Ross4eChap12sm - Chapter 12 An Alternative View of Risk and...

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Chapter 12: An Alternative View of Risk and Return: The Arbitrage Pricing Theory 12.1 Real GNP was higher than anticipated. Since returns are positively related to the level of GNP, returns should rise based on this factor. Inflation was less than the amount anticipated. Since returns for Lewis-Strident are negatively correlated to the level of inflation, returns should rise based on this factor. Interest Rates are lower than anticipated. Since returns are negatively related to interest rates, the lower than expected rate is good news. Returns should rise due to interest rates. The President’s death is bad news. Although the president was expected to retire, his retirement would not be effective for six months. During that period he would still contribute to the firm. His untimely death means that those contributions would not be made. Since he was generally considered an asset to the firm, his death will cause returns to fall. The poor research results are also bad news. Since Lewis-Striden must continue to test the drug, it will not go into production as early as expected. The delay will affect expected future earnings, and thus it will dampen returns now. The research breakthrough is positive news for Lewis Striden. Since it was unexpected, it will cause returns to rise. The competitor’s announcement is also unexpected, but it is not a welcome surprise. This announcement will lower the returns on Lewis-Striden. Systematic risk is risk that cannot be diversified away through formation of a portfolio. Generally, systematic risk factors are those factors that affect a large number of firms in the market, however, those factors will not necessarily affect all firms equally. The systematic factors in the list are real GNP, inflation and interest rates. Unsystematic risk is the type of risk that can be diversified away through portfolio formation. Unsystematic risk factors are specific to the firm or industry. Surprises in these factors will affect the returns of the firm in which you are interested, but they will have no effect on the returns of firms in a different industry and perhaps little effect on other firms in the same industry. For Lewis-Striden, the unsystematic risk factors are the president’s ability to contribute to the firm, the research results and the competitor. 12.2 a. Let m = systematic risk portion of return: 1 1 2 2 3 3 .0042(4,480 4,416) 1.4(4.3% 3.1% 0.67(11.8% 9.5%) 0.23659 m F F F m m β β β = + + = - - - - - = Answers to End-of-Chapter Problems B-175
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b. Let ε = the unsystematic portion of risk, since the news was only about this firm: 2.6% ε = - c. Total Return = Expected return, plus 2 the components of unexpected return: the systematic risk portion of return and the unsystematic portion: 9.5% 23.659% 2.6% 30.559% R R m ε = + + = + - = 12.3 a. Let m = systematic risk portion of return: ( 29 ( 29 1.94 4.8% 3.5% 1.8 15.2% 14.0% 0.362% m = - - - = b. Let ε = the unsystematic portion of risk: ( 29 0.36% 27 23 1.44% ε = - = c. Total Return: 10.0% 0.36% 1.44% 11.80% R R m ε = + + = + + = 12.4 a. The market model is specified by : ( 29 m m R R R R β ε = + - + so applying that to each Stock: Stock A: ( 29 ( 29 10.5% 1.2 14.2% A A A m m A m A R R R R R β ε ε = + - + = + - + Stock B: ( 29 ( 29 13.0% 0.98 14.2% B B m m B m B R R R
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