ADMS 3531 Chapter Notes - Chapter 12: Capital Market, S&P 500 Index, Risk Measure

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pucewildebeest131

24 Feb 2014

School

York University

Department

Administrative Studies

Course

ADMS 3531

Professor

Dale Domian

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Document Summary

Chapter 12 return, risk, and the security market line. R actual total return in the year. E(r) expected part of the return. Total return = expected return + unexpected return. Unexpected return = total return - expected return. Firms make periodic announcements about events that may significantly impact the profits of the firm: earnings, product development, personnel. News about the future is what really matters: market participants factor predictions about the future into the expected part of the stock return. 12. 2 efficient frontier and capital asset line. Markowitz examined relationship between risk and return of asset prices and developed efficient frontier. This theory states that total risk level (standard deviation or variance) is the important factor in rewards of portfolios and portfolio preference of investors. He claims that investors fin the minimum risk portfolios at every return level and choose these portfolios over the.

Related Questions

Market portfolio has an expected return of 11% and volatility of 20%. Risk-free rate is 3%. Security X and Y have betas of 1.4 and 0.9 respectively.

a) According to CAPM, what are the expected return of X and Y?

E(rm)-rf = 11% - 3% = 8%

3% +1.4*8% = 14.2%

3% +1.4 *8% = 10.2%

b) What should be X worth today, if X pays a dividend of $1.2 one year from today and is priced at 30 one year from today? The required rate of return is the expected return using CAPM from part a).

c) If security X has expected return of 15%, is it underprice/overprice/fairly priced according to CAPM? What is its alpha?

d) Plot SML and label X, Y and Market portfolio on the line.

e) What is the beta of a portfolio with 50% in X and 50% in Y?

f)What is the beta of a portfolio with 55% in Market portfolio and 45% in risk-free asset?

g) You are investing in a complete portfolio. The complete portfolio is composed of risk-free asset and a risky portfolio, P, constructed with 20% in X and 80% in Y. It turns out that your complete portfolio has an expected rate of return of 9.4%. What is the beta of your complete portfolio? (hint: you may or may not use all information to solve this problem)

Q2. Stock A has a beta of 1 and standard deviation of 50%. Market portfolio has a standard deviation of 20%. What is the correlation of stock A with the market portfolio? How much of stock Aâs total risk is due to market risk?

Q3. Assume the risk-free rate is 8% and the expected rate of return on the market is 18%. A stock has an expected return of 6%. What is its beta?

Can you tell me What does this article tell us about the bond markets performance and the interest rate environment?

Long-Term Government Bonds Shine as Fed Goes Slow

Pimco, Vanguard funds with focus on long-term debt beat out other bond funds in the 1st quarter

For investors, one of the best bets of 2016 has been a wager via U.S. Treasurys on falling interest rates.

A Pimco long-term government-bond fund was the best performer among bond funds in the first quarter. Above, Pimco offices in Newport Beach, Calif. PHOTO: MIKE BLAKE/REUTERS

The $460 million Pimco Extended Duration Fund posted a total return of 11.8% in the first quarter, making it the best performer among 2,015 U.S.-based bond mutual funds, according to data from Morningstar. Total return reflects price gains plus periodic payments.

The runner-up was $1.3 billion Vanguard Extended Duration Treasury Index Fund, which returned 11.7% during the quarter, according to Morningstar.

Both funds posted their best returns since the last quarter of 2014 and have extended those gains in the early days of the second quarter. Duration refers to a fundâs exposure to interest-rate risk, meaning its prices will rise more when rates fall and fall more when rates rise.

Analysts have warned repeatedly that bets on duration are risky, given the long decline in interest rates over recent years. The gains are striking at a time when stocks and other riskier assets have rebounded from an early-year selloff that at one point left the Dow industrials down 10%. The Dow fell 20.55 points, or 0.1%, on Monday, but is up 0.8% for the year.

While safer securities such as U.S. Treasurys and German bunds tend to decline in price when stocks and low-rated corporate bonds rally, many analysts say the simultaneous rise of safer and riskier assets this spring is tied to the unexpectedly slow pace of policy tightening by the Federal Reserve, along with signs the global economy continues its slow healing.

