This preview shows pages 1–3. Sign up to view the full content.
This preview has intentionally blurred sections. Sign up to view the full version.View Full Document
Unformatted text preview: Chapter 4 Risk and Return: The Basics Assume that you recently graduated with a major in finance, and you just landed a job as a financial planner with Barney Smith Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds are to be invested in a business at the end of one year, you have been instructed to plan for a one-year holding period. Further, your boss has restricted you to the following investment alternatives, shown with their probabilities and associated outcomes. (Disregard for now the items at the bottom of the data; you will fill in the blanks later.) Returns On Alternative Investments Estimated Rate Of Return State of the T- Alta Repo Am. Market 2-stock economy prob. Bills Inds Men Foam portfolio portfolio Recession 0.1 8.0% -22.0% 28.0% 10.0%*-13.0% 3.0% Below avg 0.2 8.0-2.0 14.7-10.0 1.0 Average 0.4 8.0 20.0 0.0 7.0 15.0 10.0 Above avg 0.2 8.0 35.0-10.0 45.0 29.0 Boom .1 8 .0 50 .0-20 .0 30 .0 43 .0 15 .0 r-hat ( r ) 1.7% 13.8% 15.0% Std dev () 0.0 13.4 18.8 15.3 Coef of var (cv) 7.9 1.4 1.0 beta (b)-0.86 0.68 *Note that the estimated returns of American Foam do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer mattresses than they would if the economy was stronger. However, if the economy is in a flat-out recession, a large number of consumers who were planning to purchase a more expensive inner spring mattress may purchase, instead, a cheaper foam mattress. Under these circumstances, we would expect American Foams stock price to be higher if there is a recession than if the economy was just below average. Barney Smiths economic forecasting staff has developed probability estimates for the state of the economy, and its security analysts have developed a sophisticated computer program which was used to estimate the rate of return on each alternative under each state of the economy. Alta Industries is an electronics firm; Repo Men collects past-due Mini Case: 4 - 1 MINI CASE debts; and American Foam manufactures mattresses and other foam products. Barney Smith also maintains an index fund which owns a market-weighted fraction of all publicly traded stocks; you can invest in that fund, and thus obtain average stock market results. Given the situation as described, answer the following questions. a. What are investment returns? What is the return on an investment that costs $1,000 and is sold after one year for $1,100? Answer: Investment return measures the financial results of an investment. They may be expressed in either dollar terms or percentage terms. The dollar return is $1,100 - $1,000 = $100. The percentage return is $100/$1,000 = 0.10 = 10%....
View Full Document