Chapters23solutions - Chapters 2 and 3 Risk and Return...

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Chapters 2 and 3 Risk and Return ANSWERS TO END-OF-CHAPTER QUESTIONS 2-2 a. The probability distribution for complete certainty is a vertical line. b. The probability distribution for total uncertainty is the X axis from - to + . 2-3 Security A is less risky if held in a diversified portfolio because of its lower beta and negative correlation with other stocks. In a single-asset portfolio, Security A would be more risky because σ A > σ B and CV A > CV B . 2-4 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 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. 2-5 The risk premium on a high beta stock would increase more. RP j = Risk Premium for Stock j = (r M - r RF )b j . If risk aversion increases, the slope of the SML will increase, and so will the market risk premium (r M – r RF ). The product (r M – r RF )b j is the risk premium of the jth stock. If b
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This note was uploaded on 12/11/2011 for the course FINC 3630 taught by Professor Jensen,m during the Summer '08 term at Auburn University.

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Chapters23solutions - Chapters 2 and 3 Risk and Return...

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