# Chapter 5 Risk and Return ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS

Save this PDF as:

Size: px
Start display at page:

## Transcription

1 Chapter 5 Risk and Return ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS 5-1 a. Stand-alone risk is only a part of total risk and pertains to the risk an investor takes by holding only one asset. Risk is the chance that some unfavorable event will occur. For instance, the risk of an asset is essentially the chance that the asset s cash flows will be unfavorable or less than expected. A probability distribution is a listing, chart or graph of all possible outcomes, such as expected rates of return, with a probability assigned to each outcome. When in graph form, the tighter the probability distribution, the less uncertain the outcome. b. The expected rate of return ( r ) is the expected value of a probability distribution of expected returns. c. A continuous probability distribution contains an infinite number of outcomes and is graphed from - and +. d. The standard deviation (σ) is a statistical measure of the variability of a set of observations. The variance (σ 2 ) of the probability distribution is the sum of the squared deviations about the expected value adjusted for deviation. The coefficient of variation (CV) is equal to the standard deviation divided by the expected return; it is a standardized risk measure which allows comparisons between investments having different expected returns and standard deviations. e. A risk averse investor dislikes risk and requires a higher rate of return as an inducement to buy riskier securities. A realized return is the actual return an investor receives on their investment. It can be quite different than their expected return. f. A risk premium is the difference between the rate of return on a risk-free asset and the expected return on Stock i which has higher risk. The market risk premium is the difference between the expected return on the market and the risk-free rate. g. CAPM is a model based upon the proposition that any stock s required rate of return is equal to the risk free rate of return plus a risk premium reflecting only the risk remaining after diversification. Mini Case: 5-1

2 h. The expected return on a portfolio. r p, is simply the weighted-average expected return of the individual stocks in the portfolio, with the weights being the fraction of total portfolio value invested in each stock. The market portfolio is a portfolio consisting of all stocks. i. Correlation is the tendency of two variables to move together. A correlation coefficient (ρ) of +1.0 means that the two variables move up and down in perfect synchronization, while a coefficient of -1.0 means the variables always move in opposite directions. A correlation coefficient of zero suggests that the two variables are not related to one another; that is, they are independent. j. Market risk is that part of a security s total risk that cannot be eliminated by diversification. It is measured by the beta coefficient. Diversifiable risk is also known as company specific risk, that part of a security s total risk associated with random events not affecting the market as a whole. This risk can be eliminated by proper diversification. The relevant risk of a stock is its contribution to the riskiness of a well-diversified portfolio. k. The beta coefficient is a measure of a stock s market risk, or the extent to which the returns on a given stock move with the stock market. The average stock s beta would move on average with the market so it would have a beta of 1.0. l. The security market line (SML) represents in a graphical form, the relationship between the risk of an asset as measured by its beta and the required rates of return for individual securities. The SML equation is essentially the CAPM, r i = r RF + b i (r M - r RF ). m. The slope of the SML equation is (r M - r RF ), the market risk premium. The slope of the SML reflects the degree of risk aversion in the economy. The greater the average investors aversion to risk, then the steeper the slope, the higher the risk premium for all stocks, and the higher the required return. 5-2 a. The probability distribution for complete certainty is a vertical line. b. The probability distribution for total uncertainty is the X axis from - to Security A is less risky if held in a diversified portfolio because of its lower beta and negative correlation with other stocks. In a single-asset portfolio, Security A would be more risky because σ A > σ B and CV A > CV B. Mini Case: 5-2

4 SOLUTIONS TO END-OF-CHAPTER PROBLEMS 5-1 r = (0.1)(-50%) + (0.2)(-5%) + (0.4)(16%) + (0.2)(25%) + (0.1)(60%) = 11.40%. σ 2 = (-50% %) 2 (0.1) + (-5% %) 2 (0.2) + (16% %) 2 (0.4) + (25% %) 2 (0.2) + (60% %) 2 (0.1) σ 2 = ; σ= 26.69% % CV = = % 5-2 Investment Beta \$35, , Total \$75,000 (\$35,000/\$75,000)(0.8) + (\$40,000/\$75,000)(1.4) = r RF = 5%; RP M = 6%; r M =? r M = 5% + (6%)1 = 11%. r s when b = 1.2 =? r s = 5% + 6%(1.2) = 12.2%. 5-4 r RF = 6%; r M = 13%; b = 0.7; r s =? r s = r RF + (r M - r RF )b = 6% + (13% - 6%)0.7 = 10.9%. Mini Case: 5-4

