Unit 6

In theory, which of the following coefficients of correlation would eliminate unsystematic risk in an investment portfolio?

-1 The correlation coefficient measures the degree to which any two variables, e.g., two stocks in a portfolio, are related. Perfect negative correlation (-1.0) means that the two variables always move in the opposite direction. Given perfect negative correlation, unsystematic risk is, in theory, eliminated.

The following information pertains to three shipping terminals operated by Krag Corp.: Terminal Percentage of Cargo Handled Percentageof Error Land 50 2 Air 40 4 Sea 10 14 Krag's internal auditor randomly selects one set of shipping documents, ascertaining that the set selected contains an error. The probability that the error occurred in the land terminal is

25% The probability of an error was 4% [(50% × 2%) + (40% × 4%) + (10% × 14%)]. Consequently, the probability that the error occurred in the land terminal is 25% [(50% × 2%) ÷ 4%].

The following information is available on market interest rates: The risk-free rate of interest 2% Inflation premium 1% Default risk premium 3% Liquidity premium 2% Maturity risk premium 1% What is the market rate of interest on a 1-year U.S. Treasury bill?

3% The total return on a U.S. Treasury security consists of the risk-free rate of interest plus an inflation premium. In practice, the safest investment in the world has been U.S. Treasury Securities. While there is some risk in these investments, they have been regarded as the risk-free rate when used in a CAPM analysis. Therefore, the nominal rate of U.S. Treasuries is often used in practice as the risk-free rate in the CAPM analysis.

Expected value in decision analysis is

An arithmetic mean using the probabilities as weights. Expected value analysis is an estimate of future monetary value based on forecasts and their related probabilities of occurrence. The expected value is found by multiplying the probability of each outcome by its payoff and summing the products. Expected value is therefore an arithmetic mean using probabilities as weights.

One type of risk to which investment securities are subject can be offset through portfolio diversification. This type of risk is referred to as

Company unique risk. Unsystematic risk, also called company or diversifiable risk, is the risk inherent in a particular investment security. Because individual securities are affected by the particular strengths and weaknesses of the issuer, this risk can be offset through portfolio diversification.

Which of the following is most useful when risk is being prioritized?

Expected value. Expected value is the predicted value for a given investment. Expected value is derived by multiplying each possible outcome by the likelihood that each outcome will occur and summing the results. Through this analysis, investors can choose the scenario that is most likely to give them their desired outcome.

Management's financial estimates are based on all of the following except:

Irrelevance. Management will only base estimates on relevant information.

The expected monetary value of an event

Is equal to the payoff of the event times the probability the event will occur. For decisions involving risk, the concept of expected value provides a rational means for selecting the best alternative. The expected value of a decision is found by multiplying the probability of each outcome by its payoff, and adding the products. The result is the long-term average payoff for repeated trials.

Management utilizes all of the following procedures to develop accounting estimates except

Management does not emphasize historical experience when making an accounting estimate. History is factual and the estimation process is not required.

The type of risk that is undiversifiable and affects the value of a portfolio is

Market risk. Prices of all stocks, even the value of portfolios, are correlated to some degree with broad swings in the stock market. Market risk is the risk that changes in a stock's price will result from changes in the stock market as a whole. Market risk is commonly referred to as undiversifiable risk.

Because of the large number of factors that could affect the demand for its new product, interactions among these factors, and the probabilities associated with different values of these factors, the marketing department would like to develop a computerized model for projecting demand for this product. By using a random-number procedure to generate values for the different factors, it will be able to estimate the distribution of demand for this new product. This method of estimating the distribution of demand for the new product is called

Monte Carlo simulation. Simulations that use a random-number procedure to generate values for the inputs are Monte Carlo simulations.

Management's financial estimates are based on all of the following except

Prespecifications. Management judgment is the basis for accounting estimates and includes the knowledge of and experience gained during current and past events, but not prespecifications of future events. If they were prespecified and known, they would not be estimates.

n decision theory, those uncontrollable future events that can affect the outcome of a decision are

States of nature. Applying decision theory requires the decision maker to develop an exhaustive list of possible future events. All possible future events that might occur must be included, even though the decision maker is likely to be uncertain about which specific events will occur. These future uncontrollable events are states of nature.

A company is conducting a risk analysis on a project. One task has a risk probability estimated to be 0.15. The task has a budget of $35,000. If the risk occurs, it will cost $6,000 to correct the problem caused by the risk event. What is the expected monetary value of the risk event?

The expected monetary value of the risk event is the probability associated with the event multiplied by the cash flows from the event. Thus, the risk event has an expected monetary value of $900 ($6,000 × 15%).

Konstans Corp. is considering purchasing an investment security with the following information: Likelihood Return on Investment50%40%10%The expected return on this investment is2%4%14%

The expected return on this investment is 4% [(50% × 2%) + (40% × 4%) + (10% × 14%)].

Dough Distributors has decided to increase its daily muffin purchases by 100 boxes. A box of muffins costs $2 and sells for $3 through regular stores. Any boxes not sold through regular stores are sold through Dough's thrift store for $1. Dough assigns the following probabilities to selling additional boxes through regular stores: Additional Sales: Probability 60: .6 100: .4 What is the expected value of Dough's decision to buy 100 additional boxes of muffins?

The expected value is determined by multiplying the probability of each outcome by its payoff and summing the products. Dough has decided to increase its daily muffin purchases by 100 boxes. Any boxes sold through regular stores generate a profit of $1 ($3 - $2). Any boxes not sold through regular stores are sold through the thrift store, resulting in a loss of $1 ($1 - $2). If Dough only sells 60 boxes of muffins through regular stores, the remaining boxes will be sold through the thrift store, and the profit will be $20 [(60 boxes × $1 profit) - (40 boxes × $1 loss)]. If Dough sells 100 boxes through regular stores, the profit will be $100 (100 boxes × $1 profit). The expected value is 60 boxes: $20 × .6 = $12 100 boxes: $100 × .4 = 40 $52

Fact Pattern:A company is considering three alternative machines to produce a new product. The cost structures (unit variable costs plus avoidable fixed costs) for the three machines are shown as follows. The selling price is unaffected by the machine used. Single purpose machine$.60x + $20,000 Semiautomatic machine$.40x + $50,000 Automatic machine$.20x + $120,000 The demand for units of the new product is described by the following probability distribution. Demand Probability 200,0000 .4 300,0000 .3 400,0000 .2 500,0000 .1 Using the expected value criterion,

The semiautomatic machine should be used because it has the lowest expected cost. The semiautomatic machine has an expected cost of $170,000 [($.40 × 300,000) + $50,000] based on an expected demand of 300,000 units [(.4 × 200,000) + (.3 × 300,000) + (.2 × 400,000) + (.1 × 500,000)]. The single purpose machine has an expected cost of $200,000 [($.60 × 300,000) + $20,000]. The automatic machine has an expected cost of $180,000 [($.20 × 300,000) + $120,000)]. Hence, the semiautomatic machine has the lowest expected cost at the expected level of demand.

Management utilizes all of the following procedures to develop accounting estimates except a. Presenting estimates in conformity with GAAP. b. Excluding uncertainty from assumptions. c. Predicting most likely circumstances and scenarios. d. Identifying circumstances requiring an estimate.

b. Excluding uncertainty from assumptions. If uncertainty is excluded from assumptions in the development of estimates, they will not be estimates, they will be factual and the estimation process is not required.