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Unformatted text preview: Chapter 8: Risk and Rates of Return Learning Objectives 179 Chapter 8 Risk and Rates of Return Learning Objectives After reading this chapter, students should be able to: Define risk and calculate the expected rate of return, standard deviation, and coefficient of variation for a probability distribution. Specify how risk aversion influences required rates of return. Graph diversifiable risk and market risk; explain which of these is relevant to a well-diversified investor. State the basic proposition of the Capital Asset Pricing Model (CAPM) and explain how and why a portfolio’s risk may be reduced. Explain the significance of a stock’s beta coefficient, and use the Security Market Line to calculate a stock’s required rate of return. List changes in the market or within a firm that would cause the required rat e of return on a firm’s stock to change. Identify concerns about beta and the CAPM. Explain the implications of risk and return for corporate managers and investors. 180 Integrated Case Chapter 8: Risk and Rates of Return Answers to End-of-Chapter Questions 8-1 a. No, it is not riskless. The portfolio would be free of default risk and liquidity risk, but inflation could erode the portfolio’s purchasing power. If the actual inflation rate is greater than that expected, interest rates in general will rise to incorporate a larger inflation premium (IP) and — as we saw in Chapter 7 — the value of the portfolio would decline. b. No, you would be subject to reinvestment rate risk. You might expect to ―roll over‖ the Treasury bills at a constant (or even increasing) rate of interest, but if interest rates fall, your investment income will decrease. c. A U.S. government-backed bond that provided interest with constant purchasing power (that is, an indexed bond) would be close to riskless. The U.S. Treasury currently issues indexed bonds. 8-2 a. The probability distribution for complete certainty is a vertical line. b. The probability distribution for total uncertainty is the X-axis from - to + . 8-3 a. The expected return on a life insurance policy is calculated just as for a common stock. Each outcome is multiplied by its probability of occurrence, and then these products are summed. For example, suppose a 1-year term policy pays $10,000 at death, and the probability of the policyholder’s death in that year is 2%. Then, there is a 98% probability of zero retu rn and a 2% probability of $10,000: Expected return = 0.98($0) + 0.02($10,000) = $200. This expected return could be compared to the premium paid. Generally, the premium will be larger because of sales and administrative costs, and insurance company profits, indicating a negative expected rate of return on the investment in the policy....
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This note was uploaded on 03/04/2009 for the course FIN 221 taught by Professor Dyer during the Spring '08 term at University of Illinois at Urbana–Champaign.
- Spring '08
- Corporate Finance