5 5-5 a. r m = (0.3)(15%) + (0.4)(9%) + (0.3)(18%) = 13.5%. r j = (0.3)(20%) + (0.4)(5%) + (0.3)(12%) = 11.6%. b. σ M = [(0.3)(15% %) 2 + (0.4)(9% %) 2 + (0.3)(18% -13.5%) 2 ] 1/2 = 14.85% = 3.85%. σ J = [(0.3)(20% %) 2 + (0.4)(5% %) 2 + (0.3)(12% %) 2 ] 1/2 = 38.64% = 6.22%. 3.85% c. CV M = = % 6.22% CV J = = % 5-6 a. r A = r RF + (r M - r RF )b A 12% = 5% + (10% - 5%)b A 12% = 5% + 5%(b A ) 7% = 5%(b A ) 1.4 = b A. b. r A = 5% + 5%(b A ) r A = 5% + 5%(2) r A = 15%. Mini Case: 5-5

6 5-7 a. r i = r RF + (r M - r RF )b i = 9% + (14% - 9%)1.3 = 15.5%. b. 1. r RF increases to 10%: r M increases by 1 percentage point, from 14% to 15%. r i = r RF + (r M - r RF )b i = 10% + (15% - 10%)1.3 = 16.5%. 2. r RF decreases to 8%: r M decreases by 1%, from 14% to 13%. r i = r RF + (r M - r RF )b i = 8% + (13% - 8%)1.3 = 14.5%. c. 1. r M increases to 16%: r i = r RF + (r M - r RF )b i = 9% + (16% - 9%)1.3 = 18.1%. 2. r M decreases to 13%: r i = r RF + (r M - r RF )b i = 9% + (13% - 9%)1.3 = 14.2%. \$142,500 \$7, Old portfolio beta = (b) + (1.00) \$150,000 \$150, = 0.95b = 0.95b 1.13 = b. New portfolio beta = 0.95(1.13) (1.75) = Alternative Solutions: 1. Old portfolio beta = 1.12 = (0.05)b 1 + (0.05)b (0.05)b 20 Mini Case: = (Σb i )(0.05) Σb i = 1.12/0.05 = New portfolio beta = ( )(0.05) = = Σb i excluding the stock with the beta equal to 1.0 is = 21.4, so the beta of the portfolio excluding this stock is b = 21.4/19 = The beta of the new portfolio is: (0.95) (0.05) = = 1.16.

7 \$400,000 \$600, Portfolio beta = (1.50) + (-0.50) \$4,000,000 \$4,000,000 \$1,000,000 \$2,000,000 + (1.25) + (0.75) \$4,000,000 \$4,000,000 = 0.1)(1.5) + (0.15)(-0.50) + (0.25)(1.25) + (0.5)(0.75) = = r p = r RF + (r M - r RF )(b p ) = 6% + (14% - 6%)(0.7625) = 12.1%. Alternative solution: First compute the return for each stock using the CAPM equation [r RF + (r M - r RF )b], and then compute the weighted average of these returns. r RF = 6% and r M - r RF = 8%. Stock Investment Beta r = r RF + (r M - r RF )b Weight A \$ 400, % 0.10 B 600,000 (0.50) C 1,000, D 2,000, Total \$4,000, r p = 18%(0.10) + 2%(0.15) + 16%(0.25) + 12%(0.50) = 12.1% First, calculate the beta of what remains after selling the stock: b p = 1.1 = (\$100,000/\$2,000,000)0.9 + (\$1,900,000/\$2,000,000)b R 1.1 = (0.95)b R b R = b N = (0.95) (0.05)1.4 = We know that b R = 1.50, b S = 0.75, r M = 13%, r RF = 7%. r i = r RF + (r M - r RF )b i = 7% + (13% - 7%)b i. r R = 7% + 6%(1.50) = 16.0% r S = 7% + 6%(0.75) = 11.5 Mini Case: 5-7

8 4.5% 5-12 The answers to a, b, c, and d are given below: r A r B Portfolio 2001 (18.00%) (14.50%) (16.25%) (0.50) (7.60) (4.05) Mean Std Dev CV e. A risk-averse investor would choose the portfolio over either Stock A or Stock B alone, since the portfolio offers the same expected return but with less risk. This result occurs because returns on A and B are not perfectly positively correlated (ρ AB = 0.88) a. b X = ; b Y = b. r X = 6% + (5%) = %. r Y = 6% + (5%) = %. c. b p = 0.8(1.3471) + 0.2(0.6508) = r p = 6% + (5%) = 12.04%. Alternatively, r p = 0.8( %) + 0.2(9.254%) = 12.04%. d. Stock X is undervalued, because its expected return exceeds its required rate of return. Mini Case: 5-8

### CHAPTER 6. Topics in Chapter. What are investment returns? Risk, Return, and the Capital Asset Pricing Model

CHAPTER 6 Risk, Return, and the Capital Asset Pricing Model 1 Topics in Chapter Basic return concepts Basic risk concepts Stand-alone risk Portfolio (market) risk Risk and return: CAPM/SML 2 What are investment

