5.

To determine the required rate of return, you must begin with the risk-free rate and add any
applicable risk premiums as shown below.
Risk-free rate 4.00 percent
Inflation risk premium 3.00 percent
Default risk premium 0.00 percent
Maturity risk premium 2.50 percent (10 years x 0.25)
Liquidity risk premium + 0.00 percent
Minimum yield required is 9.50 percent

6.
• Interest rate risk: Both
• Inflation risk: Both
• Business risk: Both
• Financial risk: Bonds
• Liquidity risk: Both
• Market risk: Both
• Political and regulatory risk: Both
• Exchange rate risk: Both
• Call risk: Bonds

7. Real rate of return = Actual “nominal” rate of return – inflation rate

(8.50% – 4.00%) = 4.50%

Yes an investor would purchase the bond if primarily worried only about inflation risk as the
bond offers a positive real rate of return. The inflation rate would need to increase quite a
bit in order to negate all of the potential “real return” of each coupon.

8. Tim would need to achieve a rate of return of 92.33%.

Ending Value − Beginning Value $100 ,000 − $51,994 $48 ,006

= = = 92 .33 %
Beginning Value $51,994 $51,994

9. a. Disposition Effect
b. Overconfidence
c. Herd Behavior

10. Goals associated with each of the lifecycle events include:

• The Early Years: Primary goal is wealth accumulation. Investors should be
placing the majority of savings into common stocks because they have the highest return
associated with them. An asset allocation of 80 percent stocks and 20 percent bonds is
common.
• The Golden Years: Primary goal is to preserve the level of wealth that has already
been accumulated and to allow this wealth to continue to grow. A mix of 60 percent
stocks and 40 percent bonds is common.
• The Retirement Years: Primary goal is to achieve maximum income with the
greatest level of safety. Capital appreciation is a secondary goal. A mix of 40 percent
stocks, 40 percent bonds, and 20 percent short-term Treasury bills is a relatively
common asset allocation recommendation.
• Late Retirement Years: Primary goals include safety and income. An asset
allocation mix of 20 percent stock, 60 percent bonds, and 20 percent short-term Treasury
bills is a relatively common recommendation from financial planners.