a. (1)Why is the T-bill s return independent of the state of the economy? Do T-bills promise a completely risk-free return? Explain.

T-bill is a short-term debt obligation backed by the government with a maturity of less than one year. T-bills commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks). T-bills are purchased for a price that is less than their par (face) value; when they mature, the government pays the holder the full par value. Effectively, your interest is the difference between the purchase price of the security and what you get at maturity. For example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would earn $200 on your investment. Therefore, you will be earning a fixed amount when it matures regardless of the state of the economy. There are no risk-free investments because even the safest investments, such as bank savings account, come with the risk of bank failure or the risk of not earning enough interest to keep up with the rate of inflation. Treasury bills are regarded as extremely safe. However, if you are forced to sell Treasuries prior to maturity, there s always a chance they may have dropped in price.

(2) Why are High Tech s returns expected to move with the economy, whereas Collections are expected to move counter the economy? The given data shows that during recession High Tech s estimated rate of return is negative and as the economy improves, the estimated rate of return also increases. On the contrary, Collections inc. displays high estimated rate of return during recession and a negative return when the economy is at its best. High Tech Inc. is an electronics firm. When the state of the economy is above average or at its boom, consumers purchase more products of High Tech Inc. than they would if the state of the economy gets worse. Under this circumstance, we would expect High Tech s stock price to be high if the economy is well. The opposite holds true with Collections Inc. because the nature of the business is on collections of past-due debts. If the economy is in recession, people are not expected to pay their debts on time. Consequently, this firm will be collecting a lot of past-due debts, thus making its stock price to increase. The opposite will happen if the economy is performing well. This explains why Collection s expected return moves counter the economy.

b. Calculate the expected rate of return on each alternative and fill in the blanks on the row for r(hat) or the expected rate of return in the previous table.

State Of the Economy (1) Recession Below Average Average Above Average Boom

COLLECTIONS INC. - EXPECTED RETURN Estimated Rate of Probability Return (2) (3) 0.1 27.0% 0.2 13.0% 0.4 0.0% 0.2 -11.0% 0.1 -21.0% 1.0 Expected return =

Product (2x3) (4) 2.7% 2.6% 0.0% -2.2% -2.1% 1.0%

State Of the Economy (1) Recession Below Average Average Above Average Boom

U.S. RUBBER - EXPECTED RETURN Estimated Rate of Probability Return (2) (3) 0.1 6.0% 0.2 -14.0% 0.4 3.0% 0.2 41.0% 0.1 26.0% 1.0 Expected return =

Product (2x3) (4) 0.6% -2.8% 1.2% 8.2% 2.6% 9.8%

State Of the Economy (1) Recession Below Average Average Above Average Boom

HIGH TECH INC. - EXPECTED RETURN Estimated Rate of Return Probability (2) (3) 0.1 -27.0% 0.2 -7.0% 0.4 15.0% 0.2 30.0% 0.1 45.0% 1.0 Expected return =

Product (2x3) (4) -2.7% -1.4% 6.0% 6.0% 4.5% 12.4%

State Of the Economy (1) Recession Below Average Average Above Average Boom

T-BILLS- EXPECTED RETURN Estimated Rate of Return Probability (2) (3) 0.1 5.5% 0.2 5.5% 0.4 5.5% 0.2 5.5% 0.1 5.5% 1.0 Expected return =

Product (2x3) (4) 0.6% 1.1% 2.2% 1.1% 0.6% 5.5%

State Of the Economy (1) Recession Below Average Average Above Average Boom

MARKET PORTFOLIO- EXPECTED RETURN Estimated Rate of Return Probability (2) (3) 0.1 -17.0% 0.2 -3.0% 0.4 10.0% 0.2 25.0% 0.1 38.0% 1.0 Expected return =

Product (2x3) (4) -1.7% -0.6% 4.0% 5.0% 3.8% 10.5%

State Of the Economy (1) Recession Below Average Average Above Average Boom

2-STOCK PORTFOLIO- EXPECTED RETURN Estimated Rate of Return Probability (2) (3) 0.1 0.0% 0.2 0.4 7.5% 0.2 0.1 12.0% 1.0 Expected return =

Product (2x3) (4) 0.0% 0.0% 3.0% 0.0% 1.2% 4.2%

c. You should recognize that basing a decision solely on expected returns is appropriate only for riskneutral individuals. Because your client, like most people, is risk-averse, the riskiness of each alternative is an important aspect of the decision. One possible measure of risk is the standard deviation of returns.

