Chapter 11 - Introduction to Risk, Return, and the Opportunity Cost of Capital

Solutions to Chapter 11 Introduction to Risk, Return, and the Opportunity Cost of Capital
capital gain + dividend ($44 $40) + $2 = = 0.15 = 15.0% initial share price $40

1.

Rate of return =

Dividend yield = dividend/initial share price = $2/$40 = 0.05 = 5% Capital gains yield = capital gain/initial share price = $4/$40 = 0.10 = 10% Est time: 0105

2.

Dividend yield = $2/$40 = 0.05 = 5% The dividend yield is unaffected; it is based on the initial price, not the final price. Capital gain = $36 $40 = $4 Capital gains yield = $4/$40 = 0.10 = 10%

Est time: 0105

3.

a.

Rate of return =

capital gain + dividend ($38 $40) + $2 = = 0% initial share price $40

Real rate of return =

1 + nominal rate of return 1+ 0 1 = 1 = 0.0385 = 3.85% 1 + inflation rate 1 + 0.04

b.

Rate of return =

($40 $40) + $2 = 0.05 = 5% $40 1 + nominal rate of return 1.05 1 = 1 = 0.0096 = 0.96% 1 + inflation rate 1.04

Real rate of return =

c.

Rate of return =

($42 $40) + $2 = 0.10 = 10% $40 1 + nominal rate of return 1.10 1 = 1 = 0.0577 = 5.77% 1 + inflation rate 1.04

Real rate of return =

Est time: 0105

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Chapter 11 - Introduction to Risk, Return, and the Opportunity Cost of Capital

4.

Real rate of return =

1 + nominal rate of return 1 1 + inflation rate 1.95 1 = 0.0833 = 8.33% 1.80 1.12 1 = 0.0980 = 9.80% 1.02

Costaguana: Real return =

United States: Real return =

The United States provides the higher real rate of return despite the lower nominal rate of return. Notice that the approximate relationship between real and nominal rates of return is valid only for low rates: Real rate of return nominal rate of return inflation rate This approximation incorrectly suggests that the Costaguanan real rate was higher than the U.S. real rate. Est time: 0105

5.

We use the following relationship:

Real rate of return = 1 + nominal rate of return 1 1 + inflation rate

Asset Class Treasury bills Treasury bonds Common stocks Est time: 0105

Nominal Rate of Return 4.0% 5.2% 11.4%

Inflation Rate 3.1% 3.1% 3.1%

Real Rate of Return 0.87% 2.04% 8.05%

6.

The nominal interest rate cannot be negative. If it were, investors would choose to hold cash (which pays a rate of return equal to zero) rather than buy a Treasury bill providing a negative return. On the other hand, the real expected rate of return is negative if the inflation rate exceeds the nominal return.

Est time: 0105

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Chapter 11 - Introduction to Risk, Return, and the Opportunity Cost of Capital

7. Year Average Price of Stocks in Market 74.810 98.710 105.360 84.202 102.372 97.304 Index (using DJIA method) 100.00 131.95 140.84 112.55 136.84 130.07 Total Market Value of Stocks 20,166.20 25,121.48 26,111.82 21,276.14 24,359.74 24,015.40 Index (using S&P method) 100.00 124.57 129.48 105.50 120.79 119.09

2005 2006 2007 2008 2009 2010

Est time: 0610 8. a. b. c. For the period 19002010, average rate of return = 11.4% (see Table 11-1). For the period 19002010, average risk premium = 7.4% (see Table 11-1). For the period 19002010, standard deviation of returns = 20% (see Table 11-4).

Est time: 0105 9. a. Stock Market Return 15.77 5.61 37.23 28.30 17.16 Total Average T-Bill Return 4.80 4.66 1.60 0.10 0.12 Risk Premium 10.97 0.95 38.83 28.20 17.04 18.33 3.67 Deviation from Mean 7.30 2.72 42.50 24.53 13.37 Squared Deviation 53.35 7.38 1,805.91 601.92 178.86 2,647.42 529.48

Year

2006 2007 2008 2009 2010

b. c.

The average risk premium was 3.67%. The variance (the average squared deviation from the mean) was 529.48.