### CHAPTER 5 Risk and Rates of Return. Tasks: Risk and Rate of Return. Stand-alone risk Portfolio risk Risk & return: CAPM / SML

Assist. Assist. Prof. Prof. Dr. Dr. Şaban Çelik Yaşar University Faculty of Economics and Administrative Sciences Department of 015/016 Fall Semester : Izmir- Turkey Risk andrate Rate of Return of Return

### CHAPTER 10 RISK AND RETURN: THE CAPITAL ASSET PRICING MODEL (CAPM)

CHAPTER 10 RISK AND RETURN: THE CAPITAL ASSET PRICING MODEL (CAPM) Answers to Concepts Review and Critical Thinking Questions 1. Some of the risk in holding any asset is unique to the asset in question.

### Finance Homework p. 65 (3, 4), p. 66-69 (1, 2, 3, 4, 5, 12, 14), p. 107 (2), p. 109 (3,4)

Finance Homework p. 65 (3, 4), p. 66-69 (1, 2, 3, 4, 5, 12, 14), p. 107 (2), p. 109 (3,4) Julian Vu 2-3: Given: Security A Security B r = 7% r = 12% σ (standard deviation) = 35% σ (standard deviation)

### Chapter 5. Risk and Return. Learning Goals. Learning Goals (cont.)

Chapter 5 Risk and Return Learning Goals 1. Understand the meaning and fundamentals of risk, return, and risk aversion. 2. Describe procedures for assessing and measuring the risk of a single asset. 3.

Chapter 5 Risk and Return Learning Goals 1. Understand the meaning and fundamentals of risk, return, and risk aversion. 2. Describe procedures for assessing and measuring the risk of a single asset. 3.

### The CAPM (Capital Asset Pricing Model) NPV Dependent on Discount Rate Schedule

The CAPM (Capital Asset Pricing Model) Massachusetts Institute of Technology CAPM Slide 1 of NPV Dependent on Discount Rate Schedule Discussed NPV and time value of money Choice of discount rate influences

### Chapter 7 Portfolio Theory and Other Asset Pricing Models

Chapter 7 Portfolio Theory and Other sset Pricing Models NSWERS TO END-OF-CHPTER QUESTIONS 7-1 a. portfolio is made up of a group of individual assets held in combination. n asset that would be relatively

### Basic Financial Tools: A Review. 3 n 1 n. PV FV 1 FV 2 FV 3 FV n 1 FV n 1 (1 i)

Chapter 28 Basic Financial Tools: A Review The building blocks of finance include the time value of money, risk and its relationship with rates of return, and stock and bond valuation models. These topics

### Answers to Concepts in Review

Answers to Concepts in Review 1. A portfolio is simply a collection of investments assembled to meet a common investment goal. An efficient portfolio is a portfolio offering the highest expected return

### Chapter 7 Risk and Return: Portfolio Theory and Asset Pricing Models ANSWERS TO END-OF-CHAPTER QUESTIONS

Chapter 7 Risk and Return: Portfolio Theory and Asset Pricing odels ANSWERS TO END-OF-CHAPTER QUESTIONS 7-1 a. A portfolio is made up of a group of individual assets held in combination. An asset that

Review for Exam Instructions: Please read carefully The exam will have 1 multiple choice questions and 5 work problems. Questions in the multiple choice section will be either concept or calculation questions.

### CHAPTER 11: ARBITRAGE PRICING THEORY

CHAPTER 11: ARBITRAGE PRICING THEORY 1. The revised estimate of the expected rate of return on the stock would be the old estimate plus the sum of the products of the unexpected change in each factor times

### CHAPTER 10. Capital Markets and the Pricing of Risk. Chapter Synopsis

CHAPE 0 Capital Markets and the Pricing of isk Chapter Synopsis 0. A First Look at isk and eturn Historically there has been a large difference in the returns and variability from investing in different

### Econ 422 Summer 2006 Final Exam Solutions

Econ 422 Summer 2006 Final Exam Solutions This is a closed book exam. However, you are allowed one page of notes (double-sided). Answer all questions. For the numerical problems, if you make a computational

### Solution: The optimal position for an investor with a coefficient of risk aversion A = 5 in the risky asset is y*:

Problem 1. Consider a risky asset. Suppose the expected rate of return on the risky asset is 15%, the standard deviation of the asset return is 22%, and the risk-free rate is 6%. What is your optimal position

### 1. Portfolio Returns and Portfolio Risk

Chapter 8 Risk and Return: Capital Market Theory Chapter 8 Contents Learning Objectives 1. Portfolio Returns and Portfolio Risk 1. Calculate the expected rate of return and volatility for a portfolio of

