Week 4 Questions (chap 6, Finance text) 1. Over the past 7 decades, we have had the opportunity to observe the rates of return and variability of these returns for different types of securities. Summarize these observations. 2. Explain the effect of inflation on rates of return. 3. Explain the concept "term structure of interest rates." 4. (a) What is meant by the investor's required rate of return? (b) How do we measure the riskiness of an asset? (c) How should the proposed measurement of risk be interpreted? 5. What is (a) unsystematic risk (company-unique or diversifiable risk) and (b) systematic risk nondiversifiable risk)? 6. What is the meaning of beta? How is it used to calculate k. the investor's required rate of return? . 7. Define the security market line. What does it represent? 8. How do we measure the beta for a portfolio? 9. If we were to graph the returns of a stock against the returns of the S&P 500 Index, and the points did not follow a very ordered pattern, what could we say about that stock? If the stock's returns tracked the S&P 500 returns very closely, then what could we say? Answers: 6-1. Data have been compiled by Ibbotson and Sinquefield on the actual returns for the following portfolios of securities from 1926-1990. 1. U.S. Treasury bills 2. U.S. government bonds 3. Corporate bonds 4. Common stocks for all socks 5. 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. 6-3 The relationship between a debt security’s 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. 6-4. (a) The investor's required rate of return is the minimum rate of return necessary to attract an investor to purchase or hold a security. (b) 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. (c) 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 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. (b) 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. 6-6. Beta indicates the responsiveness of a security's return 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. 6-7. 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. 6-8. The beta for a portfolio is equal to the weighted average of the individual stock betas, weighted by the percentage invested in each stock. 6-9. 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.
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