Week 3 Chapter 7 and Chapter 8

Chapter 7
Question 7
When you use a historical risk premium and your expected
future risk premium, what are the assumptions that you are
making about investors and markets? Under what conditions
would a historical risk premium give you too high of a
number (to use as an expected premium)?
1. The risk preference remained constant.
2. The risk of investment has remained constant
3. The absence of selection bias with the sample you are
examining
The historical risk premium will be too high in the case of a survivor
market bias.
Example:
Assume one invested in the 10 largest equity markets in the world,
the US being one. In a 10 year period investments in a few other
equity markets would have earned as large a premium as the US
equity market, and some like Austria would have resulted in
investors earning little or even negative returns.
Thus the

Question 9
The standard deviation in the Mexican Equity Index is 48%,
and the standard deviation in the S&P 500 is 20%. You use
an equity risk premium of 5.5% for the United States.
a. Estimate the country equity risk premium for Mexico
using relative equity standard deviations.
Total risk premium using equity std deviation = 5.5% (48/20) =
13.2%
Country risk premium = 13.2% - 5.5% = 7.7%
b. Now assume that you are told that Mexico is rated BBB by
Standard & Poors and that it has dollar-denominated bonds
outstanding that trade at a spread of about 3% above the
Treasury bond rate. If the standard deviation in these bonds
is 24%, estimate the country risk premium for Mexico.
Country risk premium = 3% (48/24) = 6%

Chapter 8
Question 1
1. In December 1995, Boise Cascade's stock had a beta of
0.95. The Treasury bill rate at the time was 5.8%, and the
Treasury bond rate was 6.4%. The firm had debt outstanding
of $1.7 billion and a market value of equity of $1.5 billion;
the corporate marginal tax rate was 36%. (The historical risk
premium for stocks over Treasury bills is 8.5% and the risk
premium for stocks over Treasury bonds is 5.5%.)
a. Estimate the expected return on the stock for a shortterm investor in the company.
The Expected Return on the stock = 0.058 + 0.95(0.085) = 14%
b. Estimate the expected return on the stock for a long-term
investor in the company.
The expected return 0.064 + 0.95(0.055) =11.63%.
c. Estimate the cost of equity for the company.
Cost of equity would be the long term required rate of return from
CAPM
0.064 + 0.95(0.055) =11.63%.
Company assuming going concern

Question 8