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Chapter 11 - Introduction to Risk, Return, and the Opportunity Cost of Capital

Therefore: Standard deviation = Est time: 1115

529.48 = 23.01%

10.

In 2010, the Dow was nearly four times its 1990 level. Therefore, in 2010, a 40-point movement was far less significant in percentage terms than it was in 1990. We would expect to see more 40-point days in 2010 even if market risk as measured by percentage returns is no higher than it was in 1990.

Est time: 0105 11. Investors would not have invested in bonds during the period 19771981 if they had expected to earn negative average returns. Unanticipated events must have led to these results. For example, inflation and nominal interest rates during this period rose to levels not seen for decades. These increases, which resulted in large capital losses on long-term bonds, were almost certainly unanticipated by investors who bought those bonds in prior years. The results for this period demonstrate the perils of attempting to measure normal maturity (or risk) premiums from historical data. While experience over long periods may be a reasonable guide to normal premiums, the realized premium over short periods may contain little information about expectations of future premiums. Est time: 0610 12. If investors become less willing to bear investment risk, they will require a higher risk premium to compensate them for holding risky assets. Security prices of risky investments will fall until the expected rates of return on those securities rise to the now-higher required rates of return.

Est time: 0105 13. Based on the historical risk premium of the S&P 500 (7.6%) and the current level of the risk-free rate (about 3.5%), one would predict an expected rate of return of 11.1%. If the stock has the same systematic risk, it also should provide this expected return. Therefore, the stock price equals the present value of cash flows for a 1-year horizon.
P0 = $2 + $50 = $46.80 1.111

Est time: 0105

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Chapter 11 - Introduction to Risk, Return, and the Opportunity Cost of Capital

14.

Boom:

$8 + ($240 $80) = 210% $80 $4 + ($90 $80) = 18% $80 $0 + ($0 $80) = 100% $80

Normal:

Recession:
r=

210 + 18 + (100) = 42.5% 3

1 1 1 ( 210 42.5) 2 + (18 42.5) 2 + (100 42.5) 2 = 16,320.92 3 3 3

Variance =

Standard deviation = = 127.75% Est time: 0610 15. The bankruptcy lawyer does well when the rest of the economy is floundering but does poorly when the rest of the economy is flourishing and the number of bankruptcies is down. Therefore, the Leaning Tower of Pita is a risk-reducing investment. When the economy does well and the lawyers bankruptcy business suffers, the stock return is excellent, thereby stabilizing total income.

Est time: 0105 16. Escapist Films: Boom:

$0 + ($18 $25) = 28% $25 $1 + ($26 $25) = 8% $25 $3 + ($34 $25) = 48% $25

Normal:

Recession:
r=

( 28) + 8 + 48 = 9.33% 3
1 1 1 ( 28 9.33) 2 + (8 9.33) 2 + ( 48 9.33) 2 = 963.56 3 3 3

Variance =

Standard deviation = = 31.04%

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Chapter 11 - Introduction to Risk, Return, and the Opportunity Cost of Capital

Portfolio rate of return: Boom: (28 + 210)/2 = 91% Normal: (8 + 18)/2 = 13% Recession: (48 100)/2 = 26% Expected return = 26% Variance =
1 1 1 (91 26) 2 + (13 26) 2 + (26 26) 2 = 2,366 3 3 3

Standard deviation = = 48.64% Est time: 1115 17. a. 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 (5%)] + (0.6 15%) + (0.2 25%) = 13.0% rbonds = (0.2 14%) + (0.6 8%) + (0.2 4%) = 8.4% Variance (stocks) = [0.2 (5 13)2] + [0.6 (15 13)2] + [0.2 (25 13)2] = 96 Standard deviation =
96 = 9.80%

b.

Variance (bonds) = [0.2 (14 8.4)2] + [0.6 (8 8.4)2] + [0.2 (4 8.4)2] = 10.24 Standard deviation = c.
10.24 = 3.20%

Stocks have both higher expected return and higher volatility. More riskaverse investors will choose bonds, while those who are less risk-averse might choose stocks.