(1) Calculate this value for each alternative and fill in the blank on the row for standard deviation in the table.

COLLECTIONS INC. - STANDARD DEVIATION Product State Of the Economy (1) Recession Below Average Average Above Average Boom Probability (2) 0.1 0.2 0.4 0.2 0.1 1.0 Estimated Rate of Return (3) 27.0% 13.0% 0.0% -11.0% -21.0% Expected return = (2)x(3) (4) 2.7% 2.6% 0.0% -2.2% -2.1% 1.0% Deviation: Actual(3) -1.0% Expctd return (5) 26.00% 12.00% -1.00% -12.00% -22.00% Deviation Squared Deviation x Probability (7) 0.00676 0.00288 0.00004 0.00288 0.00484 0.0174 0.13190906 13.19%

(6) 6.7600% 1.4400% 0.0100% 1.4400% 4.8400% Variance = Std Deviation (square root of variance) = Std Deviation expressed as percentage =

U.S. RUBBER - STANDARD DEVIATION Product State Of the Economy (1) Recession Below Average Average Above Average Boom Probability (2) 0.1 0.2 0.4 0.2 0.1 1.0 Estimated Rate of Return (3) 6.0% -14.0% 3.0% 41.0% 26.0% Expected return = (2)x(3) (4) 0.6% -2.8% 1.2% 8.2% 2.6% 9.8% Deviation: Actual(3) -9.8% Expctd Return (5) -3.80% -23.80% -6.80% 31.20% 16.20% Deviation Squared (6) 0.1444% 5.6644% 0.4624% 9.7344% 2.6244% Variance = Squared Deviation x Probability (7) 0.0001444 0.0113288 0.0018496 0.0194688 0.0026244 0.035416 0.188191392 18.82%

Std Deviation (square root of variance) = Std Deviation expressed as percentage =

HIGH TECH INC. - STANDARD DEVIATION Product State Of the Economy (1) Recession Below Average Average Above Average Boom Probability (2) 0.1 0.2 0.4 0.2 0.1 1.0 Estimated Rate of Return (3) -27.0% -7.0% 15.0% 30.0% 45.0% Expected return = (2)x(3) (4) -2.7% -1.4% 6.0% 6.0% 4.5% 12.4% Deviation: Actual(3) -12.4% Expctd Return (5) -39.40% -19.40% 2.60% 17.60% 32.60% Deviation Squared (6) 15.5236% 3.7636% 0.0676% 3.0976% 10.6276% Variance = Squared Deviation x Probability (7) 0.0155236 0.0075272 0.0002704 0.0061952 0.0106276 0.040144 0.200359677 20.04%

Std Deviation (square root of variance) = Std Deviation expressed as percentage =

T-BILLS - STANDARD DEVIATION Product State Of the Economy (1) Recession Below Average Average Above Average Boom Probability (2) 0.1 0.2 0.4 0.2 0.1 1.0 Estimated Rate of Return (3) 5.5% 5.5% 5.5% 5.5% 5.5% Expected return = (2)x(3) (4) 0.6% 1.1% 2.2% 1.1% 0.6% 5.5% Deviation: Actual(3) -5.5% Expctd Return (5) 0.00% 0.00% 0.00% 0.00% 0.00% Deviation Squared (6) 0.0000% 0.0000% 0.0000% 0.0000% 0.0000% Variance = Squared Deviation x Probability (7) 0 0 0 0 0 0 0 0.00%

Std Deviation (square root of variance) = Std Deviation expressed as percentage =

