouh to cause the mar/et ris/ premium to
rise by : percentae points. #xplain what e?ect this would have
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on the *"I and on returns of hih'ris/ versus low'ris/
securities.
The sml is rotate upward. The re+uired rate of return will rise a reat
deal on hih ris/ stoc/s but not as much on low ris/.
c. Discuss the /inds of chanes Luestions 19a and 19b would
have on short'run and lon'run e?ectsM for example, miht an
increase in expected in-ation lead to lower returns in the short
run followed by hiher returns in the lon run?
0o ,dea
11. @ather than focusin on ris/ from an investorsH decision'ma/in
perspective, consider the ris/ of corporate decisions and how
investorsH perceptions a?ect the Btrue ris/C of corporate decisions.
a. &hy is it important for operatin manaers to be coniDant of
the way investors loo/ at ris/? By diversifyin their assets, the
variability of returns can be lowered when some proAects do
badly and other perform better.
b. *uppose a particular decision appears particularly ris/y to
investors Efor instance, it would ma/e the frm loo/ ris/yF, but
the frmHs manaers, who /now more about the situation than
investors, thin/ the decision is really not very ris/y. 4ow miht
this situation a?ect the decision to accept a particular proAect
based on each of the followin factors?
E1F The proAect can be fnanced with internal fundsM therefore,
the frm does not need to sell securities to underta/e the
proAect.
Because the company will still have its securities it can lower the ris/
of the proAect.
E(F The proAect is very lare, and securities must be sold to
fnance it.
This would increase the ris/ of the proAect
E6F The proAect is lon'termM therefore, it will ta/e years for the
company to complete the proAect and bein receivin cash
-ows.
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The ris/ will be hiher as the future cash -ows would have to be
weihed aainst the present loss and loss of opportunities
E:F The proAect is short'term, so the company can complete it
and receive cash -ows within a few months.
@is/ would be lower
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