CH7 - CHAPTER 7 Introduction to Risk Return and the...

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CHAPTER 7 Introduction to Risk, Return, and the Opportunity Cost of Capital Answers to Practice Questions 1. Recall from Chapter 3 that: (1 + r nominal ) = (1 + r real ) × (1 + inflation rate) Therefore: r real = (1 + r nominal )/(1 + inflation rate) - 1 a. 1996: 19.2% 1997: 31.2% 1998: 26.6% 1999: 17.8% 2000: -12.1% b. From the results for Part (a), the average real return was 16.5 percent. c. The risk premium for each year was: 1996: 17.9% 1997: 28.1% 1998: 23.7% 1999: 16.3% 2000: -15.0% d. From the results for Part (c), the average risk premium was 14.2 percent. e. The standard deviation ( σ ) of the risk premium is calculated as follows: 2 2 2 2 0.142) (0.237 0.142) (0.281 0.142) (0.179 [ 1 5 1 σ - + - + - × - = ] 0.142) 0.150 ( 0.142) (0.163 2 2 - - + - + 2. Internet exercise; answers will vary. 61 0.02886 ] 0.115420 [ 4 1 σ 2 = × = 17.0% 0.170 σ = =
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3. a. A long-term United States government bond is always absolutely safe in terms of the dollars received. However, the price of the bond fluctuates as interest rates change and the rate at which coupon payments can be invested also changes as interest rates change. And, of course, the payments are all in nominal dollars, so inflation risk must also be considered. b. It is true that stocks offer higher long-run rates of return than bonds, but it is also true that stocks have a higher standard deviation of return. So, which investment is preferable depends on the amount of risk one is willing to tolerate. This is a complicated issue and depends on numerous factors, one of which is the investment time horizon. If the investor has a short time horizon, then stocks are generally not preferred. c. Unfortunately, 10 years is not generally considered a sufficient amount of time for estimating average rates of return. Thus, using a 10-year average is likely to be misleading. 4. If the distribution of returns is symmetric, it makes no difference whether we look at the total spread of returns or simply the spread of unexpectedly low returns. Thus, the speaker does not have a valid point as long as the distribution of returns is symmetric. 5. The risk to Hippique shareholders depends on the market risk, or beta, of the investment in the black stallion. The information given in the problem suggests that the horse has very high unique risk, but we have no information regarding the horse’s market risk. So, the best estimate is that this horse has a market risk about equal to that of other racehorses, and thus this investment is not a particularly risky one for Hippique shareholders. 6. In the context of a well-diversified portfolio, the only risk characteristic of a single security that matters is the security’s contribution to the overall portfolio risk. This contribution is measured by beta. Lonesome Gulch is the safer investment for a diversified investor because its beta (+0.10) is lower than the beta of
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CH7 - CHAPTER 7 Introduction to Risk Return and the...

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