### Chapter 13 Composition of the Market Portfolio 1. Capital markets in Flatland exhibit trade in four securities, the stocks X, Y and Z,

Chapter 13 Composition of the arket Portfolio 1. Capital markets in Flatland exhibit trade in four securities, the stocks X, Y and Z, and a riskless government security. Evaluated at current prices in

### Chapter 11, Risk and Return

Chapter 11, Risk and Return 1. A portfolio is. A) a group of assets, such as stocks and bonds, held as a collective unit by an investor B) the expected return on a risky asset C) the expected return on

Review for Exam 2 Instructions: Please read carefully The exam will have 25 multiple choice questions and 5 work problems You are not responsible for any topics that are not covered in the lecture note

### Module 7 Asset pricing models

1. Overview Module 7 Asset pricing models Prepared by Pamela Peterson Drake, Ph.D., CFA Asset pricing models are different ways of interpreting how investors value investments. Most models are based on

### Capital Allocation Between The Risky And The Risk- Free Asset. Chapter 7

Capital Allocation Between The Risky And The Risk- Free Asset Chapter 7 Investment Decisions capital allocation decision = choice of proportion to be invested in risk-free versus risky assets asset allocation

### Chapter 8 Risk and Return

Chapter 8 Risk and Return LEARNING OBJECTIVES (Slides 8-2 & 8-3) 1. Calculate profits and returns on an investment and convert holding period returns to annual returns. 2. Define risk and explain how uncertainty

### CHAPTER 9: THE CAPITAL ASSET PRICING MODEL

CHAPTER 9: THE CAPITAL ASSET PRICING MODEL PROBLEM SETS 1. E(r P ) = r f + β P [E(r M ) r f ] 18 = 6 + β P(14 6) β P = 12/8 = 1.5 2. If the security s correlation coefficient with the market portfolio

### 1. a. (iv) b. (ii) [6.75/(1.34) = 10.2] c. (i) Writing a call entails unlimited potential losses as the stock price rises.

1. Solutions to PS 1: 1. a. (iv) b. (ii) [6.75/(1.34) = 10.2] c. (i) Writing a call entails unlimited potential losses as the stock price rises. 7. The bill has a maturity of one-half year, and an annualized

### DO NOT COPY PORTFOLIO SELECTION AND THE CAPITAL ASSET PRICING MODEL

UVA-F-1604 Rev. Mar. 4, 011 PORTFOLIO SELECTION AND THE CAPITAL ASSET PRICING MODEL What portfolio would you recommend to a 8-year-old who has just been promoted to a management position, and what portfolio

### WEB APPENDIX. Calculating Beta Coefficients. b Beta Rise Run Y 7.1 1 8.92 X 10.0 0.0 16.0 10.0 1.6

WEB APPENDIX 8A Calculating Beta Coefficients The CAPM is an ex ante model, which means that all of the variables represent before-thefact, expected values. In particular, the beta coefficient used in

### Corporate Finance Sample Exam 2A Dr. A. Frank Thompson

Corporate Finance Sample Exam 2A Dr. A. Frank Thompson True/False Indicate whether the statement is true or false. 1. The market value of any real or financial asset, including stocks, bonds, CDs, coins,

### Chapter 11. Topics Covered. Chapter 11 Objectives. Risk, Return, and Capital Budgeting

Chapter 11 Risk, Return, and Capital Budgeting Topics Covered Measuring Market Risk Portfolio Betas Risk and Return CAPM and Expected Return Security Market Line CAPM and Stock Valuation Chapter 11 Objectives

### 15.401 Finance Theory

Finance Theory MIT Sloan MBA Program Andrew W. Lo Harris & Harris Group Professor, MIT Sloan School Lecture 13 14 14: : Risk Analytics and Critical Concepts Motivation Measuring Risk and Reward Mean-Variance

### Chapter 7 Risk, Return, and the Capital Asset Pricing Model

Chapter 7 Risk, Return, and the Capital Asset Pricing Model MULTIPLE CHOICE 1. Suppose Sarah can borrow and lend at the risk free-rate of 3%. Which of the following four risky portfolios should she hold

### Chapter 5 Uncertainty and Consumer Behavior

Chapter 5 Uncertainty and Consumer Behavior Questions for Review 1. What does it mean to say that a person is risk averse? Why are some people likely to be risk averse while others are risk lovers? A risk-averse

### Capital Market Equilibrium and the Capital Asset Pricing Model

Capital Market Equilibrium and the Capital Asset Pricing Model Econ 422 Investment, Capital & Finance Spring 21 June 1, 21 1 The Risk of Individual Assets Investors require compensation for bearing risk.