MARKET PORTFOLIO- STANDARD DEVIATION Product State Of the Economy (1) Recession Below Average Average Above Average Boom Probability (2) 0.1 0.2 0.4 0.2 0.1 1.0 Estimated Rate of Return (3) -17.0% -3.0% 10.0% 25.0% 38.0% Expected return = (2)x(3) (4) -1.7% -0.6% 4.0% 5.0% 3.8% 10.5% Deviation: Actual(3) -10.5% Expctd Return (5) -27.50% -13.50% -0.50% 14.50% 27.50% Deviation Squared (6) 7.5625% 1.8225% 0.0025% 2.1025% 7.5625% Variance = Squared Deviation x Probability (7) 0.0075625 0.003645 1E-05 0.004205 0.0075625 0.022985 0.151608047 15.16%

Std Deviation (square root of variance) = Std Deviation expressed as percentage =

2-STOCK PORTFOLIO- STANDARD DEVIATION Product State Of the Economy (1) Recession Below Average Average Above Average Boom Probability (2) 0.1 0.2 0.4 0.2 0.1 1.0 Estimated Rate of Return (3) 0.0% 7.5% 12.0% Expected return = (2)x(3) (4) 0.0% 0.0% 3.0% 0.0% 1.2% 4.2% Deviation: Actual(3) -4.2% Expctd Return (5) -4.20% -4.20% 3.30% -4.20% 7.80% Deviation Squared (6) 0.1764% 0.1764% 0.1089% 0.1764% 0.6084% Variance = Squared Deviation x Probability (7) 0.0001764 0.0003528 0.0004356 0.0003528 0.0006084 0.001926 0.043886217 4.39%

Std Deviation (square root of variance) = Std Deviation expressed as percentage =

(2) What type of risk is measured by the standard deviation? Standard deviation is one of the statistical measures of stand-alone risk which is the risk an investor would face if he or she held only one asset. It also measures the dispersion around the expected value. It is regarded as the most common statistical indicator of an asset s risk.

(3) Draw a graph that shows roughly the shape of the probability distributions for High Tech, U.S. Rubber and T-bills.

d. Suppose you suddenly remembered that the coefficient of variation (CV) is regarded as being a better measure of stand-alone risk than the standard deviation when the alternative being considered have widely differing expected returns. Calculate the missing CVs and fill in the blanks on the row for CV in the table. Does the CV produce the same risk rankings as the standard deviation? Explain.
COEFFICIENT OF VARIATION T-BILLS (CV) HIGH TECH INC. COLLECTIONS U.S. RUBBER MARKET PORTFOLIO = = = = = = Standard Deviation Expected Return 0 5.5 20.04 12.4 13.2 1.0 18.8 9.8 15.2 10.5 = = = = = 0.00 1.62 13.2 1.92 1.45

Measurement Expected Return Standard Deviation Coefficient of Variation

T-BILLS 5.5 0 0

HIGH TECH COLLECTIONS 12.4 1.0 20.04 13.20 e1.62 13.20

U.S. RUBBER 9.8 18.8 1.92

MARKET PORTFOLIO 10.5 15.2 1.45

The coefficient of variation produced a different risk ranking as compared to the standard deviations. In the standard deviation, High Tech has the highest risk rating while in the coefficient of variation collections has the highest risk ratings. The market portfolio has a standard deviation of 15.2 but it has a coefficient of variation 1.45. Other alternatives also have significant differences. These differences are due to the fact that CV measures the relative dispersion of that is useful in comparing the risks of assets with differing expected returns.

e. Suppose you created a 2-stock portfolio by investing $50,000 in High Tech and $50,000 in Collections. (1) Calculate the expected return, the standard deviation, and the coefficient of variation for this portfolio and fill in the appropriate blanks in the table.

State Of the Economy Recession Below Average Average Above Average Boom

High Tech $50,000 -27.0% -7.0% 15.0% 30.0% 45.0%

Collections $50,000 27.0% 13.0% 0.0% -11.0% -21.0%

Portfolio Return Calculation (.5 x -27%) + (.5 x 27%) (.5 x -7%) + (.5 x 13%) (.5 x 15%) + (.5 x 0%) (.5 x 30%) + (.5 x 11%) (.5 x 45%) + (.5 x 21%) Expected value of portfolio return =

Expected Portfolio Return 0 3 7.5 20.5 33 64 12.8%

(64/5)

Standard Deviation (Portfolio)

