Financial Management in Organizations Chapter 6

What is the nature of the risk associated with "risk-free" U.S. government bonds?

"Risk-free" U.S. Government bonds have virtually no risk of default, but they are exposed to interest rate risk -- the chance that interest rates will rise, causing bond prices to fall and investors to experience either a real or an "opportunity" loss.

Jim Bowles is an investor who believes the economy is gaining strength and, therefore, wishes to increase the risk of his 14 security portfolio. Each security has a current market value of $5,000 and the current beta of the portfolio is 1.02. The beta of the least risky security is .76. If Jim replaces the least risky security with another security with the same market value but a beta of 1.45, what will the portfolio beta be then?

1.02 = (13/14)(X) + (1/14)(.76) So X = 1.04 βp = (13/14)(1.04) + (1/14)(1.45) = 1.069

An investor, who believes the economy is slowing down, wishes to reduce the risk of her portfolio. She currently owns 12 securities, each with a market value of $3,000. The current beta of the portfolio is 1.21 and the beta of the riskiest security is 1.62. What will the portfolio beta be if the riskiest security is replaced with a security of equal market value but a beta of 0.80?

1.21 = 11/12(x) + 1/12(1.62) so x = 1.17 portfolio beta = 11/12(1.17) + 1/12(.80) = 1.14

Sally's broker told her that the expected return from her portfolio was 14.2%. If 40% of her securities have an expected return of 10.3 percent and 20% have an expected return of 12.8 percent, what is the expected return of the remaining portion of her portfolio?

14.2% - 0.4(10.3%) - 0.2(12.8%) = 0.4 X X = 18.8%

What is the risk structure of interest rates?

15. The risk structure of interest rates is the pattern of interest rate yields for debt securities that are similar in all respects except for their risk.

How is risk defined in a financial sense?

Risk in a financial sense is defined as variability of returns. The greater the variability of a security's returns over time, the higher is its risk.

The____________is a statistical measure of the dispersion of a variable about the mean. It is an absolute measure of risk and is measured as the square root of the weighted average squared deviations of individual observations from the mean.

standard deviation

The stock of Amrep Corporation has a beta value estimated to be 1.4. How would you interpret this beta value? How would you evaluate the firm's systematic risk?

A beta of 1.4 indicates that Amrep has more than an average level of systematic risk (an average level being indicated by a beta of 1.0). An investor would expect Amrep common stock to have 40 percent more variability in its systematic returns than a stock with a beta of 1.0.

How is a security's beta value computed?

A security's beta value is computed as the slope of a regression line between holding period returns on the market portfolio and the individual security's holding period returns. It is specifically defined as the ratio of the covariance of the security's holding period returns with market holding period returns to the variance of the market's holding period returns.

What effect do increasing inflation expectations have on the required returns of investors in common stock?

An increase in the expected future inflation rate increases the investors' required rates of return on all securities, including common stocks. An increase in the required rate of return causes stock prices to decline as investors become unwilling to purchase these securities at existing prices.

____________is a measure of the systematic risk of an asset or security. It is defined as the ratio of the covariance of returns for some asset or security j and the market portfolio m to the variance of returns on the market portfolio.

Beta

Determine the beta of a portfolio consisting of equal investments in the following common stocks: Security Beta Apple Computer 1.15 Coca-Cola 1.05 Harley-Davidson 1.50 Homestake Mining 0.50

Bp = .25(1.15) + .25(1.05) + .25(1.50) + .25(.50) = 1.05

____________is the Capital Asset Pricing Model, a theory which describes the relationship between risk and required return for securities and other assets.

CAPM

Explain how diversification can reduce the risk of a portfolio of assets to below the weighted average of the risk of the individuals assets.

Diversification can reduce the risk of a portfolio of assets below that of the weighted average risk of the individual assets because when assets are combined together in a group or portfolio, extreme returns in one direction from one asset may be offset by extreme returns in the other direction from another asset.

Why do yield curves sometimes have a downward slope and at other times have an upward slope?

Downward sloping yield curves usually indicate that investors expect interest rates (and inflation rates) to decline in the future. Upward sloping yield curves reflect both future interest rate expectations but the liquidity premium required for long-term securities.

Don has $3,000 invested in AT&T with an expected return of 11.6 percent; $10,000 in IBM with an expected return of 12.8 percent; and $6,000 in GM with an expected return of 12.2 percent. What is Don's expected return on his portfolio?

