Financial Management: Principles and Applications, 11e (Titman) Chapter 7 An Introduction to Risk and Return-History of Financial Market Returns
7.1 Realized and Expected Rates of Return and Risk 1) You You purchased the stock of Sargent Motors at a price of $75.75 one ear ago toda. !f ou sell the stock toda for $"#.% &hat is our holding period return' () 5.* +) 1,.5* -) 17.5* ) ,5.* (ns&er/ iff/ , 0opic/ 0o pic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ holding period return 2rinciples/ 2rinciple ,/ 0here 0here !s a Risk3Return 0radeoff 0radeoff ,) You You ha4e in4ested in a proect that has the follo&ing paoff schedule/ 2ro6a6ilit of 2aoff ccurrence $8 .1 5 $5 ., $9 . $7 . $" . 5 :hat is the expected 4alue of the in4est;ent
2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 8) You are considering in4esting in a proect &ith the follo&ing possi6le outco;es/ 2ro6a6ilit of !n4est;ent States ccurrence Returns State 1/ Econo;ic 6oo; 15* 19* State ,/ Econo;ic gro&th 85* 1,* State / Econo;ic decline ,5* 5* State 8/ epression 15* 35* -alculate the expected rate of return for this in4est;ent. () #."* +) 7.* -) ".* ) 9.* (ns&er/ iff/ , 0opic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ holding period return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 5) Spartan Sofas% !nc. is selling for $5. per share toda. !n one ear% Spartan &ill 6e selling for $8". per share% and the di4idend for the ear &ill 6e $.. :hat is the cash return on Spartan stock' () * +) ,* -) 9* ) 1* (ns&er/ + iff/ , 0opic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ holding period return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 9) :hat is the standard de4iation of an in4est;ent that has the follo&ing expected scenario' 1"* pro6a6ilit of a recession% ,.* return? 95* pro6a6ilit of a ;oderate econo;% #.5* return? 17* pro6a6ilit of a strong econo;% 18.,* return. () .9"* +) 1.,* -) ".87* ) 9.99* (ns&er/ ( iff/ , 0opic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ standard de4iation 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff
,
7) You are considering in4esting in a fir; that has the follo&ing possi6le outco;es/ Econo;ic 6oo;/ pro6a6ilit of ,5*? return of ,5* Econo;ic gro&th/ pro6a6ilit of 9*? return of 15* Econo;ic decline/ pro6a6ilit of 15*? return of 35* :hat is the expected rate of return on the in4est;ent' () 15.* +) 11.7* -) 18.5* ) ,5.* (ns&er/ iff/ , 0opic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ holding period return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff ") :hich of the follo&ing 6est ;easures the risk of holding an asset in isolation =i.e.% stand3alone risk)' () 0he ;ean co34ariance +) 0he standard de4iation -) 0he coefficient of opti;ization ) 0he standard asset pricing ;odel E) 0he correlation (ns&er/ + iff/ , 0opic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ standard de4iation 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff #) 0he holding period return is al&as positi4e. (ns&er/ @(ASE iff/ 1 0opic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ holding period return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 1) +ecause returns are ;ore certain for the least risk in4est;ents% the reBuired return on these in4est;ents should 6e higher than the reBuired returns on ;ore risk in4est;ents. (ns&er/ @(ASE iff/ 1 0opic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ holding period return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff
11) E4en though an in4estor expects a positi4e rate of return% it is possi6le that the actual return &ill 6e negati4e. (ns&er/ 0RCE iff/ 1 0opic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ holding period return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 1,) 0he expected rate of return is the &eighted a4erage of the possi6le returns for an in4est;ent. (ns&er/ 0RCE iff/ 1 0opic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ holding period return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 1) 0he expected rate of return is the su; of each possi6le return ti;es it likelihood of occurrence. (ns&er/ 0RCE iff/ 1 0opic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ holding period return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 18) 0he higher the standard de4iation% the less risk the in4est;ent has. (ns&er/ @(ASE iff/ 1 0opic/ 7.1 Realized and Expected Rates of Return and Risk e&ords/ standard de4iation 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 15) Csing the follo&ing infor;ation for Mcono4an% !nc.
