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economy? Is the return on a 1- year T-bond risk free? The T- bond return is independent of the state of the economy because government securities are considered to be free of default risk. Without risk of default, the state of the economy will not affect the expected return of a government security. However, government securities are not entirely risk free. There are other risks associated with these securities such as liquidity risk and reinvestment risk. 2. Calculate the expected rate of return on each of the four alternatives listed in Table 1. Based solely on expected returns, which of the potential investments appears best? Expected Returns 1-year T-bond TECO Gold Hill S&P 500 E(Return) 0.08 0.135 0.088 0.15 Based on this table,the S&P 500 fund is expecting the highest returns, at 15%. 6. Suppose and investor starts with a portfolio consisting of one randomly selected stock. A. What would happen to the portfolio’s risk if more and more randomly selected stocks were added? The more stocks that are added to a portfolio, the less risk that the investor is taking on because you are more diversified but you still have systematic risk. B. What are the implications for investors? Do portfolio effects impact the way investors should think about the riskiness of individual securities? Would you expect this to affect companies’ cost of capital? The more stocks the less risk, investors want to increase there returns with the least amount of risk possible. Yes, portfolio effects the way investors think because they need to effectively choose there variety of securities in order to reduce the unsystematic risk. The risk of a companies’ stock does affect its cost of capital. C. Explain the differences between total risk, diversifiable (company-specific) risk, and market risk. Total risk- diversifiable and market risk of a portfolio Diversifiable risk- risk that can be reduced by diversifying you portfolio or choosing stocks in different sectors of the market along with choosing lower risk investments such as bonds. D. Assume that you choose to hold a single stock portfolio. Should you expect to be
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This note was uploaded on 04/20/2008 for the course FIN 3123 taught by Professor Qayyum during the Spring '08 term at Mississippi State.

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case 2 almost complete - Capital Markets and Corporate...

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