E(Rp) = (3/19)11.6% + (10/19)12.8% + (6/19)12.2% = 12.42%

An investor plans to invest 75 percent of her funds in the common stock of Gamma Industries and 25 percent in Epsilon Company. The expected return on Gamma is 12 percent and the expected return on Epsilon is 16 percent. The standard deviation of returns for Gamma is 8 percent and for Epsilon is 12 percent. The correlation between the returns for Gamma and Epsilon is +0.8. Determine the expected return on the investor's portfolio.

E(Rp) =0 .75(12%) + 0.25(16%) = 13%

Correlation is a statistical measure of the relationship between a series of numbers representing data. Which of the following statements about correlation is/are correct? I. Perfectly negatively correlated describes two negatively correlated stocks that have a correlation coefficient of -1. II. Perfectly positively correlated describes two positively correlated stocks that have a correlation coefficient of 0.

I only

Discuss the general relationship between risk and expected returns.

In general, the higher a security's risk, the greater is its expected return.

Is it possible for investors ever to require a lower rate of return on a company's equity than on its debt, assuming that the debt is in a junk-bond category of quality?

No. The cost of equity capital for a firm must always be greater than the cost of debt capital to that same firm, because equity capital has the lowest priority of payment in case of default, has no fixed dividends, and has no known maturity date. Sometimes, at very high interest rates it might appear that the cost of equity is lower than the cost of debt for a firm, but this illusion simply reflects errors in the process of calculating the cost of equity.

____________ define the percentage chance of occurrence of each of one or more possible outcomes.

Probability distributions

What factors determine investors' required rates of return on corporate bonds? Common stocks? U.S. government bonds?

Required rates of return on all securities include a default-risk-free rate of return, composed of a real rate of return and a purchasing power loss premium. Government and corporate bonds also have a maturity risk premium, reflecting the term structure of interest rates prevailing in the capital markets. Corporate bonds and equities have a default risk premium to reflect the possibility that interest and/or principal will not be paid when due. Some corporations issue various classes of debt and preferred stock securities. For the more junior debt securities of a firm, that is, the bonds with the least protection in the case of default, such as subordinated debentures, investors demand a seniority risk premium. Within individual security classes, such as common stock or corporate bonds, one observes significant differences in required rates of return between firms. These differences reflect the business and financial risk facing that firm. Finally, some securities, such as the stock of closely held firms or small corporate bond offerings, reflect a marketability risk premium.

____________ refers to the chance for some unfavorable event to occur. In finance, risk is the possibility that actual returns or cash flows from an investment will be less than expected.

Risk

____________is that portion of the variability in a security's return that is caused by factors affecting the market as a whole. It is also called nondiversifiable risk.

Systematic risk

Distinguish between unsystematic and systematic risk. Under what circumstances are investors likely to ignore the unsystematic risk characteristics of a security?

Systematic risk refers to that portion of the variability of an individual security's return that is caused by factors affecting the market as a whole. It is usually measured by the security's "beta" value. Unsystematic risk is risk that is unique to the firm. It is the variability of a security's returns that is caused by such factors as management capabilities and decisions, strikes, availability of supplies, unique effects of government regulation, the firm's operating and financial leverage, and the effects of foreign competition. An investor who owns a well-diversified portfolio of individual securities will be exposed to very little unsystematic risk. Hence this risk dimension can be ignored in many cases.

Under what circumstances can the beta concept be used to estimate the rate of return required by investors in a stock?What problems are encountered when using the CAPM?

The beta concept can be used to estimate the cost of equity capital for a firm, assuming that investors tend to hold well-diversified portfolios of securities, making systematic risk the appropriate risk measure. Because beta must be estimated from historical data, it is important to remember that historically estimated betas do not capture any future change in the firm's systematic risk characteristics. Hence, if a firm is about to merge or significantly change its product line makeup, then the historical beta may not be an accurate reflection of expected future systematic risk. When computing the cost of equity using the beta concept, an analyst must estimate the expected risk-free rate and the expected market rate of return. These estimates are subject to differences in judgment between analysts.

Under what circumstances will the coefficient of variation of a security's returns and the standard deviation of that security's returns give the same relative measure of risk when compared with the risk of another security?

The coefficient of variation and the standard deviation of a security's return will give the same relative measure of risk when compared to the risk of another security when both securities have the same level of expected returns.

What are the primary variables that influence the risk of a portfolio of assets?

