FIN 4504 Lecture Notes - Lecture 12: Risk Premium, Takers, Risk-Free Interest Rate

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taupedolphin629

16 Oct 2016

School

University of Florida

Department

Finance, Insurance and Real Estate

Course

FIN 4504

Professor

Li Qing

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Document Summary

Beta a measure of systematic risk. How volatile an investment is compared to the overall market. A (cid:271)eta of (cid:1005). (cid:1004) i(cid:374)di(cid:272)ates that the se(cid:272)u(cid:396)it(cid:455)"s p(cid:396)i(cid:272)e (cid:373)o(cid:448)es (cid:449)ith the (cid:373)a(cid:396)ket. If an asset is less volatile than the market, it will have a beta lower than 1. 0. If an asset is more volatile than the market, it will have a beta greater than 1. 0. Beta = covariance (stock price, market index)/ variance (market index) If beta is a measure of risk, then investors who hold stocks with higher return for taking on that risk. Capm is capital asset pricing model, one of the most fundamental concepts in investment theory. It is an equilibrium model that predicts the relationship between the risk & equilibrium expected returns on risky assets. To get the p(cid:396)edi(cid:272)tio(cid:374), (cid:449)e (cid:374)eed to k(cid:374)o(cid:449) the e(cid:454)pe(cid:272)ted (cid:396)etu(cid:396)(cid:374) o(cid:374) the (cid:373)a(cid:396)ket, the sto(cid:272)k"s (cid:271)eta coefficient, & the risk free rate. > no information asymmetry, no transaction costs, no tax.

Related Questions

1. If we are able to eliminate all of the unsystematic or diversifiable risk in a portfolio then, what is the result?

a.

a risk-free portfolio
b.
a portfolio that has an expected return of zero
c.

a portfolio that contains only systematic risk

2. A portfolio consists 20% of a risk-free asset and 80% of a stock. The risk-free return is 4%. The stock has an expected return of 15% and a standard deviation of 30%. Whatâs the expected return of the portfolio?

a.
9.5%
b.
15.0%
c.
12.8%

d.
2%

3. The risk-free rate is 5% and the expected return on the market portfolio is 13%. A stock has a beta of 1.5, what is its expected return?

a.
12%
b.
19.5%
c.

17%

4. For what value of the correlation coefficient for the returns of a pair of stocks will the benefits of diversification the largest?

a.

1.0
b.

-1.0
c.

0.0
d.

0.5

5. Which of the following is an example of systematic risk?
a.
IBM posts lower than expected earnings.
b.
The overall stock market becomes more risky due to super fasting trading algorithms.
c.

Intel announces record earnings.

6. According to the CAPM (capital asset pricing model), the security market line is a straight line. The intercept of this line should be equal to

a.
zero
b.
the expected risk premium on the market portfolio
c.
the expected return on the market portfolio
d.
the risk-free rate

7. A portfolio has 40% invested in Asset 1, 50% invested in Asset 2 and 10% invested in Asset 3. Asset 1 has a beta of 1.2, Asset 2 has a beta of 0.8 and Asset 3 has a beta of 1.8, whatâs the beta of the portfolio?

a.
0.80
b.
1.06
c.
1.27

8. Suppose you can borrow and lend at the risk free-rate of 3%. Which of the following four risky portfolios has the best return relative to risk. (Hint: Calculate Sharpe Ratios the ratio of risk premium to standard deviation for each portfolio)

a.
portfolio with a standard deviation of 15% and an expected return of 12%
b.
portfolio with a standard deviation of 12% and an expected return of 9%
c.
portfolio with a standard deviation of 25% and an expected return of 18%
d.
portfolio with a standard deviation of 19% and an expected return of 15%

9. Which statements are TRUE regarding risk and return?

Statement I:
Diversification is the process of removing systematic risk from a portfolio.
Statement II:
In general, the greater the risk, the greater the return required by an investor.
Statement III:
Investors should focus on real returns if they are concerned about the purchasing power of their wealth.

a.
Statements II and III only
b.
Statement I only
c.
Statements I and III only
d.
Statements I and II only

10. The beta of the risk-free asset is:
a.

1.0
b.

0.5
c.

0.0
d.

-1.0

Fill in the blank using a number of terms listed below (@1 point per question).

Beta coefficient, Bonds, CAPM, Cash flows, Change, CV, Convertible bonds, Correlation, Correlation coefficient, Debenture, Discount, Diversifiable risk, Expected return, Interest rate risk, Inverted, Junk Bonds, Market risk, More, Normal, Opposite, Probability distribution, Ratings, Reinvestment rate risk, Risk, Risk averse investor, Risk premium, Standard deviation

______________is the chance that some unfavorable event will occur. For instance, the risk of an asset is essentially the chance that the assetâs cash flows will be unfavorable or less than expected.

A __________________ is a listing, chart or graph of all possible outcomes, such as expected rates of return, with a probability assigned to each outcome.

The ______________________is a statistical measure of the variability of a set of observations. The variance of the probability distribution is the sum of the squared deviations about the expected value adjusted for deviation.

The _______________________ is equal to the standard deviation divided by the expected return; it is a standardized risk measure which allows comparisons between investments having different expected returns and standard deviations.

A _______________________ dislikes risk and requires a higher rate of return as an inducement to buy riskier securities. A realized return is the actual return an investor receives on their investment. It can be quite different than their _______________________.

A ________________ is the difference between the rate of return on a risk-free asset and the expected return on Stock i which has higher risk.

_________________ is a model based upon the proposition that any stockâs required rate ofreturn is equal to the risk free rate of return plus a risk premium reflecting onl y the risk remaining after diversification.

_________________ is the tendency of two variables to move together. A _________________ of +1.0 means that the two variables move up and down in perfect synchronization, while a coefficient of -1.0 means the variables always move in opposite directions.

_________________ is that part of a securityâs total risk that cannot be eliminated by diversification. It is measured by the beta coefficient. _________________ is also known as company specific risk. This risk can be eliminated by proper diversification.

The _________________ is a measure of a stockâs market risk, or the extent to which the returns on a given stock move with the stock market.

Please guys answer all the questions. I have to turn this in 6 hours. Thanks in Advance.

1)A firm should never undertake an investment if accepting it would increase the firmâs cost of capital.

A)True

B)False

2)If a investment under consideration has beta of zero, its purchase will not affect the firmâs market risk.

A)True

B)Fase

3) A particular project might have highly volatile forecasted cash flows, yet not have high market risk.

A)True

B)False

4)If a firm is considering purchasing an asset (with normal cash flows) whose beta is greater than the current beta of the firm, it should evaluate it using a discount rate greater than the firmâs current cost of capital.

A)True

B)False

5)If a company uses the same discount rate to evaluate all projects,

A)it will become riskier over time, and its value will decline.

B)it will become riskier over time, and its value will rise.

C)it will become less risky over time, and its value will rise.

D)it will become less risky over time, and its value will decline.

E)there is no reason to expect its risk position or value to change.

6)Tropicaliâs overall average cost of capital is 10%. Its frozen foods division is riskier than the firm as a whole, its fresh produce division has risk similar to the firmâs, and its institutional foods division has less risk. Tropicali adjusts for both divisional and project risk by adding/subtracting 2 percentage points to/from its corporate cost of capital. The hurdle rate for a low-risk project in the frozen foods division is:

a. 6%.

b. 8%.

c. 10%.

d. 12%.

e. 14%.

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FIN 4504 Lecture Notes - Lecture 12: Risk Premium, Takers, Risk-Free Interest Rate

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