Essay about Chap 9 Mini Case

4303 Words Jan 27th, 2013 18 Pages
Chapter 6 (11ed. Ch.)4
Risk and Return: The Basics

MINI CASE

Assume that you recently graduated with a major in finance, and you just landed a job as a financial planner with Barney Smith Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds are to be invested in a business at the end of one year, you have been instructed to plan for a one-year holding period. Further, your boss has restricted you to the following investment alternatives, shown with their probabilities and associated outcomes. (Disregard for now the items at the bottom of the data; you will fill in the blanks later.)

Returns On Alternative Investments
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If the treasury sold inflation-indexed, tax-exempt bonds, they would be truly riskless, but all actual securities are exposed to some type of risk.

b. 2. Why are Alta Ind.’s returns expected to move with the economy whereas Repo Men’s are expected to move counter to the economy?

Answer: Alta Industries’ returns move with, hence are positively correlated with, the economy, because the firm’s sales, and hence profits, will generally experience the same type of ups and downs as the economy. If the economy is booming, so will Alta. On the other hand, Repo Men is considered by many investors to be a hedge against both bad times and high inflation, so if the stock market crashes, investors in this stock should do relatively well. Stocks such as Repo Men are thus negatively correlated with (move counter to) the economy. (note: in actuality, it is almost impossible to find stocks that are expected to move counter to the economy. Even Repo Men shares have positive (but low) correlation with the market.)

c. Calculate the expected rate of return on each alternative and fill in the blanks on the row for [pic] in the table above.

Answer: The expected rate of return, [pic], is expressed as follows:

[pic]

Here [pic] is the probability of occurrence of the ith state, [pic] is the estimated rate of return for that state, and n is the number of states. Here is the calculation for Alta

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