The primary variables that influence the risk of a portfolio of assets are the risk of the individual assets in that portfolio, the relative proportion of each asset in the portfolio, and the correlation between the returns of the assets in the portfolio.

If the returns from a security were known with certainty, what shape would the probability distribution of returns graph have?

The probability distribution of a security whose returns are known with certainty is a single vertical line with a height equal to 1.0 (100%) at the level of the known return.

What is the term structure of interest rates?

The term structure of interest rates is the pattern of interest rate yields for debt securities that are similar in all respects except for their time remaining to maturity.

What is the primary difference between 20 year bonds issued by the U.S. Government and 20 year bonds issued by IBM?

There is virtually no risk of default on U.S. Government bonds, because the U.S. government can always print more money (although it would be worthless). In contrast, IBM bonds do carry some default risk, albeit a small risk.

Dana has a portfolio of 8 securities, each with a market value of $5,000. The current beta of the portfolio is 1.28 and the beta of the riskiest security is 1.75. Dana wishes to reduce her portfolio beta to 1.15 by selling the riskiest security and replacing it with another security with a lower beta. What must be the beta of the replacement security?

To find the beta for the 7 securities: 1.28 = 7/8(x) + 1/8(1.75) x = 1.21 New security's beta would be: 1.15 = 7/8 (1.21) + 1/8 beta beta = 0.73

____________is risk that is unique to a firm. It is also called diversifiable risk.

Unsystematic risk

If inflation expectations increase, what would you expect to happen to the returns required by investors in bonds? What would happen to bond prices?

With increased inflation expectations, required returns on bonds would tend to increase and bond prices would decline.

Investors generally are considered to be risk ____ because they expect to be compensated for assuming risk.

averse

The security market line can be thought of as expressing relationships between required rates of return and

beta

The____________is a line joining the risk-free rate and the market portfolio. It indicates the risk and expected returns that can be obtained by investing various proportions of one's wealth in the risk-free security and the market portfolio of (risky) securities.

capital market line

All of the following factors have their primary impact on unsystematic risk except

changes in inflation

All of the following are primary sources of systematic risk except: changes in the amount of foreign competition facing an industry interest rate changes changes in purchasing power changes in investor expectations about the economy

changes in the amount of foreign competition facing an industry

The____________is a regression line relating the periodic holding period returns for a specific security to the periodic holding period returns on the market portfolio.

characteristic line

The____________is a relative statistical measure of the degree to which two series of numbers, such as the returns from two securities, tend to move or vary together.

correlation coefficient

Values of the ____ can range from +1.0 to -1.0.

correlation coefficient

The____________is an absolute statistical measure of the degree to which two series of numbers tend to move or vary together.

covariance

The____________consists of the set of efficient portfolios

efficient frontier

In order to completely eliminate the risk (i.e., a portfolio standard deviation of zero) in a two-asset portfolio, the correlation coefficient between the securities must be ____.

equal to -1.0

The ____ is a statistical measure of the mean or average value of the possible outcomes.

expected value

Which of the following is not an example of a source of systematic risk?

foreign competition with an industry's products

Which of the following is not an approach for managing risk:

ignoring systematic risk

The____________coefficient of variation

is a measure of relative risk. It is defined as the ratio of the standard deviation to the mean of some variable.

The risk-free rate of return is 5.51 percent, based on an expected inflation premium of 2.54 percent. The expected return on the market is 12.8 percent. What is the required rate of return for Envoy common stock which has a beta of 1.35?

kj = 5.51 + 1.35(12.8-5.51) = 15.35%

In general, when the correlation coefficient between the returns on two securities is ____, the risk of a portfolio is ____ the weighted average of the total risk of the two individual securities.

less than +1.0 and less than equal to +1.0

A____________is a collection of two or more assets or securities.

portfolio

A____________is____________if, for a given standard deviation, there is no other portfolio with a higher expected return, or, for a given expected return, there is no other portfolio with a lower standard deviation.

portfolio , efficient

The____________of an investment is the level of return investors demand, given the risk of the investment.

required rate of return

A beta value of 0.5 for a security indicates

security has a below average systematic risk

The____________defines the relationship between systematic risk and the required returns for individual securities.

security market line

The ____ is an absolute measure of risk, and the ____ is a relative measure of risk.

standard deviation, coefficient of variation

The most relevant risk that must be considered for any widely traded individual security is its ____.

systematic risk

The risk remaining after extensive diversification is primarily:

systematic risk