ADMS 3530 Lecture Notes - United States Treasury Security, Risk-Free Interest Rate, Risk Premium

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rubygnu252

10 Apr 2013

School

York University

Department

Administrative Studies

Course

ADMS 3530

Professor

Lois King

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Document Summary

Aggressive stocks have a beta of greater than 1. 0 and are more sensitive to macroeconomic conditions (as measured by the market portfolio). Month 2 = stock +2. 0%, market +1. 4%; month 3 = stock -2. 5%, market -2. 0%: beta is greater than 1. 0, beta is less than 1. 0, beta equals 1. 0, there is no consistent pattern of returns. According to this data, the stock"s beta is greater than 1: if a two-stock portfolio is equally invested in stocks with betas of 1. 4 and 0. 7, then the portfolio beta is, 0. 70, 1. 05, 1. 40, 2. 10. Portfolio beta is just the weighted average of the betas of the individual stocks in the portfolio. Initial scenario: rp = 5% + 1(8) = 13% Second scenario: rp = 4% +1. 5(9) = 17. 5% If an investment plots below the security market line, then it is not providing sufficient return based on its risk level (as measured by beta).

Related Questions

Hi, giving points to help me with these questions :

1.The correlation coefficient between well diversified portfolio A (50 different assets) and well diversified portfolio B (50 different assets) is -.7.

A new portfolio of A and B together will be less risky than a portfolio that is composed of either just the assets in Portfolio A or just the assets in portfolio B.

AnswerTrue or False

2.Plastics, Inc. will pay an annual dividend of $1.85 next year. The company just announced that future dividends will be increasing by 2.25 percent annually. How much are you willing to pay for one share of this stock if you require a 16 percent return?

True or False

3.Assume that common stock values are consistent with the following model:

E(R_x) = r_f + B_x{E(R_m)- r_f)}

E(R_x) = required return on asset x.

r_f = risk free rate of interest

B_x = Beta of security x.

E(R_m) = expected return on market portfolio.

E(R_m)- r_f = market risk premium

4.If the risk free rate of interest increases but the required risk premium for security x remains the same; the expected return on security x be less than the required return on security x until the price of security x falls.

Answer

True or False

5.Which one of the following is the best example of unsystematic risk?

A.Inflation exceeding market expectations

Answer A.Inflation exceeding market expectations

B.A Warehouse fire

C.Decrease in the value of the dollar

D.Decrease in value of the dollar

E.Increase in Consumer spending

raspberrychimpanzee157

Calculating the market risk premium beta and required rate of return. CAPM. Portfolio Risk & Return.

We have a portfolio of three positively correlated but not perfectly correlated stocks.

(Correlation co-efficient between 0-1)

Stock Expected Rate of Return Standard Deviation Beta

X 10% 16% .75

Y 12% 16% 1.25

Z 13% 16% 1.50

What is the market risk premium for the portfolio ?

Required Rate of Return For the Stock = Risk Free rate of Return +

+ ( Market Risk Premium * Beta of stock )

Market Risk Premium = Market Required Rate of Return â Risk Free rate of Return

The returns on stocks X, Y and Z and their beta have been provided. Using the information provided, we will first calculate the market risk premium.

The capital asset pricing model is a model based on the proposition that any stock's required rate of return is equal to the risk free rate of return plus a risk premium that reflects only the risk remaining after diversification.

The required rate of return for a stock is calculated by adding the risk free rate of return to the product of the market risk premium and the stock's beta.

The market risk premium shows the premium that investors require for bearing the risk of average stock and is calculated by deducting the risk free rate from the market's required rate of return.

Now, using stock X or any other stock, we can calculate the market risk premium. We'll use stock X. The expected return on this stock is 10%. The risk free rate is 7& and the stock's beta is .75.

By solving the equation we determine the market risk premium to be 4%.

Next, we will calculate the beta of Fund Q.

Fund Q has 1/3 of its funds invested in each of the three stocks X, Y, and Z.

Thus, the beta of Fund Q will be the sum of one third of the beta of each stock. One third of .75 is .25. One third of 1.25 is .4167 and one third of 1.5 is .5. By adding .25, .4167 and .5, we calculate the beta of Fund Q as 1.1667.

Letâs now calculate the required return of Fund Q. The risk free rate is 7%. The market risk premium is calculated to be 4%. The beta of Fund Q is 1.1667. By adding 7% to the product of 4% and 1.1667, we determine the required return on Fund Q to be 11.67%.

Since the returns on the three stocks included in Fund Q are not positively correlated, the standard deviation of the fund will be less than 16%.

CONCEPTS IN THIS CASE

expected return
risk
portfolio choice
diversification
systematic risk
nonsystematic risk
beta
capital asset pricing model
arbitrage pricing

Your supervisor has asked that you quantify the effects of diversification using three potential portfolios. The information given regarding each portfolio is as follows:

Probability	Return (%) on Security A	Return (%) on Security B	Return (%) on Security C
.20	8	24	16
.30	10	16	10
.30	12	12	12
.20	14	17	6

Using the information above, calculate the following for each individual security:

What is the expected return for security A?

What is the expected return for security B?

What is the expected return for security C?

What is the variance of the return for security A?

What is the variance of the return for security B?

What is the variance of the return for security C?

Using the information above, calculate the following for each pair of securities:

What is the covariance of securities A and B?

What is the covariance of securities A and C?

What is the covariance of securities B and C?

If your firm makes equal investments in securities A and B (50% in each):

What is the expected return of the portfolio that combines A and B?

What is the variance of the portfolio that combines A and B?

If your firm makes equal investments in securities A and C (50% in each):

What is the expected return of the portfolio that combines A and C?

What is the variance of the portfolio that combines A and C?

If your firm makes equal investment in securities B and C (50% in each):

What is the expected return of the portfolio that combines B and C?

What is the expected variance of the portfolio that combines B and C?

Given the results of your work in questions 3, 4, and 5 above, which portfolio would you recommend to your supervisor? Explain.

You have searched online resources and found the beta of each security. Security A has a beta of 1.0, security B has a beta of .50 and security C has a beta of 1.50. If the risk-free interest rate is 5% and the expected return for the market portfolio is 12%:

What is the CAPM risk premium for security A?

What is the CAPM risk premium for security B?

What is the CAPM risk premium for security C?

How would your definition of the risk premium change if you used the Arbitrage Pricing Theory (APT) equation?

brownjellyfish613

ADMS 3530 Lecture Notes - United States Treasury Security, Risk-Free Interest Rate, Risk Premium

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