CHAPTER I: The Investment Settings

4. Discuss why you would expect the saving-borrowing pattern to differ by occupation (for
example, for a doctor versus a plumber).
Naturally, individuals are pursuing to maintain a constant level of consumption
depending on their needs. One factor affecting their consumption decisions is their occupation
subject to income earned. The pattern of how they borrow and save over their lifetime varies
inversely. People usually borrow when they have high needs and/or low incomesand save when
they have low needs and/or high incomes.
For instance, a doctor and a plumber in terms of occupation.Because of their different
incomes, their consumption differs. A doctor receives an income higher than a plumber, given
that both occupations are paid per service and dependence of the available clients.Practically, a
one-service payment to a doctor typically matches the compounded payments to a plumber.
Savings for high-yielding occupations is greater than those after. Mostly a doctor tends to save
more proportion of his income either by securing it in a financial institutionin the fear of
inflation, unemployment and /or illness and for the desire of bequest, or by investing it in terms
of durable goods such as car, house and appliances than the plumber who generally prefers to
hold cash for everyday transactions and whose income is more closely to his consumption level.
Likewise, being a plumber is considered as a self-employment work which doesnt warrant any
social security entitlements, yet still decreasing savings in his part, as compared to the doctors
job. However,when consumption exceeds income, borrowings inclines. In respect to their future
income expectations, the former commonly opt to have higher borrowings than the plumber if he
anticipate that his income will increase in the future, thus enabling him to repay these loans.
5. The Wall Street Journal reported that the yield on common stocks is about 2
percent,whereas a study at the University of Chicago contends that the annual rate of
return oncommon stocks since 1926 has averaged about 10 percent. Reconcile these
statements.
The analysis and estimation of the required rate of return are complicated by the behavior
of market rates over time. Even though all stocks have recognized returns, annual yields during
any year can usually differ substantially; hence, differences in yields result from the riskiness of
each investment.
6. Some financial theorists consider the variance of the distribution of expected rates of
return to be a good measure of uncertainty. Discuss the reasoning behind this measure
ofrisk and its purpose.
Most people are risk averse, in that they wish to minimize the amount of risk they must
endure to earn a certain level of expected return. If investors were indifferent to risk, they would
not be influenced by the differences among various stocks, whereas the risk-averse investor
would clearly prefer less risky. Therefore, most people want to know the range, or dispersion, of
possible outcomes, as well as the likelihood of certain outcomes occurring.

CHAPTER I: The Investment Settings

Accordingly, historical data are taken into account to examine the investments past
performance and to indicate its future performance. By using historical returns on a firm's stock,
investor can easily calculate the variance of past returns. Even this method does not provide an
absolute basis for determining the riskiness of the stock, past returns are not always reliable
indicators of future results. Nonetheless, calculating variance, together with the standard
deviation, based on historical returns is often the preferred method, because it relies on historical
fact, as opposed to not quantified speculation regarding the future.
The fact that variances can be estimated for portfolios made up of a large number of
assets suggests an approach to optimizing portfolio construction, in which investors trade off
expected return and variance. If an investor can specify the maximum amount of risk, he is
willing to take on (in terms of variance), the task of portfolio optimization becomes the
maximization of expected returns subject to this level of risk. Alternatively, if an investor
specifies her desired level of return, the optimum portfolio is the one that minimizes the variance
subject to this level of return.The larger the variances for an expected rate of return, the greater
the dispersion ofexpected returns and the greater the uncertainty, or risk, of the investment.
7. A stockbroker calls you and suggests that you invest in the Lauren Computer Company.
After analyzing the firms annual report and other material, you believe that the
distribution of expected rates of return is as follows:

Compute the expected return [E(Ri)] on Lauren Computer stock.

[E(Ri)] = [(-0.60)(0.05)+(-0.30)(0.20)+(-0.10)(0.10)+(0.20)(0.30)+(0.40)(0.20)+(0.80)(0.15)]
= [(-0.03)+(-0.06)+(-0.01)+(0.06)+(0.08)+(0.12)]
= 0.16
8. Without any formal computations, do you consider Madison Beer in Problem 6 orLauren
Computer in Problem 7 to present greater risk? Discuss your reasoning.
Considering the firms annual report, Lauren Computer seems to be more risky than
Madisons. As the rate of return measured rises, the probability for it to exist becomes lower
which makes the Laurens stocks to be more risky brought by the uncertainty. The probability
rate sets the determination that it might gain, but in Laurens case, the assurance to achieve such
expectations is at most 15% only.
Thank you!