MORE IN MARKETS

A Measure of Stock-Market âFearâ Just Hit an All-Time High

Spreads Point to Growing Stress in Japanese Government Bond Market

By One Measure, U.S. Rates Are Already Negative

At the same time, many investors are concerned that the rally in stocks, bonds and commodities off Feb. 11 lows may have gone too far too fast.

âWe are still stuck in low growth,ââ Jack Flaherty,portfolio manager at money manager GAM, which has over $119 billion in global assets under management. âIt may be time to lighten up a bit and pauseâ on purchases of riskier assets, he said.

The uncertainty is why many investors are buying long-term U.S. government bonds, even though analysts have warned that slim yields leave bondholders vulnerable to potentially large capital losses if interest rates do rise.

The average U.S. equity mutual fund posted a total return of minus-0.4% between January and March, according to Morningstar. The average return for all U.S.-based bond funds tracked by Morningstar was 2.1% for the period. Quarter-end data for all funds are typically finalized in the early days of the following period.

âIt has been a good start for bond funds,ââ said Jeff Tjornehoj, head of Americas research at Lipper. That performance âmay be hard to repeat this quarter.â

Stock funds on average returned 4.4% in the fourth quarter last year, according to Morningstar. Bond funds posted a negative 0.1% return in the final quarter of 2015.

U.S. Treasury bonds overall have posted a total return of 3.6% this year through Friday, according to data from Barclays. U.S. bonds sold by lower-rated firms, or junk bonds, have returned 3.8% over the same period. S&P 500 has returned 0.8%, according to FactSet.

The Vanguard fund passively tracks an index of long-term Treasury bonds. The fund âwill tend to have extreme resultsâboth on the up and down sideââ given its focus on buying government bonds with very long-term maturity, said a representative of Vanguard in a written statement.

The Pimco fund is actively managed by three fund managers at Pacific Investment Management Co.: Stephen Rodosky, Michael Cudzil and Josh Thimons. A representative at Pimco declined to comment.

The Pimco fund attracted $19.7 million of new cash between January and February, topping the $11.9 million it obtained for the whole year of 2015, according to the latest data from fund tracker Lipper.

The Vanguard fund attracted $20.4 million of new cash during the first two months of the year, after suffering a net withdrawal of $115.7 million in 2015, according to Lipper.

The Vanguard fund posted a loss of 20.9% in 2013, according to Morningstar, when worries about the Fed reducing bond purchases rattled the bond market. The Pimco fund lost 21.2% that year.

But U.S. bond yields have largely been on a downward trend since the financial crisis. The two funds both posted an annualized return of about 17% on average over the past five years through Friday, according to Morningstar.

Instructions: Use the formula below to compute the problems: âPlease Read the question carefully.â

K_d = Yield (1 â T)

1. Telecom Systems can issue debt yielding 8 percent. The company is in a 35 percent bracket. What is its after-tax cost of debt?

2. After-tax cost of debt: Royal Jewelers Inc., has an aftertax cost of debt of 6 percent. With a tax rate of 40 percent, what can you assume the yield on the debt is?

Cash flow: Assume a corporation has earnings before depreciation and taxes of $100,000, depreciation of $50,000, and that it has a 30 percent tax bracket. Compute its cash flow using the format below.

Earnings before depreciation and taxes _____

Depreciation _____

Earnings before taxes _____

Taxes @ 30% _____

Earnings after taxes _____

Depreciation _____

Cost of preferred stock: Medco Corporation can sell preferred stock for $80 with an estimated flotation cost of $3. It is anticipated the preferred stock will pay $6 per share in dividends.

a. Compute the cost of preferred stock for Medco Corp.

b. Do we need to make a tax adjustment for the issuing firm?

5. Cost of preferred stock: The Meredith Corporation issued $100 par value preferred stock 10 years ago. The stock provided an 8 percent yield at the time of issue. The preferred stock is now selling for $75. What is the current yield or cost of the preferred stock? (Disregard flotation costs.)

