FIN 320: Chapter Eight (Risk and Rates of Return)

Calculate Happy Corp.'s new required return. Then, on the graph, use the green points (rectangle symbols) to plot the new SML suggested by this analyst's prediction.

(0,5), (1,11)

Calculate Happy Corp.'s new required return. Then, on the graph, use the green points (rectangle symbols) to plot the new SML suggested by this analyst's prediction.

(0,7), (1.2,12.4)

If investors expect the average realized return from 2014 to 2018 on FF's stock to continue into the future, its coefficient of variation (CV) will be ___.

0.45 (0.0799 / 0.1778)

If investors expect the average realized return from 2014 to 2018 on BLM's stock to continue into the future, its coefficient of variation (CV) will be ___.

0.45 (Standard Deviation / Average Return = 0.0913 / 0.2032)

According to Brandon's recommendation, assuming that the market is in equilibrium, how much will the portfolio's required return change?

0.8690 percentage points

The expected rate of return on Falcon Freight's stock over the next year is ___.

1.38%

The expected rate of return on Tyler's portfolio over the next year is ___.

1.79%

The expected rate of return on Happy Dog Soap's stock over the next year is ___.

10.51%

What is the expected return on Andre's stock portfolio?

10.70% ( % of Portfolio * Expected Return) + ... (e.g. 0.20*0.06)+(0.30*0.14) + ...

An analyst believes that inflation is going to increase by 3.0% over the next year, while the market risk premium will be unchanged. The analyst uses the Capital Asset Pricing Model (CAPM). The following graph plots the current SML. Happy Corp.'s new required rate of return is ___.

11.0%

The expected rate of return on Dominic's portfolio over the next year is ___.

11.73%

The expected rate of return on Black Sheep Broadcasting's stock over the next year is ___.

15.38%

The expected rate of return on Celestial Crane Cosmetics's stock over the next year is ___.

19.13%

Suppose an investor, Erik, is offered the investment opportunities described in the table below. Each investment costs $1,000 today and provides a payoff, also described below, one year from now.

1: 100% chance of receiving $1,100 2: 50% chance of receiving $1,000 50% chance of receiving $1,200 3: 50% chance of receiving $200 50% chance of receiving $2,000

Risk-free rate (rRF): Market risk premium (RPM): Happy Corp. stock's beta: Required rate of return on Happy Corp. stock:

2.0% 6.0% 1.0 8.0%

Given the preceding data, the average realized return on BLM's stock is ___.

20.32% ([0.2000 + 0.1360 + 0.2400 + 0.3360 + 0.1040] / 5)

The expected rate of return on Ethan's portfolio over the next year is ___.

21.26%

The expected rate of return on Lumbering Ox Truckmakers's stock over the next year is ___.

27.63%

Risk-free rate (rRF): Market risk premium (RPM): Happy Corp. stock's beta: Required rate of return on Happy Corp. stock:

5.0% 4.5% 1.2 10.4%

Generally, investors would prefer to invest in assets that have:

A higher-than-average expected rate of return given its perceived risk.

A financial planner is examining the portfolios held by several of her clients. Which of the following portfolios is likely to have the smallest standard deviation?

A portfolio consisting of about three randomly selected stocks from different sectors.

Use the following graph of the security market line (SML) to plot each stock's beta and expected return on the graph.

A: (0.5, 7.5) B: (1, 12) C: (2, 14)

Wilson holds a portfolio that invests equally in three stocks (wAwA = wBwB = wCwC = 1/3).

A: 0.5, 23%, 7.5% B: 1.0, 38%, 12.0% C: 2.0, 45%, 14.0%

Suppose all stocks in the portfolio were equally weighted. Which of these stocks would have the least amount of stand-alone risk?

Andalusian Limited

8. Portfolio risk and return Elle holds a $10,000 portfolio that consists of four stocks. Her investment in each stock, as well as each stock's beta, is listed in the following table:

Andalusian Limited (AL): $3,500, 1.00, 9.00% Tobotics Inc. (TI): $2,000, 1.701, 1.50% Western Gas & Electric Co. (WGC): $1,500, 1.15, 20.00% Makissi Corp. (MC): $3,000, 0.30, 25.50%

A collection of financial assets and securities is referred to as a portfolio. Most individuals and institutions invest in a portfolio, making portfolio risk analysis an integral part of the field of finance. Just like stand-alone assets and securities, portfolios are also exposed to risk. Portfolio risk refers to the possibility that an investment portfolio will not generate the investor's expected rate of return.

