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Unformatted text preview: Chapter 8: Risk and Rates of Return Learning Objectives 177 Chapter 8 Risk and Rates of Return Learning Objectives After reading this chapter, students should be able to: Explain the difference between stand-alone risk and risk in a portfolio context. Explain how risk aversion affects a stock’s required rate of return. Discuss the difference between diversifiable risk and market risk, and explain how each type of risk affects well-diversified investors. Explain what the CAPM is and how it can be used to estimate a stock’s required rate of return. Discuss how changes in the general stock and the bond markets could lead to changes in the required rate of return on a firm’s stock. Discuss how changes in a firm’s operations might lead to changes in the required rate of return on the firm’s stock. 178 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 6—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 return 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. b. There is a perfect negative correlation between the returns on the life insurance policy and the returns on the policyholder’s human capital. In fact, these events (death and future lifetime earnings capacity) are mutually exclusive. The prices of goods and services must cover their costs. Costs include labor, materials, and capital. Capital costs to a borrower include a return to the saver who supplied the capital, plus a mark-up (called a “spread”) for...
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- Spring '10
- Interest, Risk premium, rM – rRF