6. Costs of retained earnings and new common stock: Barton Electronics wants you to calculate its cost of common stock. During the next 12 months, the company expects to pay dividends (D₁) of $1.20 per share, and the current price of its common stock is $30 per share. The expected growth rate is 9 percent.

a. Compute the cost of retained earnings (K_e). Use Formula 11-6.

b. If a $2 flotation cost is involved, compute the cost of new common stock (K_n). Use Formula 11-7.

7. A firm's cost of preferred stock is equal to the preferred dividend divided by market price plus the dividend growth rate (K_p= D/P_o+ g).

8. The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.

a. True

b. False

9. The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

a. True

b. False

10. The CAPM is built on historic conditions, although in most cases we use expected future data in applying it. Because betas used in the CAPM are calculated using expected future data, they are not subject to changes in future volatility. This is one of the strengths of the CAPM.

a. True

b. False

11. You have the following data on three stocks:

Stock	Standard Deviation	Beta
A	20%	0.59
B	10%	0.61
C	12%	1.29

If you are a strict risk minimizer, you would choose Stock if it is to be held in isolation and Stock if it is to be held as part of a well-diversified portfolio.

a. A; A.

b. A; B.

c. B; A.

d. C; A.

e. C; B.

12. A portfolioâs risk is measured by the weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and thus reduce the riskiness of their portfolios.

a. True

b. False

13. You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is CORRECT?

a. The price of Bond B will decrease over time, but the price of Bond A will increase over time.

b. The prices of both bonds will remain unchanged.

c. The price of Bond A will decrease over time, but the price of Bond B will increase over time.

d. The prices of both bonds will increase by 7% per year.

e. The prices of both bonds will increase over time, but the price of Bond A will increase at a faster rate.

14. A 12-year bond has an annual coupon of 9%. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7%. Which of the following statements is CORRECT?

a. If market interest rates decline, the price of the bond will also decline.

b. The bond is currently selling at a price below its par value.

c. If market interest rates remain unchanged, the bondâs price one year from now will be lower than it is today.

d. The bond should currently be selling at its par value.

e. If market interest rates remain unchanged, the bondâs price one year from now will be higher than it is today.

15. Suppose the real risk-free rate is 3.50% and the future rate of inflation is expected to be constant at 2.20%. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average.

a. 5.14%

b. 5.42%

c. 5.70%

d. 5.99%

e. 6.28%

16. Suppose 1-year T-bills currently yield 7.00% and the future inflation rate is expected to be constant at 3.20% per year. What is the real risk-free rate of return, r*? Disregard any cross-product terms, i.e., if averaging is required, use the arithmetic average.

a. 3.80%

b. 3.99%

c. 4.19%

d. 4.40%

e. 4.62%

17. Assume that interest rates on 20-year Treasury and corporate bonds are as follows:

T-bond = 7.72% AAA = 8.72% A = 9.64% BBB = 10.18%

The differences in these rates were probably caused primarily by:

a. Tax effects.

b. Default and liquidity risk differences.

c. Maturity risk differences.

d. Inflation differences.

e. Real risk-free rate differences.

18. You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment?

a. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for only 5 rather than 10 years, hence that each payment is for $20,000 rather than for $10,000.

b. The discount rate increases.

c. The riskiness of the investmentâs cash flows decreases.

d. The total amount of cash flows remains the same, but more of the cash flows are received in the earlier years and less are received in the later years.

e. The discount rate decreases.

19. Assume that inflation is expected to decline steadily in the future, but that the real risk-free rate, r*, will remain constant. Which of the following statements is CORRECT, other things held constant?

a. If the pure expectations theory holds, the Treasury yield curve must be downward sloping.

b. If the pure expectations theory holds, the corporate yield curve must be downward sloping.

c. If there is a positive maturity risk premium, the Treasury yield curve must be upward sloping.

d. If inflation is expected to decline, there can be no maturity risk premium.

e. The expectations theory cannot hold if inflation is decreasing.

20. Disregarding risk, if money has time value, it is impossible for the present value of a given sum to exceed its future value.

a. True

b. False

ADMS 3531 Chapter Notes - Chapter 12: Capital Market, S&P 500 Index, Risk Measure

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