### AN OVERVIEW OF FINANCIAL MANAGEMENT

CHAPTER 1 Review Questions AN OVERVIEW OF FINANCIAL MANAGEMENT 1. Management s basic, overriding goal is to create for 2. The same actions that maximize also benefits society 3. If businesses are successful

### Models of Risk and Return

Models of Risk and Return Aswath Damodaran Aswath Damodaran 1 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for

### Chapter 10 Capital Markets and the Pricing of Risk

Chapter 10 Capital Markets and the Pricing of Risk 10-1. The figure below shows the one-year return distribution for RCS stock. Calculate a. The expected return. b. The standard deviation of the return.

### Lecture 2: Delineating efficient portfolios, the shape of the meanvariance frontier, techniques for calculating the efficient frontier

Lecture 2: Delineating efficient portfolios, the shape of the meanvariance frontier, techniques for calculating the efficient frontier Prof. Massimo Guidolin Portfolio Management Spring 2016 Overview The

### SAMPLE MID-TERM QUESTIONS

SAMPLE MID-TERM QUESTIONS William L. Silber HOW TO PREPARE FOR THE MID- TERM: 1. Study in a group 2. Review the concept questions in the Before and After book 3. When you review the questions listed below,

### CHAPTER 7: OPTIMAL RISKY PORTFOLIOS

CHAPTER 7: OPTIMAL RIKY PORTFOLIO PROLEM ET 1. (a) and (e).. (a) and (c). After real estate is added to the portfolio, there are four asset classes in the portfolio: stocks, bonds, cash and real estate.

### Lecture 1: Asset Allocation

Lecture 1: Asset Allocation Investments FIN460-Papanikolaou Asset Allocation I 1/ 62 Overview 1. Introduction 2. Investor s Risk Tolerance 3. Allocating Capital Between a Risky and riskless asset 4. Allocating

### Lecture 6: Arbitrage Pricing Theory

Lecture 6: Arbitrage Pricing Theory Investments FIN460-Papanikolaou APT 1/ 48 Overview 1. Introduction 2. Multi-Factor Models 3. The Arbitrage Pricing Theory FIN460-Papanikolaou APT 2/ 48 Introduction

### CHAPTER 6: RISK AVERSION AND CAPITAL ALLOCATION TO RISKY ASSETS

CHAPTER 6: RISK AVERSION AND CAPITAL ALLOCATION TO RISKY ASSETS PROBLEM SETS 1. (e). (b) A higher borrowing is a consequence of the risk of the borrowers default. In perfect markets with no additional

### Chapter 9 Interest Rates

Chapter 9 Interest Rates Concept Questions 1. Short-term rates have ranged between zero and 14 percent. Long-term rates have fluctuated between about two and 13 percent. Long-term rates, which are less

### CHAPTER 11. Proposed Project. Incremental Cash Flow for a Project. Treatment of Financing Costs. Estimating cash flows:

CHAPTER 11 Cash Flow Estimation and Risk Analysis Estimating cash flows: Relevant cash flows Working capital treatment Inflation Risk Analysis: Sensitivity Analysis, Scenario Analysis, and Simulation Analysis

### Chapter 6 - Practice Questions

Chapter 6 - Practice Questions 1. If a T-bill pays 5 percent, which of the following investments would not be chosen by a risk-averse investor? A) An asset that pays 10 percent with a probability of 0.60

### Chapter 10. Chapter 10 Topics. Recent Rates

Chapter 10 Introduction to Risk, Return, and the Opportunity Cost of Capital Chapter 10 Topics Rates of Return Risk Premiums Expected Return Portfolio Return and Risk Risk Diversification Unique & Market

### Chapter 5. Conditional CAPM. 5.1 Conditional CAPM: Theory. 5.1.1 Risk According to the CAPM. The CAPM is not a perfect model of expected returns.

Chapter 5 Conditional CAPM 5.1 Conditional CAPM: Theory 5.1.1 Risk According to the CAPM The CAPM is not a perfect model of expected returns. In the 40+ years of its history, many systematic deviations

### Holding Period Return. Return, Risk, and Risk Aversion. Percentage Return or Dollar Return? An Example. Percentage Return or Dollar Return? 10% or 10?

Return, Risk, and Risk Aversion Holding Period Return Ending Price - Beginning Price + Intermediate Income Return = Beginning Price R P t+ t+ = Pt + Dt P t An Example You bought IBM stock at \$40 last month.

### Chapter 6 The Tradeoff Between Risk and Return

Chapter 6 The Tradeoff Between Risk and Return MULTIPLE CHOICE 1. Which of the following is an example of systematic risk? a. IBM posts lower than expected earnings. b. Intel announces record earnings.