8
7., ( +rief Jistor of @inancial Market Returns 1) 0he risk3return tradeoff tells us that expected returns should 6e higher on in4est;ents that ha4e higher risk. (ns&er/ 0RCE iff/ 1 0opic/ 7., ( +rief Jistor of @inancial Market Returns e&ords/ risk 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff ,) Riskier in4est;ents ha4e traditionall had lo&er returns than less risk in4est;ents ha4e had. (ns&er/ @(ASE iff/ 1 0opic/ 7., ( +rief Jistor of @inancial Market Returns e&ords/ risk 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff ) Aess risk in4est;ents ha4e lo&er standard de4iations than do ;ore risk in4est;ents. (ns&er/ 0RCE iff/ 1 0opic/ 7., ( +rief Jistor of @inancial Market Returns e&ords/ risk% return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 8) !n4est;ents in e;erging ;arkets ha4e higher 4olatilit than do C.S. Stocks. (ns&er/ 0RCE iff/ 1 0opic/ 7., ( +rief Jistor of @inancial Market Returns e&ords/ standard de4iation 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 5) Expected return and realized return are the sa;e thing. (ns&er/ @(ASE iff/ 1 0opic/ 7., ( +rief Jistor of @inancial Market Returns e&ords/ holding period return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 9) Jistoricall% in the Cnited States stocks ha4e had higher returns and greater 4olatilit than ha4e go4ern;ent 6onds. (ns&er/ 0RCE iff/ 1 0opic/ 7., ( +rief Jistor of @inancial Market Returns e&ords/ risk% return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff
5
7) 0reasur +ills ha4e less default risk than do Ko4ern;ent +onds. (ns&er/ 0RCE iff/ 1 0opic/ 7., ( +rief Jistor of @inancial Market Returns e&ords/ risk% return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff ") !n4estors are al&as re&arded for taking higher risk &ith higher realized returns. (ns&er/ @(ASE iff/ 1 0opic/ 7., ( +rief Jistor of @inancial Market Returns e&ords/ risk% return 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff #) !n4estors ;ake different in4est;ent choices partiall 6ecause indi4iduals do not all ha4e the sa;e tolerance for risk. (ns&er/ 0RCE iff/ 1 0opic/ 7., ( +rief Jistor of @inancial Market Returns e&ords/ in4estor tolerance 2rinciples/ 2rinciple ,/ 0here !s a Risk3Return 0radeoff 7. Keo;etric 4s. (rith;etic (4erage Rates of Return 1) Marcus +erger in4ested $#"8,. in Ja&keehats% !nc. four ears ago. Je sold the stock toda for $11%#9.,,. :hat is his geo;etric a4erage return' () 0here is insufficient infor;ation to deri4e an ans&er. +) ,.#"* -) .7* ) .#5* (ns&er/ iff/ 1 0opic/ 7. Keo;etric 4s. (rith;etic (4erage Rates of Return e&ords/ holding period return 2rinciples/ 2rinciple 1/ Mone Jas a 0i;e Lalue ,) Marcus +erger in4ested $#"8,. in Ja&keehats% !nc. four ears ago. Je sold the stock toda for $11%#9.,,. :hat is his arith;etic a4erage return' () 0here is insufficient infor;ation to deri4e an ans&er. +) ,.#"* -) .7* ) .#5* (ns&er/ ( iff/ 1 0opic/ 7. Keo;etric 4s. (rith;etic (4erage Rates of Return e&ords/ arith;etic a4erage return 2rinciples/ 2rinciple 1/ Mone Jas a 0i;e Lalue 9
Use the following to answer the following question(s).
Rodd Richards in4ested $1,18."" in :ol4erine Meat istri6utors =:.M..) fi4e ears ago. 0he in4est;ent had earl arith;etic returns of 3#.7*% 3".1*% 15 *% 7.,*% and 15.8*. ) :hat is the arith;etic a4erage return of Rodd Richard
7
Use the following information to answer the following question(s).
Susan +right &ill get returns of 1"*% 3,.*% 318*% 17.9*% and ".* in the next fi4e ears on her in4est;ent in -offee0o&n% !nc. stock% &hich she purchases for $7%81#.99 toda. 9) :hat is the arith;etic a4erage return on her stock if she sells it fi4e ears fro; toda' () 1.#,* +) .#"* -) 9.87* ) 7.11* (ns&er/ ( iff/ , 0opic/ 7. Keo;etric 4s. (rith;etic (4erage Rates of Return e&ords/ arith;etic a4erage return 2rinciples/ 2rinciple 1/ Mone Jas a 0i;e Lalue 7) :hat is the geo;etric a4erage return on her stock if she sells it fi4e ears fro; toda' () 3,.* +) .5#* -) .97* ) 8.""* (ns&er/ + iff/ , 0opic/ 7. Keo;etric 4s. (rith;etic (4erage Rates of Return e&ords/ geo;etric a4erage return 2rinciples/ 2rinciple 1/ Mone Jas a 0i;e Lalue ") Jo& ;uch &ill Susan
"
