FIN 450 Ch. 5

Assume that the economy can experience high growth, normal growth, or recession. Under these conditions, you expect the following stock market returns for the coming year: State of the Economy;Probability;Return High Growth: 0.2; 65% Normal Growth: 0.7; 18% Recession: 0.1; -20% Compute the expected value of a $1,000 investment over the coming year. If you invest $1,000 today, how much money do you expect to have next year? What is the percentage expected rate of return? The expected value is _______ and the expected rate of return is _______ %. Compute the standard deviation of the percentage return over the coming year. Standard deviation = _____ If the risk-free return is 7 percent, what is the risk premium for a stock market investment? Risk premium = _______

$1,236; 23.6% 23.6% 16.6%

The expected return from a portfolio made up equally of two assets that move perfectly opposite of each other would have a standard deviation equal to

0

Which of the following investments would be most attractive to a risk-averse investor? How would your answer differ if the investor were described as risk-neutral?

A risk-averse investor will prefer investment B because it has a higher expected return than investment A for the same level of risk and the same expected return as investment C for a lower level of risk. A risk-neutral investor would be indifferent between investments B and C and prefer them to investment A because they have a higher expected value.

For each of the following events, identify whether it represents systematic risk or idiosyncratic risk. a. Your favorite restaurant is closed by the county health department. b. Unexpectedly high inflation leads to a reduction in consumer spending in many developed nations. c. Freezing weather in Florida destroys the orange crop. d. A hurricane on the gulf coast damages dozens of homes and businesses.

Idiosyncratic risk Systematic risk Idiosyncratic risk Idiosyncratic risk

Which one of the following is true?

Investments with higher risk generally have a higher expected return than risk-free investments.

Which one of the following would not be included in a definition of risk?

Risk can always be avoided at no cost.

For each of the following actions, identify whether the method of risk assessment motivating the action is due to the value at risk or the standard deviation of an underlying probability distribution. a. You buy life insurance. b. A homeowner purchases fire insurance. c. In your role as a central banker, you provide emergency loans to illiquid intermediaries. d. A clothing boutique decides to sell both men's and women's apparel.

Value at risk Value at risk Value at risk Standard deviation

If ABC Inc. and XYZ Inc. have returns that are perfectly positively correlated,

adding XYZ Inc. to a portfolio that consists of only ABC Inc. will neither increase nor decrease the risk of the portfolio.

A risk-averse investor will

always prefer an investment with a certain return to one with the same expected return but that has any amount of uncertainty.

Unique risk is another name for

idiosyncratic risk.

The risk premium for an investment

increases with risk.

Which one of the following investment strategies involves generating a higher expected rate of return through increasing risk?

leverage

Another name for the expected value of an investment would be the

mean value

If the returns of two assets are perfectly positively correlated, an investor who puts half of their savings into each will

not gain from diversification.

The difference between standard deviation and value at risk is

standard deviation reflects the spread of possible outcomes, whereas value at risk focuses on the value of the worst outcome.

Inflation presents risk because

there is no certainty regarding what inflation will be in the future.