(0-12.8)+(13-12.8)+(7.5-12.8)+(20.5-12.8)+(33-12.8) 5 less 1 13.74%

Coefficient of Variation

= =

13.74%/12.8% 1.07

(2) How does the riskiness of this 2-stock portfolio compare with the riskiness of the individual stocks if they were held in isolation? The standard deviation of Collections is equal to 13.2 and SD of High Tech is 20.04. The 2-stock portfolio s SD is on the other hand equal to 13.74. Since SD measures how far the actual return is likely to deviate from the expected return, it means that SD measures risk. If we compare the 2stock portfolio s riskiness to the riskiness of the individual stock, there will be a different result oh the two stocks. Collections inc. is less risky if held in isolation than if included on a 2-stock portfolio. High Tech, on the contrary is much risky if held in isolation than if invested on a 2-stock portfolio. f. Suppose an investor starts with a portfolio consisting of one randomly selected stock. What would happen: (1) To the riskiness and to the expected return of the portfolio as more randomly selected stocks were added to the portfolio? If an investor starts with a portfolio consisting of one randomly selected stock and that additional stock has a higher expected return, the portfolio s expected return will also increase and vice versa if you added a stock with a lower expected return. The diversifiable risk will be reduced by adding more stocks. It is however essential to consider that stocks in the portfolio should be negatively correlated and not positively correlated. The returns on the 2 perfectly positively correlated stocks with the same expected return would move up and down together and a portfolio consisting of these stocks would be as risky as individual stocks.
(2) What is the implication for investors? Draw a graph of the two portfolios to illustrate your answer.

Investors should consider the concept of correlation to develop an efficient portfolio. To reduce overall risk, investors should diversify by combining, or adding to the portfolio, assets that have a negative correlation. Combining negatively correlated assets can reduce the overall variability of returns. The graph shows that the perfectly positively correlated moves exactly together while the perfectly negatively correlated move in exactly opposite directions. The graph with a perfectly correlated shows a line because the two stocks and the portfolio would have the same return at each point in time. Thus, diversification is completely useless for reducing risk if the stocks are perfectly positively correlated.

g. (1) Should the effects of a portfolio impact the way investors think about the riskiness of individual stocks? The risk of a stock held in a portfolio is typically lower than the stock s risk when it is held alone. The portfolio s risk is generally smaller because diversification lowers the portfolio s risk. Since investors dislike risk and since risk can be reduced by holding portfolios, most stocks are held in portfolio. Investors who are rational and averse would choose to hold a portfolio rather than individual stocks. Investors will start to think that the fact that one particular s stock price goes up or down is not important- what is important is the return on the portfolio and the portfolio s risk. Therefore, the risk and return of an individual stock should be analyzed in terms of how the security affects the risk and return of the portfolio in which it is held. (2) If you decided to hold a 1-stock portfolio (and consequently were exposed to more risk than diversified investors), could you expect to be compensated for all of your risk; that is, could you earn a risk premium on the part of your risk that you could have eliminated by diversifying? Investors must be compensated for bearing risk- the greater the risk of a stock, the higher its required return. However, compensation is required only for risk that cannot be eliminated by diversification. If risk premiums existed on a stock due to its diversifiable risk, that stock would be a bargain to welldiversified investors. h. The expected rates of return and the beta coefficients of the alternatives supplied by the CDIB s computer program are as follows: Security High Tech Market U.S. Rubber T-bills Collections Return 12.4% 10.5 9.8 5.5 1.0 Risk (Beta) 1.32 1.00 0.88 0.00 (0.87)

(1) What is a beta coefficient, and how are betas used in risk analysis? Beta coefficient is a metric that shows the extent to which a given stock s returns move up and down with the stock market and thus measures market risk. When estimating a stock s beta, historical data are often used and the stock s historical beta is assumed to give a reasonable estimate of how the stock will move relative to the market in the future. Historical data of stocks are plotted on a graph showing the movement of each stock with the market. Each stock has a slope and the slope of the lines is the stock s beta coefficients. It is apparent that the steeper a stock s line, the greater its volatility and thus the larger its loss in a down market. Hence, beta measures a given stock s volatility relative to the market.

