CHAPTER 6 Risk and Rates of Return Homework Solutions

ANSWERS TO END-OF-CHAPTER QUESTIONS

6-1. Data have been compiled by Ibbotson and Sinquefield on the actual returns for the following portfolios of securities from 1926-2002. 1. 2. 3. 4. 5. U.S. Treasury bills U.S. government bonds Corporate bonds Common stocks for large firms Common stocks for small firms

Investors historically have received greater returns for greater risk-taking with the exception of the U.S. government bonds. Also, the only portfolio with returns consistently exceeding the inflation rate has been common stocks. 6.2 When a rate of interest is quoted, it is generally the nominal or, observed rate. The real rate of interest represents the rate of increase in actual purchasing power, after adjusting for inflation. Consequently, the nominal rate of interest is equal to the sum of the real rate of interest, the inflation rate, and the product of the real rate and the inflation rate. The relationship between a debt securitys rate of return and the length of time until the debt matures is known as the term structure of interest rates or the yield to maturity. In most cases, longer terms to maturity command higher returns or yields. (a) (b) The investor's required rate of return is the minimum rate of return necessary to attract an investor to purchase or hold a security. Risk is the potential variability in returns on an investment. Thus, the greater the uncertainty as to the exact outcome, the greater is the risk. Risk may be measured in terms of the standard deviation or by the variance term, which is simply the standard deviation squared. A large standard deviation of the returns indicates greater riskiness associated with an investment. However, whether the standard deviation is large relative to the returns has to be examined with respect to other investment opportunities. Alternatively, probability analysis is a meaningful approach to capture greater understanding of the significance of a standard deviation

6-3

6-4.

(c)

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figure. However, we have chosen not to incorporate such an analysis into our explanation of the valuation process. 6-5. (a) Unique risk is the variability in a firm's stock price that is associated with the specific firm and not the result of some broader influence. An employee strike is an example of a company-unique influence. Systematic risk is the variability in a firm's stock price that is the result of general influences within the industry or resulting from overall market or economic influences. A general change in interest rates charged by banks is an example of systematic risk.

(b)

6-6.

Beta indicates the responsiveness of a security's returns to changes in the market returns. Beta is multiplied by the market risk premium and added to the risk-free rate of return to calculate a required rate of return. The security market line is a graphical representation of the risk-return trade-off that exists in the market. The line indicates the minimum acceptable rate of return for investors given the level of risk. Since the security market line results from actual market transactions, the relationship not only represents the risk-return preferences of investors in the market but also represents the investors' available opportunity set. The beta for a portfolio is equal to the weighted average of the individual stock betas, weighted by the percentage invested in each stock. If a stock has a great amount of variability about its characteristic line (the graph of the stock's returns against the market's returns), then it has a high amount of unsystematic or company-unique risk. If, however, the stock's returns closely follow the market movements, then there is little unsystematic risk.

6-7.

6-8. 6-9.

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SOLUTIONS TO END-OF-CHAPTER PROBLEMS

Solutions to Problems Set A
6-1A. krf = .1213 or 12.13% = nominal rate of interest 6-2A. krf = .1044 or 10.44% = nominal rate of interest 6-3A.

2.535%

No, Pritchard should not invest in the security. The level of risk is excessive for a return which is less than the rate offered on treasury bills. 6-4A. Common Stock A:

Common Stock B

3.10%

9.11%

Common Stock A is better. It has a higher expected return with less risk.

6-6A. (a) (b) = 18% The 18 percent "fair rate" compensates the investor for the time value of money and for assuming risk. However, only nondiversifiable risk is being considered, which is appropriate.

6-7A. Eye balling the characteristic line for the problem, the rise relative to the run is about 0.5. That is, when the S & P 500 return is eight percent Aram's expected return would be about four percent. Thus, the beta is also approximately 0.5 (4 8).

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6-8A. A B C D 6-9A. 10.56% 6-10A. If Tasaco = 12.22% LBM = 11.48% 14.63% 11.06% 9.90% 12.79%

Exxos = 10.97% 6-11A. Asman Time 1 2 3 4 Price $10 12 11 13 Return 20.00% -8.33 18.18 Salinas Price Return $30 28 -6.67% 32 14.29 35 9.38

A holding-period return indicates the rate of return you would earn if you bought a security at the beginning of a time period and sold it at the end of the period, such as the end of the month or year. 6-13A. a. b. c. d.
kp

= 0.95

15.8%

Plot the security market line and the individual stocks A "winner" may be defined as a stock that falls above the security market line, which means these stocks are expected to earn a return exceeding what should be expected given their beta or systematic risk. In the above graph, these stocks include 1, 3, and 5. "Losers" would be those stocks falling below the security market line, which are represented by stocks 2 and 4 ever so slightly. Our results are less than certain because we have problems estimating the security market line with certainty. For instance, we have difficulty in specifying the market portfolio.

e.

6-18A (a) 9.8% 147

(b) (c)

8.4% If beta is 1.2: Required rate of return If beta is 0.85: Required rate of return = 13.4% = 10.95%

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