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Week 9 Homework Assignment Chapter 11 10. We use the following relationship: 1 + nominal rate of return Real rate of return = −1 1 + inflation rate Asset Class Treasury bills Treasury bonds Common stocks Nominal Rate of Return 3.80% 5.30% 11.40% Inflation Rate 3.00% 3.00% 3.00% Real Rate of Return 0.78% 2.23% 8.16% 12. In 2018, the Dow was nearly 206% above the 2009 level. Therefore, in 2018, a 40-point movement was far less significant in percentage terms than it was in 2009. We would expect to see more 40-point days in 2018 even if market risk as measured by percentage returns is no higher than it was in 2009. 13. a. b. Interest rates tend to fall at the outset of a recession and rise during boom periods. Because bond prices move inversely with interest rates, bonds provide higher returns during recessions when interest rates fall. rstock = [0.2 (−.05)] + (0.6 .15) + (0.2 .25) = .13 or 13.0% rbonds = (0.2 .14) + (0.6 .08) + (0.2 .04) = .084 or 8.4% Variance (stocks) = [0.2 (−.05 − .13)2] + [0.6 (.15 − .13)2] + [0.2 (.25 – .13)2] = .0096 Standard deviation = .0096 = .098 or 9.80% Variance (bonds) = [0.2 (.14 − .084)2] + [0.6 (.08 − .084)2] + [0.2 (.04 − .084)2] = .001024 Standard deviation = c. .001024 = 3.20% Stocks have both higher expected return and higher volatility. More risk-averse investors will choose bonds, while those who are less risk-averse might choose stocks. Solutions to Chapter 12 Risk, Return, and Capital Budgeting 1. The risks of deaths of individual policyholders are largely independent and are therefore diversifiable. The insurance company is satisfied to charge a premium that reflects actuarial probabilities of death, without an additional risk premium. In contrast, flood damage is not independent across policyholders. If my coastal home floods in a storm, there is a greater chance that my neighbor’s will too. Because flood risk is not diversifiable, the insurance company may not be satisfied with charging a premium that reflects only the expected value of payouts. 2. The actual returns for the Snake Oil fund exhibit considerable variation around the regression line. This indicates that the fund is subject to diversifiable risk: It is not well diversified. The variation in the fund’s returns is influenced by more than just market-wide events. 3. Beta tells us how sensitive the stock return is to changes in market performance. The market return was 5% less than your prior expectation. Therefore, the stock would be expected to fall short of your original expectation by: 0.8 5% = 4% The “updated” expectation for the stock return is 12% – 4% = 8%. 4. a. A diversified investor will find the lowest-beta stock safest. This is Walmart, which has a beta of 0.37. b. Walmart also has the lowest total volatility; the standard deviation of its returns is 16.4%. c. = (2.39 + 1.07 + 0.37)/3 = 1.28 d. The portfolio will have the same beta as Intel (1.07). The total risk of the portfolio will be 1.07 times the total risk of the market portfolio because the effect of firmspecific risk will be diversified away. Therefore, the standard deviation of the portfolio is 1.07 20% = 21.40%. e. Using the CAPM, we compute the expected rate of return on each stock from the equation r = rf + (rm – rf). In this case: rf = 4% and (rm– rf) = 8% Marathon Oil: r = 4% + (2.39 8%) = 23.12% Intel: r = 4% + (1.07 8%) = 12.56% Walmart: r = 4% + (0.37 8%) = 6.96% Chapter 11: 10. Real versus Nominal Returns. The inflation rate in the United States has averaged 3% a year since 1900. What was the average real rate of return on Treasury bills, Treasury bonds, and common stocks in that period? Use the data in Table 11.1 . (LO11-2) 12. Market Indexes. In February 2009, the Dow Jones Industrial Average was at a level of about 8,000. In mid-2018, it was about 24,500. Would you expect the Dow in 2018 to be more or less likely to move up or down by more than 40 points in a day than in 2009? Does this mean the market was riskier in 2018 than it was in 2009? (LO11-2) 13. Scenario Analysis. Consider the following scenario analysis: (LO11-2) Rate of Return Scenario Probability Stocks Bonds Recession 0.20 −5% +14% Normal economy 0.60 +15 +8 Boom 0.20 +25 +4 a. Is it reasonable to assume that Treasury bonds will provide higher returns in recessions than in booms? b. Calculate the expected rate of return and standard deviation for each investment. c. Which investment would you prefer? Chapter 12: 1. Diversifiable Risk. In light of what you’ve learned about market versus diversifiable (specific) risks, explain why an insurance company has no problem in selling life insurance to individuals but is reluctant to issue policies insuring against flood damage to residents of coastal areas. Why don’t the insurance companies simply charge coastal residents a premium that reflects the actuarial probability of damage from hurricanes and other storms? (LO12-1) 2. Specific versus Market Risk. Figure 12.10 plots monthly rates of return from 2014 to 2018 for the Snake Oil mutual fund. Was this fund fully diversified? Explain. (LO12-1) 3. Using Beta. A stock with a beta of .8 has an expected rate of return of 12%. If the market return this year turns out to be 5 percentage points below expectations, what is your best guess as to the rate of return on the stock? (LO12-1) 4. Specific versus Market Risk. Figure 12.11 shows plots of monthly rates of return on three stocks versus the stock market index. (The plots are similar to those in Figure 12.2 but are taken from an earlier period.) The beta and standard deviation of each stock is given beside its plot. (LO12-1) a. b. Which stock is safest for a diversified investor? Which stock is safest for an undiversified investor who puts all her funds in one of these stocks? c. Consider a portfolio with equal investments in each stock. What would this portfolio’s beta have been? d. Consider a well-diversified portfolio made up of stocks with the same beta as Intel. What are the beta and standard deviation of this portfolio’s return? The standard deviation of the market portfolio’s return is 20%. e. What is the expected rate of return on each stock? Use the capital asset pricing model with a market risk premium of 8%. The risk-free rate of interest is 4%.

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