(2) Do the expected returns appear to be related to each alternative s market risk? Based on the given data, High tech has the highest expected return which is 12.4%. At the same time, it also has the greatest risk of 1.32. On the other hand, Collections has the lowest expected return and the lowest risk which is 1.0% and 0.87 consequently. This only shows that the expected returns are related to each alternative s market risk. High tech is 1.32% riskier than the average stock while T-bills is 0% risky. Collections, on the other hand, 0.87% less riskier than the average stock. The market has a beta of 1.0 which means that the market portfolio is the average-risk portfolio. (3) Is it possible to choose among the alternatives on the basis of the information developed thus far? Use the data given at the start of the problem to construct a graph that shows how the t-bill s, high tech s, and the market s beta coefficients are calculated. Then, discuss what betas measure and how they are used in risk analysis. The beta coefficient is relative measure of nondiversifiable risk. It is an index of the degree of movement of an asset s return in response to a change in the market return. An assets historical returns are used in finding the asset s beta coefficient. The market return is the return on on the market portfolio of all traded securities. Betas for actively traded stocks can be obtained from a variety of sources.

i. The yield curve is currently flat; that is, long term treasury bonds also have a 5.5% yield. Consequently, CDIB assumes that the risk-free rate is 5.5%. (1) Write out the Security Market Line (SML) equation, use it to calculate the required rate of return on each alternative, and graph the relationship between the expected and required rates of return. Required return on stock = Risk-free return + (Market risk premium) (Stock s beta) High Tech = 5.5% + (10.5 5.5) (1.32) = 12.10% Market = 5.5% + (10.5 5.5) (1) = 10.5% U.S. Rubber = 5.5% + (10.5 5.5) (10.88) = 9.9% T-bills = 5.5% + (10.5 5.5) (0) = 5.5% Collection = 5.5% + (10.5 5.5) (-.87) = 1.15%

(2) How do the expected rates of return compare with the required rates of return? The Market and the T-bills have the same expected rate of return and required rate of return. The market has a beta of 1.00 which is considered as the risk of an average stock. Therefore its required rate of return will be equal to its expected rate of return. T-bills on the other hand has a beta of 0.00. Since t-bills are considered as risk-free the expected rate of return will also be equal to the required rate of return. High tech has a high expected rate of return. However, it also has a high beta coefficient. This results to a lower required rate of return unlike in the case of collections and U.S. Rubber which have both lower beta coefficients than the market. Their required rates of return therefore are higher than their expected rates of return. (3) Does the fact that collections has an expected return that is less than the T-bill rate make any sense? Explain. T-bills are considered as risk-free investments that s why the beta of t-bills is equal to 0.00. Since collections has a lesser expected return than t-bills, it gives collections a negative beta. Collections is therefore less volatile to the movement of the market and investors think that collections is a low-risk company. Adding up collections to a portfolio of regular stocks stabilizes the portfolio s returns and makes it less risky. Collections has no market risk premium which means that it has no additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. (4) What would be the market risk and the required return of a 50-50 portfolio of High Tech and Collections? Of High Tech and U.S. Rubber?

Portfolio A Asset Proportion High Tech 0.5 Collections 0.5 1

Beta 1.32 -0.87

Portfolio B Asset Proportion High Tech 0.5 U.S.Rubber 0.5 1

Beta 1.32 0.88

Beta (A) = (.5 x 1.32) + (.5 x -0.87) = 0.23 Beta (B) = (.5 x 1.32) + (.5 x 0.88) = 1.10 Portfolio B s returns are more responsive to changes in market returns and are therefore more risky than Portfolio A.

j. (1) Suppose investor raise inflation expectations by 3% over current estimates as reflected in the 5.5% risk-free rate. What effect would higher inflation have on the SML and on the returns required on high and low risk securities?

If investors raise inflation by 3%, there will be a shift in the SML since the risk-free rate of return will also increase from the original 5.5%. Increase in risk-free rate return on all risky assets because the same inflation premium is built into required rates of return on both riskless and risky assets.

(2) suppose instead that investor s risk aversion increase(inflation remains constant). What effect would this have on SML? If there will be no risk aversion, there will be no risk premium. In that case, SML would plot as a horizontal line.