Est time: 0610 18. a. Recession: Normal economy: Boom: b. (5% 0.6) + (14% 0.4) = 2.6% (15% 0.6) + (8% 0.4) = 12.2% (25% 0.6) + (4% 0.4) = 16.6%

Expected return = (0.2 2.6%) + (0.6 12.2%) + (0.2 16.6%) = 11.16% Variance = [0.2 (2.6 11.16)2] + [0.6 (12.2 11.16)2] + [0.2 (16.6 11.16)2] = 21.22 Standard deviation =
21.22 =

4.61%

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Chapter 11 - Introduction to Risk, Return, and the Opportunity Cost of Capital

c. Stocks Bonds Portfolio

The investment opportunities have these characteristics: Mean Return 13.00% 8.40% 11.16% Standard Deviation 9.80% 3.20% 4.61%

The best choice depends on the degree of your aversion to risk. Nevertheless, we suspect most people would choose the portfolio over stocks since the portfolio has almost the same return with much lower volatility. This is the advantage of diversification. Est time: 0610 19. If we use historical averages to compute the normal risk premium, then our estimate of normal returns and normal risk premiums will fall when we include a year with a negative market return. This makes sense if we believe that each additional year of data reveals new information about the normal behavior of the market portfolio. We should update our beliefs as additional observations about the market become available.

Est time: 0105 20. Risk reduction is most pronounced when the stock returns vary against each other. When one firm does poorly, the other will tend to do well, thereby stabilizing the return of the overall portfolio.

Est time: 0105 21. a. b. General Steel ought to have greater sensitivity to broad market movements. Steel production is more sensitive to changes in the economy than is food consumption. Club Med sells a luxury good (expensive vacations), while General Cinema sells movies, which are less sensitive to changes in the economy. Club Med will have greater market risk.

Est time: 0105 22. a. The expected rate of return on the stock is 4%. The standard deviation is 22%.

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Chapter 11 - Introduction to Risk, Return, and the Opportunity Cost of Capital

b.

Because the stock offers a risk premium of zero (its expected return is the same as the expected return for Treasury bills), it must have no market risk. All the risk must be diversifiable, and therefore of no concern to investors.

Est time: 0105 23. Sassafras is not a risky investment for a diversified investor. Its return is better when the economy enters a recession. Therefore, the company risk offsets the risk of the rest of the portfolio. Sassafras is a portfolio stabilizer despite the fact that there is a 90% chance of loss. Compare Sassafras to purchasing an insurance policy. Most of the time, you lose money on your insurance policy. But the policy pays off big if you suffer losses elsewherefor example, if your house burns down. For this reason, we view insurance as a risk-reducing hedge, not as speculation. Similarly, Sassafras may be viewed as analogous to an insurance policy on the rest of your portfolio since it tends to yield higher returns when the rest of the economy fares poorly. In contrast, the Leaning Tower of Pita has returns that are positively correlated with the rest of the economy. It does best in a boom and goes out of business in a recession. For this reason, Leaning Tower would be a risky investment for a diversified investor since it increases exposure to the macroeconomic or market risk to which the investor is already exposed. Est time: 0610 24. a. Using Excels AVERAGE and STDEV functions gives: XOM Average Standard deviation 0.83% 5.76% BP 0.38% 8.96% WMT 0.29% 4.66%

b. Using Excels CORREL function gives: XOM XOM BP WMT 1 0.575497 0.03348 1 0.211748 1 BP WMT

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Chapter 11 - Introduction to Risk, Return, and the Opportunity Cost of Capital

Not surprisingly, two firms from the same industry, ExxonMobil and British Petroleum, have the highest correlation, at 0.58. c. Using Excel, the standard deviation for an equally weighted portfolio of Walmart and Shell is 3.64. Using the values from part (a), the average standard deviation for the two stocks is 5.21% = (5.76% + 4.66%)/2.

d.

Using Excel, the standard deviation for an equally weighted portfolio of BP and ExxonMobil is 6.57%. Using the values from part (a), the average standard deviation for the two stocks is 7.36% = (8.96% + 5.76%)/2. Pairing Walmart with ExxonMobil provides greater benefits from diversification because the correlation in their returns is the lowest (0.03348).

Est time: 1115

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