### Chapter 5. The Behavior of Interest Rates. 5.1 Determinants of Asset Demand

Chapter 5 The Behavior of Interest Rates 5.1 Determinants of Asset Demand 1) Of the four factors that influence asset demand, which factor will cause the demand for all assets to increase when it increases,

### A reading prepared by Pamela Peterson Drake

Risk, return, and diversification A reading prepared by Pamela Peterson Drake O U T L I N E 1. Introduction 2. Diversification and risk 3. Modern portfolio theory 4. Asset pricing models 5. Summary 1.

### 15 Solution 1.4: The dividend growth model says that! DIV1 = \$6.00! k = 12.0%! g = 4.0% The expected stock price = P0 = \$6 / (12% 4%) = \$75.

1 The present value of the exercise price does not change in one hour if the risk-free rate does not change, so the change in call put is the change in the stock price. The change in call put is \$4, so

### Chapter 11. Topics Covered. Chapter 11 Objectives. Risk, Return, and Capital Budgeting

Chapter 11 Risk, Return, and Capital Budgeting Topics Covered Measuring Market Risk Portfolio Betas Risk and Return CAPM and Expected Return Security Market Line CAPM and Stock Valuation Chapter 11 Objectives

### CFA Examination PORTFOLIO MANAGEMENT Page 1 of 6

PORTFOLIO MANAGEMENT A. INTRODUCTION RETURN AS A RANDOM VARIABLE E(R) = the return around which the probability distribution is centered: the expected value or mean of the probability distribution of possible

### RISK AND RETURN WHY STUDY RISK AND RETURN?

66798_c08_306-354.qxd 10/31/03 5:28 PM Page 306 Why Study Risk and Return? The General Relationship between Risk and Return The Return on an Investment Risk A Preliminary Definition Portfolio Theory Review

### Risk and Uncertainty. Managerial Economics: Economic Tools for Today s Decision Makers, 4/e

Risk and Uncertainty Chapter 14 Managerial Economics: Economic Tools for Today s Decision Makers, 4/e By Paul Keat and Philip Young Risk and Uncertainty Risk versus Uncertainty Sources of Business Risk

### Risk and Return. a. 25.3% b. 22.5% c. 23.3% d. 17.1%

Risk and Return 1. The Duncan Company's stock is currently selling for \$15. People generally expect its price to rise to \$18 by the end of next year and that it will pay a dividend of \$.50 per share during

### Rate of Return. Reading: Veronesi, Chapter 7. Investment over a Holding Period

Rate of Return Reading: Veronesi, Chapter 7 Investment over a Holding Period Consider an investment in any asset over a holding period from time 0 to time T. Suppose the amount invested at time 0 is P

### Capital budgeting & risk

Capital budgeting & risk A reading prepared by Pamela Peterson Drake O U T L I N E 1. Introduction 2. Measurement of project risk 3. Incorporating risk in the capital budgeting decision 4. Assessment of

### any any assistance on on this this examination.

I I ledge on on my honor that I have not given or received any any assistance on on this this examination. Signed: Name: Perm #: TA: This quiz consists of 11 questions and has a total of 6 ages, including

### Chapter 9. The Valuation of Common Stock. 1.The Expected Return (Copied from Unit02, slide 36)

Readings Chapters 9 and 10 Chapter 9. The Valuation of Common Stock 1. The investor s expected return 2. Valuation as the Present Value (PV) of dividends and the growth of dividends 3. The investor s required

### Principles of Managerial Finance. Lawrence J. Gitman Chad J. Zutter

Global edition Principles of Managerial Finance Fourteenth edition Lawrence J. Gitman Chad J. Zutter This page is intentionally left blank. 278 Part 3 Valuation of Securities Figure 6.2 Impact of Inflation

### NorthCoast Investment Advisory Team 203.532.7000 info@northcoastam.com

NorthCoast Investment Advisory Team 203.532.7000 info@northcoastam.com NORTHCOAST ASSET MANAGEMENT An established leader in the field of tactical investment management, specializing in quantitative research

### Exercise 10. Here are inflation rates and US stock market and Treasury bill returns between 1929 and 1933:

CHAPTER 8 Exercise 10. Here are inflation rates and US stock market and Treasury bill returns between 199 and 1933: Year Inflation Stock Market Return T-bill Return 199 - -14.5 4.8 1930-6.0-8.3.4 1931-9.5-43.9

### This is the trade-off between the incremental change in the risk premium and the incremental change in risk.

I. The Capital Asset Pricing Model A. Assumptions and implications 1. Security markets are perfectly competitive. a) Many small investors b) Investors are price takers. Markets are frictionless a) There

### Executive Summary of Finance 430 Professor Vissing-Jørgensen Finance 430-62/63/64, Winter 2011

Executive Summary of Finance 430 Professor Vissing-Jørgensen Finance 430-62/63/64, Winter 2011 Weekly Topics: 1. Present and Future Values, Annuities and Perpetuities 2. More on NPV 3. Capital Budgeting

