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Part 4 Ch 04

# Part 4 Ch 04 - CHAPTER 4 INTEGRATIVE PROBLEM 4-11 ASSUME...

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CHAPTER 4 INTEGRATIVE PROBLEM 62 4-11 ASSUME THAT YOU RECENTLY GRADUATED WITH A MAJOR IN FINANCE, AND YOU JUST LANDED A JOB IN THE TRUST DEPARTMENT OF A LARGE REGIONAL BANK. YOUR FIRST ASSIGNMENT IS TO INVEST \$100,000 FROM AN ESTATE FOR WHICH THE BANK IS TRUSTEE. BECAUSE THE ESTATE IS EXPECTED TO BE DISTRIBUTED TO THE HEIRS IN ABOUT ONE YEAR, YOU HAVE BEEN INSTRUCTED TO PLAN FOR A ONE-YEAR HOLDING PERIOD. FURTHER, YOUR BOSS HAS RESTRICTED YOU TO THE FOLLOWING INVESTMENT ALTERNATIVES, SHOWN WITH THEIR PROBABILITIES AND ASSOCIATED OUTCOMES. (DISREGARD FOR NOW THE ITEMS AT THE BOTTOM OF THE TABLE; YOU WILL FILL IN THE BLANKS LATER.) RETURNS ON ALTERNATIVE INVESTMENTS ESTIMATED RATE OF RETURN STATE OF THE T- HIGH COLLEC- U.S. MARKET 2-STOCK ECONOMY PROB. BILLS TECH TIONS RUBBER PORTFOLIO PORTFOLIO RECESSION 0.1 8.0% -22.0% 28.0% 10.0% -13.0% BELOW AVERAGE 0.2 8.0 - 2.0 14.7 -10.0 1.0 AVERAGE 0.4 8.0 20.0 0.0 7.0 15.0 ABOVE AVERAGE 0.2 8.0 35.0 -10.0 45.0 29.0 BOOM 0 .1 8 .0 50 .0 -20 .0 30 .0 43 .0 k ˆ σ CV β THE BANK'S ECONOMIC FORECASTING STAFF HAS DEVELOPED PROBABILITY ESTIMATES FOR THE STATE OF THE ECONOMY, AND THE TRUST DEPARTMENT HAS A SOPHISTICATED COMPUTER PROGRAM THAT WAS USED TO ESTIMATE THE RATE OF RETURN ON EACH ALTERNATIVE UNDER EACH STATE OF THE ECONOMY. HIGH TECH INC. IS AN ELECTRONICS FIRM; COLLECTIONS INC. COLLECTS PAST-DUE DEBTS; AND U.S. RUBBER MANUFACTURES TIRES AND VARIOUS OTHER RUBBER AND PLASTICS PRODUCTS. THE BANK ALSO MAINTAINS AN “INDEX FUND,” WHICH OWNS A MARKET-WEIGHTED FRACTION OF ALL PUBLICLY TRADED STOCKS; YOU CAN INVEST IN THAT FUND AND THUS OBTAIN AVERAGE STOCK MARKET RESULTS. GIVEN THE SITUATION AS DESCRIBED, ANSWER THE FOLLOWING QUESTIONS:

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ANSWER : The 8 percent T-bill return does not depend on the state of the economy because the Treasury must (and will) redeem the bills at par regardless of the state of the economy. The T-bills are risk-free in the default risk sense because the 8 percent return will be realized in all possible economic states. However, remember that this return is composed of the real risk-free rate, say, 3 percent, plus an inflation premium, say 5 percent. Because there is uncertainty about inflation, it is unlikely that the realized real rate of return would equal the expected 3 percent. For example, if inflation averaged 6 percent over the year, then the realized real return would be only 8% - 6% = 2%, not the expected 3%. Thus, in terms of purchasing power, T-bills are not riskless. Also, if you invested in a portfolio of T-bills, and rates then declined, your nominal income would fall —that is, T-bills are exposed to reinvestment rate risk . So, we conclude that there are no truly risk-free securities in the United States. If the Treasury sold inflation-indexed, tax-exempt bonds, they would be truly riskless, but all actual securities are exposed to some type of risk.
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Part 4 Ch 04 - CHAPTER 4 INTEGRATIVE PROBLEM 4-11 ASSUME...

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