3330 PS4 sol

3330 PS4 sol - Cornell University Fall 2010 Economics 3330...

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Cornell University Fall 2010 Economics 3330: Problem Set 4 Solutions 1. True/False/Explain State whether each of the following is true or false and explain your answer. Please limit your explanations to no more than two sentences. a. The “rule of 72” holds that it is the last 72 years of data that are relevant for estimating the future returns of an asset. False. The “rule of 72” says that the approximate amount of time for an asset to double in value is approximately equal to 72 divided by the interest rate. b. The Sharpe ratio is not changed by using the standard deviation of the return of the asset in place of the standard deviation of the excess return of the asset. False. If the risk-free rate of return is varies over time, then the two standard deviations will differ. c. Even if the arithmetic average return is negative, the geometric average will be lower than the arithmetic. There are two acceptable answers to this question. 1) True. Variance reduces the geometric return regardless of the sign of the returns. 2) False. In the special case when the average return is constant, the arithmetic and geometric returns will be the same. 2. Indexing and Risk (Question 6 of Text, modified) There are two U.S. government bonds with the same maturity: one is not indexed and offers a 5% return, and the other is indexed and offers a 1.5% return plus the CPI. a. Suppose that inflation will average 3.5% until the bond’s mature. What would be the safer asset for a retiree? What would be the safer asset for a bond manager benchmarked to a nominal index? The safer one for the retiree is the indexed bond because it reduces variation in consumption. For the manager it is the nominal bond, because it reduces benchmark tracking error. b. If we observe the risk-free nominal rate of 5% and a risk-free real rate of 1.5%, can we infer
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3330 PS4 sol - Cornell University Fall 2010 Economics 3330...

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