### Volatility and Premiums in US Equity Returns. Eugene F. Fama and Kenneth R. French *

Volatility and Premiums in US Equity Returns Eugene F. Fama and Kenneth R. French * Understanding volatility is crucial for informed investment decisions. This paper explores the volatility of the market,

### CAPM, Arbitrage, and Linear Factor Models

CAPM, Arbitrage, and Linear Factor Models CAPM, Arbitrage, Linear Factor Models 1/ 41 Introduction We now assume all investors actually choose mean-variance e cient portfolios. By equating these investors

### We have discussed the notion of probabilistic dependence above and indicated that dependence is

1 CHAPTER 7 Online Supplement Covariance and Correlation for Measuring Dependence We have discussed the notion of probabilistic dependence above and indicated that dependence is defined in terms of conditional

### M.I.T. Spring 1999 Sloan School of Management 15.415. First Half Summary

M.I.T. Spring 1999 Sloan School of Management 15.415 First Half Summary Present Values Basic Idea: We should discount future cash flows. The appropriate discount rate is the opportunity cost of capital.

### AFM 472. Midterm Examination. Monday Oct. 24, 2011. A. Huang

AFM 472 Midterm Examination Monday Oct. 24, 2011 A. Huang Name: Answer Key Student Number: Section (circle one): 10:00am 1:00pm 2:30pm Instructions: 1. Answer all questions in the space provided. If space

### The CAPM & Multifactor Models

The CAPM & Multifactor Models Business Finance 722 Investment Management Professor Karl B. Diether The Ohio State University Fisher College of Business Review and Clarification In the last few lectures

### Option Pricing Applications in Valuation!

Option Pricing Applications in Valuation! Equity Value in Deeply Troubled Firms Value of Undeveloped Reserves for Natural Resource Firm Value of Patent/License 73 Option Pricing Applications in Equity

### LECTURE 17: RISK AND DIVERSIFICATION

LECTURE 17: RISK AND DIVERSIFICATION I. STUDENT LEARNING OBJECTIVES A. Risk aversion B. Investment implications of risk aversion C. Standard deviation as a measure of risk for individual securities and

### FIN 3710. Final (Practice) Exam 05/23/06

FIN 3710 Investment Analysis Spring 2006 Zicklin School of Business Baruch College Professor Rui Yao FIN 3710 Final (Practice) Exam 05/23/06 NAME: (Please print your name here) PLEDGE: (Sign your name

### CHAPTER 6 : Some Alternative Investment Rules

CHAPTER 6 : Some Alternative Investment Rules 1. INTERNAL RATE OF RETURN [IRR] IRR is the discount rate which makes NPV=0 C1 C2 CT NPV C + + + L + 2 (1 + IRR ) (1 + IRR ) (1 + IRR) = 0 = T 2. NPV PROFILE

### Chapter 11 Cash Flow Estimation and Risk Analysis

Chapter 11 Cash Flow Estimation and Risk Analysis ANSWERS TO END-OF-CHAPTER QUESTIONS 11-1 a. Cash flow, which is the relevant financial variable, represents the actual flow of cash. Accounting income,

### INVESTMENTS IN OFFSHORE OIL AND NATURAL GAS DEPOSITS IN ISRAEL: BASIC PRINCIPLES ROBERT S. PINDYCK

INVESTMENTS IN OFFSHORE OIL AND NATURAL GAS DEPOSITS IN ISRAEL: BASIC PRINCIPLES ROBERT S. PINDYCK Bank of Tokyo-Mitsubishi Professor of Economics and Finance Sloan School of Management Massachusetts Institute

### A Basic Introduction to the Methodology Used to Determine a Discount Rate

A Basic Introduction to the Methodology Used to Determine a Discount Rate By Dubravka Tosic, Ph.D. The term discount rate is one of the most fundamental, widely used terms in finance and economics. Whether

### Economic Feasibility Studies

Economic Feasibility Studies ١ Introduction Every long term decision the firm makes is a capital budgeting decision whenever it changes the company s cash flows. The difficulty with making these decisions

### The Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) Tee Kilenthong UTCC c Kilenthong 2016 Tee Kilenthong UTCC The Capital Asset Pricing Model (CAPM) 1 / 36 Main Issues What is an equilibrium implication if all investors

### CHAPTER 20: OPTIONS MARKETS: INTRODUCTION

CHAPTER 20: OPTIONS MARKETS: INTRODUCTION 1. Cost Profit Call option, X = 95 12.20 10 2.20 Put option, X = 95 1.65 0 1.65 Call option, X = 105 4.70 0 4.70 Put option, X = 105 4.40 0 4.40 Call option, X

