Chapter 4 - Solution Manual

# A simple equation can be illustrated to express the

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A simple equation can be illustrated to express the relationship between risk and return. This equation uses the risk free return (the Treasury Bill rate) as its foundation and is stated: R s = R f + R p Where: R s = The expected return on a given risky security R f = The risk free rate R p = The risk premium Since investors can eliminate the risk associated with acquiring a particular company's common stock by acquiring diversified portfolios, they are not compensated for bearing unsystematic risk. And, since well diversified investors are only exposed to systematic risk, investors using the CAPM as the basis for acquiring their portfolios will only be subject to systematic risk. Consequently, the only relevant risk is systematic risk and investors will be rewarded with higher expected returns for bearing market-related risk that will not be affected by company specific risk. The measure of the parallel relationship of a particular common stock with the overall trend in the stock market is termed Beta ( ! ). ! may be viewed as a gauge of a particular stock's volatility to the volatility of the total stock market. A stock with a ! of 1.00 has a perfect relationship to the performance of the overall market as measured by a market index such as Dow-Jones Industrials or the Standard and Poor's 500 - stock index. Stocks with a ! of greater than 1.00 tend to rise and fall by a greater percentage than the market; whereas, stocks with a ! of less than 1.00 are less likely to rise and fall than is the general market index. Therefore ! can be viewed as a particular stock's sensitivity to market changes, and as a measure of systematic risk. Case 4-2 a. In the supply and demand model, price is determined by (1) the availability of the product (price) and (2) the desire to possess that product (demand). The assumptions of this model are: 1. All economic units possess complete knowledge of the economy. 2. All goods and services in the economy are completely mobile and can be easily shifted within the economy. 3. Each buyer and seller must be so small in relation to the total supply and demand that neither has an influence on the price or demand in total. 4. There are no artificial restrictions placed on demand, supply, or prices of goods and services. b. The securities market is considered the best example of the supply and demand model because stock exchanges provide a relatively efficient distribution system and information concerning securities is available through many different outlets. c. The efficient markets hypothesis holds that the price of a security is determined by the purchaser's knowledge of available relevant information about that security. According to this

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67 theory, the market for securities can be described as efficient if it reflects all available information and reacts instantaneously to new information. The three forms of the efficient market hypothesis differ in their definitions of all available information as follows: Weak form - Available information consists of past price history of the security.
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