Artemis Inc.: 20%, 6.00%, 30.00% Babish & Co.: 30%, 14.00%, 34.00% Cornell Industries: 35%, 13.00%, 37.00% Danforth Motors: 15%, 5.00%, 39.00%

Brandon is an analyst at a wealth management firm. One of his clients holds a $7,500 portfolio that consists of four stocks.

Atteric Inc. (AI): 35%, 0.750, 38.00% Arthur Trust Inc. (AT): 20%, 1.600, 42.00% Li Corp. (LC): 15%, 1.100, 45.00% Transfer Fuels Co. (TF): 30%, 0.300, 49.00%

If the risk-free rate is 4% and the market risk premium is 5.5%, what is Elle's portfolio's beta and required return?

Beta = 0.9525 (Sum of all Weighted Betas) Required Return = 9.24% (0.04+0.9525*0.055)

If the risk-free rate is 7% and the market risk premium is 8.5%, what is Ariel's portfolio's beta and required return?

Beta = 0.9825 (Sum of all Weighted Beta) Required Return = 15.35% (0.07+0.913*0.085)

Company A = Orange, tall, thin Company B = Green, short, wide Based on the graph's information, which of the following statements is true?

Company A has a smaller standard deviation.

Company G = Orange, tall, thin Company H = Green, short, wide Based on the graph's information, which company's returns exhibit the greater risk?

Company H

Company G = Orange, tall, thin Company H = Green, short, wide Based on the graph's information, which statement is false?

Company H has lower risk.

In contrast to his brother Erik, Devin is a risk lover (or exhibits risk seeking behavior). Which of the following statements is true about Devin?

Everything else remaining constant, Devin will prefer option 3.

The market risk component of the total portfolio risk can be reduced by randomly adding stocks to the portfolio.

False

The risk in a portfolio will increase if more stocks that are negatively correlated with other stocks are added to the portfolio.

False

Suppose all stocks in the portfolio were equally weighted. Which of these stocks would have the least amount of stand-alone risk?

Kulatsu Motors Co.

Suppose all stocks in Ariel's portfolio were equally weighted. Which of these stocks would contribute the least market risk to the portfolio?

Mainway Toys Co.

Suppose all stocks in Elle's portfolio were equally weighted. Which of these stocks would contribute the least market risk to the portfolio?

Makissi Corp.

An analyst believes that inflation is going to increase by 2.0% over the next year, while the market risk premium will be unchanged. The analyst uses the Capital Asset Pricing Model (CAPM).

New Required Rate of Return: 12.4%

Suppose, based on the earnings consensus of stock analysts, Brandon expects a return of 6.24% from the portfolio with the new weights. Does he think that the required return as compared to expected returns is undervalued, overvalued, or fairly valued?

Overvalued

Five years of realized returns for FF are given in the following table. Remember: 1. While FF was started 40 years ago, its common stock has been publicly traded for the past 25 years. 2. The returns on its equity are calculated as arithmetic returns. 3. The historical returns for FF for 2014 to 2018 are:

Stock Return: 17.50%, 11.90%, 21.00%, 29.40%, 9.10%

Five years of realized returns for BLM are given in the following table. Remember: 1. While BLM was started 40 years ago, its common stock has been publicly traded for the past 25 years. 2. The returns on its equity are calculated as arithmetic returns. 3. The historical returns for BLM for 2014 to 2018 are:

Stock Return: 20.00%, 13.60%, 24.00%, 33.60%, 10.40%

Tyler owns a two-stock portfolio that invests in Falcon Freight Company (FF) and Pheasant Pharmaceuticals (PP). Three-quarters of Tyler's portfolio value consists of FF's shares, and the balance consists of PP's shares.

Strong: 0.20, 27.5%, 38.5% Normal: 0.35, 16.5%, 22% Weak: 0.45, -22%, -27.5%

Dominic owns a two-stock portfolio that invests in Happy Dog Soap Company (HDS) and Black Sheep Broadcasting (BSB). Three-quarters of Dominic's portfolio value consists of HDS's shares, and the balance consists of BSB's shares.