### Practice Set #4 and Solutions.

FIN-469 Investments Analysis Professor Michel A. Robe Practice Set #4 and Solutions. What to do with this practice set? To help students prepare for the assignment and the exams, practice sets with solutions

### CHAPTER 3. Arbitrage and Financial Decision Making. Chapter Synopsis

CHAPTER 3 Arbitrage and Financial Decision Making Chapter Synopsis 3.1 Valuing Decisions When considering an investment opportunity, a financial manager must systematically compare the costs and benefits

### LESSON 29: MARKOWITZ MODEL

LESSON 29: MARKOWITZ MODEL Harry M. Morkowitz is credited with introducing new concepts of risk measurement and their application to the selection of portfolios. He started with the idea of risk aversion

### Risk and return (1) Class 9 Financial Management, 15.414

Risk and return (1) Class 9 Financial Management, 15.414 Today Risk and return Statistics review Introduction to stock price behavior Reading Brealey and Myers, Chapter 7, p. 153 165 Road map Part 1. Valuation

### THE CAPITAL ASSET PRICING MODEL

THE CAPITAL ASSET PRICING MODEL Szabolcs Sebestyén szabolcs.sebestyen@iscte.pt Master in Finance INVESTMENTS Sebestyén (ISCTE-IUL) CAPM Investments 1 / 30 Outline 1 Introduction 2 The Traditional Approach

### FINANCIAL ECONOMICS OPTION PRICING

OPTION PRICING Options are contingency contracts that specify payoffs if stock prices reach specified levels. A call option is the right to buy a stock at a specified price, X, called the strike price.

### The Tangent or Efficient Portfolio

The Tangent or Efficient Portfolio 1 2 Identifying the Tangent Portfolio Sharpe Ratio: Measures the ratio of reward-to-volatility provided by a portfolio Sharpe Ratio Portfolio Excess Return E[ RP ] r

### One Period Binomial Model

FIN-40008 FINANCIAL INSTRUMENTS SPRING 2008 One Period Binomial Model These notes consider the one period binomial model to exactly price an option. We will consider three different methods of pricing

### Cost of Capital Presentation for ERRA Tariff Committee Dr. Konstantin Petrov / Waisum Cheng / Dr. Daniel Grote April 2009 Experience you can trust.

Cost of Capital Presentation for ERRA Tariff Committee Dr. Konstantin Petrov / Waisum Cheng / Dr. Daniel Grote April 2009 Experience you can trust. Agenda 1.Definition of Cost of Capital a) Concept and

### XII. RISK-SPREADING VIA FINANCIAL INTERMEDIATION: LIFE INSURANCE

XII. RIS-SPREADIG VIA FIACIAL ITERMEDIATIO: LIFE ISURACE As discussed briefly at the end of Section V, financial assets can be traded directly in the capital markets or indirectly through financial intermediaries.

### ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure

ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure Chapter 9 Valuation Questions and Problems 1. You are considering purchasing shares of DeltaCad Inc. for \$40/share. Your analysis of the company

### Chapter 7 Stocks, Stock Valuation, and Stock Market Equilibrium ANSWERS TO END-OF-CHAPTER QUESTIONS

Chapter 7 Stocks, Stock Valuation, and Stock Market Equilibrium ANSWERS TO END-OF-CHAPTER QUESTIONS 7-1 a. A proxy is a document giving one person the authority to act for another, typically the power

### Chapter 9 The Cost of Capital ANSWERS TO SELEECTED END-OF-CHAPTER QUESTIONS

Chapter 9 The Cost of Capital ANSWERS TO SELEECTED END-OF-CHAPTER QUESTIONS 9-1 a. The weighted average cost of capital, WACC, is the weighted average of the after-tax component costs of capital -debt,

### 2. Exercising the option - buying or selling asset by using option. 3. Strike (or exercise) price - price at which asset may be bought or sold

Chapter 21 : Options-1 CHAPTER 21. OPTIONS Contents I. INTRODUCTION BASIC TERMS II. VALUATION OF OPTIONS A. Minimum Values of Options B. Maximum Values of Options C. Determinants of Call Value D. Black-Scholes

### In developing appropriate investment strategies, one of the most important considerations is risk tolerance.

Investment Risk Explained Introduction In developing appropriate investment strategies, one of the most important considerations is risk tolerance. Risk is an unavoidable part of the investment process.

### MODERN PORTFOLIO THEORY AND INVESTMENT ANALYSIS

MODERN PORTFOLIO THEORY AND INVESTMENT ANALYSIS EIGHTH EDITION INTERNATIONAL STUDENT VERSION EDWIN J. ELTON Leonard N. Stern School of Business New York University MARTIN J. GRUBER Leonard N. Stern School