1) (n in4estor &ho &ishes to hold a stock for fi4e ears &ill 6e ;ost interested in geo ;etric a4erage rather than in the arith;etic a4erage return. (ns&er/ 0RCE iff/ 1 0opic/ 7. Keo;etric 4s. (rith;etic (4erage Rates of Return e&ords/ co;pound interest 2rinciples/ 2rinciple 1/ Mone Jas a 0i;e Lalue 11) !f an in4estor holds a stock for six ears% the 4alue at the end of six ears &ill 6e the initial cost ti;es =1 G geo;etric a4erage return)to the sixth po&er. (ns&er/ 0RCE iff/ 1 0opic/ 7. Keo;etric 4s. (rith;etic (4erage Rates of Return e&ords/ co;pound interest 2rinciples/ 2rinciple 1/ Mone Jas a 0i;e Lalue 1,) !f an in4estor holds a stock for three ears% the 4alue at the end of three ears &ill al&as 6e the initial cost of the stock ti;es =1 G arith;etic a4erage return) to the third po&er. (ns&er/ @(ASE iff/ 1 0opic/ 7. Keo;etric 4s. (rith;etic (4erage Rates of Return e&ords/ co;pound interest 2rinciples/ 2rinciple 1/ Mone Jas a 0i;e Lalue 1) :h do the arith;etic a4erage return and the geo;etric return differ' (ns&er/ 0he arith;etic a4erage return does not take &hat the 4alue of the in4est;ent &as at the start of each period. Jence% e4en though a co;pan ;a ha4e the sa;e arith;etic return for t&o consecuti4e ears% the dollar a;ount of those returns &ill 6e different in later ears than in the first ear. @or instance% if the in4estor started &ith $1%% and earned ,* the first ear% lost ,* the second ear% and earned 15* the third ear% the a4erage arith;etic return &ould 6e 5*% and the ,* gain the first ear &ould 6e $,% 6ut the ,* loss the second ear &ould 6e $,8. 0he in4est;ent &ould 6e &orth $118 after three ears% gi4ing an a4erage geo;etric return of .5*% different fro; the a4erage arith;etic return. iff/ , 0opic/ 7. Keo;etric 4s. (rith;etic (4erage Rates of Return e&ords/ co;pound interest 2rinciples/ 2rinciple 1/ Mone Jas a 0i;e Lalue
#
7.8 :hat eter;ines Stock 2rices' 1) Each of the follo&ing &ould tend to &eaken the Efficient Market Jpothesis E-E20/ () 0here is pu6licl a4aila6le infor;ation that +oeing (ircraft has procured a contract to 6uild ,5 planes for the C.S. Ko4ern;ent and the price of +oeing Buickl goes up. +) (-K% !nc. perfor;ed &ell for the past six ;onths% 6ut the ust lost a ;aor distri6ution contract% 6ut the price of (-K stock continues to go up. -) Aouis4ille Slugger% !nc.% gets a contract to suppl 6ats for Aittle Aeague pla% a contract it ne4er had 6efore% and stock price re;ains sta6le. ) isne corporation% a gro&th co;pan% opens a ne& the;e park% &hich in4estors expect &ill do tre;endousl &ell% and the stock price stas sta6le% &hile Cr6an Electric -o;pan% &hich has a set infrastructure% and generates #5* of its earnings fro; assets it o&ns% outperfor;s isne. (ns&er/ ( iff/ 1 0opic/ 7.8 :hat eter;ines Stock 2rices' e&ords/ efficient ;arkets 2rinciples/ 2rinciple 8/ Market 2rices Reflect !nfor;ation ,) Stock prices go up &hen there is positi4e infor;ation a6out a co;pan% and go do&n &he n there is negati4e infor;ation a6out the co;pan. (ns&er/ 0RCE iff/ 1 0opic/ 7.8 :hat eter;ines Stock 2rices' e&ords/ efficient ;arkets 2rinciples/ 2rinciple 8/ Market 2rices Reflect !nfor;ation ) (n in4estor &ith access to all pu6licl a4aila6le infor;ation &ill 6e a6le to ;ake higher than expected profit if the ;arket has se;i3strong efficienc. (ns&er/ @(ASE iff/ 1 0opic/ 7.8 :hat eter;ines Stock 2rices' e&ords/ efficient ;arkets 2rinciples/ 2rinciple 8/ Market 2rices Reflect !nfor;ation 8) !f a ;arket has &eak for; efficienc% an in4estor can ;ake higher than expected profits 6 studing the past price patterns of a stock. (ns&er/ @(ASE iff/ 1 0opic/ 7.8 :hat eter;ines Stock 2rices' e&ords/ efficient ;arkets 2rinciples/ 2rinciple 8/ Market 2rices Reflect !nfor;ation
1
5) !f an indi4idual &ith inside infor;ation can ;ake higher than expected profits% the ;arket is no ;ore than se;i3strong for; efficient. (ns&er/ 0RCE iff/ 1 0opic/ 7.8 :hat eter;ines Stock 2rices' e&ords/ efficient ;arkets 2rinciples/ 2rinciple 8/ Market 2rices Reflect !nfor;ation 9) Cnder the efficient ;arket hpothesis% &ould securities 6e properl priced. (ns&er/ !f ;arkets &ere perfectl efficient% then in4estors &ould price a stock 6ased on the co;pan
11