Strong: 0.25, 37.5%, 52.5% Normal: 0.45, 22.5%, 30% Weak: 0.30, -30%, -37.5%

Ethan owns a two-stock portfolio that invests in Celestial Crane Cosmetics Company (CCC) and Lumbering Ox Truckmakers (LOT). Three-quarters of Ethan's portfolio value consists of CCC's shares, and the balance consists of LOT's shares.

Strong: 0.50, 42.5%, 59.5% Normal: 0.25, 25.5%, 34% Weak: 0.25, -34%, -42.5%

Which of the following statements best describes the shape of the SML if investors were not at all risk averse?

The SML would be a horizontal line.

If Erik is risk averse, which investment will he prefer?

The investor will choose option 1.

Based on your understanding of P/E ratios, in which of the following situations would the average trailing P/E ratio (current price divided by earnings per share over the previous 12 months) of the S&P 500 Index be higher?

The outlook for the economy and the markets is for an improvement.

Which of the following statements best describes a shift in the SML caused by increased risk aversion?

The risk-free rate will remain constant.

The preceding data series represents ___ of FF's historical returns. Based on this conclusion, the standard deviation of FF's historical returns is ___.

a sample / 7.99% (STDEV.S(17.5%,11.9%,21%,29.4%,9.1%))

The preceding data series represents ___ of BLM's historical returns. Based on this conclusion, the standard deviation of BLM's historical returns is ___.

a sample / 9.13% ((0.0083392)^(1/2))

A stock is in equilibrium if its expected return ___ its required return. In general, assume that markets and stocks are in equilibrium (or fairly valued), but sometimes investors have different opinions about a stock's prospects and may think that a stock is out of equilibrium (either undervalued or overvalued).

equals

The SML helps determine the risk-aversion level among investors. The steeper the slope of the SML, the ___ the level of risk aversion.

higher

Suppose instead of replacing Atteric Inc.'s stock with Transfer Fuels Co.'s stock, Brandon considers replacing Atteric Inc.'s stock with the equal dollar allocation to shares of Company X's stock that has a higher beta than Atteric Inc. If everything else remains constant, the portfolio's beta would ___.

increase

Suppose each stock in Andre's portfolio has a correlation coefficient of 0.4 (ρ = 0.4) with each of the other stocks. If the weighted average of the risk of the individual securities (as measured by their standard deviations) included in the partially diversified four-stock portfolio is 35%, the portfolio's standard deviation (σpσp) most likely is ___ 35%.

less than

The SML helps determine the risk-aversion level among investors. The higher the level of risk aversion, the ___ the slope of the SML.

steeper

Based on the analyst's expected return estimates, Stock A is ___, Stock B is ___, and Stock C is in equilibrium and fairly valued.

undervalued / undervalued

Given the preceding data, the average realized return on FF's stock is ___.

17.78% (17.5%+11.9%+21%+29.4%+9.1% / 5)

The expected rate of return on Pheasant Pharmaceuticals's stock over the next year is ___.

3.02%

Ariel holds a $5,000 portfolio that consists of four stocks. Her investment in each stock, as well as each stock's beta, is listed in the following table:

Omni Consumer Products Co. (OCP): $1,750, 0.80, 15.00% Kulatsu Motors Co. (KMC): $1,000, 1.90, 11.50% Three Waters Co. (TWC): $750, 1.15, 16.00% Mainway Toys Co. (MTC): $1,500, 0.50, 28.50%

You invest $100,000 in 40 stocks, 20 bonds, and a certificate of deposit (CD). To which kind of risk will you primarily be exposed?

Portfolio risk

The following graph plots the current security market line (SML) and indicates the return that investors require from holding stock from Happy Corp. (HC).

Return on HC's Stock: (1,8)

The following graph plots the current security market line (SML) and indicates the return that investors require from holding stock from Happy Corp. (HC).

Return on HC's Stock: (1.2,10.4)

A portfolio's risk is not equal to the weighted average of the individual stocks' standard deviations.

True

When returns on Stock A increase, returns on Stock B also increase. In general, this would mean that Stocks A and B are positively correlated.

True