FIN 451 Week 2 Problem Set

FIN 451 Week 2 Problem Set

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FIN 451 Week 2 Problem Set

1. Chapter 5: problem sets, numbers 5, 6, and 11, and CFA problems, numbers 1 and 10
2. Chapter 6: problem sets, number 21, and CFA problems, number 2

APA format is not required, but solid academic writing is expected.

Answers should be submitted using an Excel spreadsheet in order to show all calculations, where applicable.

You are not required to submit this assignment to Turnitin.

Answers should be submitted using an Excel spreadsheet in order to show all calculations, where applicable.
5. Suppose your expectations regarding the stock market are as follows:
State of the Economy Probability HPR
Boom 0.3 44%
Normal growth 0.4 14
Recession 0.3 216
Use Equations 5.6–5.8 to compute the mean and standard deviation of the HPR on
stocks. (LO 5-4)
6. The stock of Business Adventures sells for $40 a share. Its likely dividend payout
and end-of-year price depend on the state of the economy by the end of the year as
follows: (LO 5-2)
Dividend Stock Price
Boom $2.00 $50
Normal economy 1.00 43
Recession .50 34
a. Calculate the expected holding-period return and standard deviation of the holdingperiod
return. All three scenarios are equally likely.
www.mhhe.com/bkm

b. Calculate the expected return and standard deviation of a portfolio invested half in
Business Adventures and half in Treasury bills. The return on bills is 4%.
11. Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be
either $50,000 or $150,000, with equal probabilities of .5. The alternative riskless
investment in T-bills pays 5%. (LO 5-3)
a. If you require a risk premium of 10%, how much will you be willing to pay for the
portfolio?
b. Suppose the portfolio can be purchased for the amount you found in ( a ). What will
the expected rate of return on the portfolio be?
c. Now suppose you require a risk premium of 15%. What is the price you will be willing
to pay now?
d. Comparing your answers to ( a ) and ( c ), what do you conclude about the relationship
between the required risk premium on a portfolio and the price at which the portfolio
will sell?
1. A portfolio of nondividend-paying stocks earned a geometric mean return of 5%
between January 1, 2005, and December 31, 2011. The arithmetic mean return for
the same period was 6%. If the market value of the portfolio at the beginning of
2005 was $100,000, what was the market value of the portfolio at the end of
2011?
10. Probabilities for three states of the economy and probabilities for the returns on a
particular stock in each state are shown in the table below.
State of Economy
Probability of
Economic State
Stock
Performance
Probability of Stock
Performance in Given
Economic State
Good .3 Good .6
Neutral .3
Poor .1
Neutral .5 Good .4
Neutral .3
Poor .3
Poor .2 Good .2
Neutral .3
Poor .5
What is the probability that the economy will be neutral and the stock will experience
poor performance?
Chapter 6
21. The following figure shows plots of monthly rates of return and the stock market for
two stocks. (LO 6-5)
a. Which stock is riskier to an investor currently holding her portfolio in a diversified
portfolio of common stock?
b. Which stock is riskier to an undiversified investor who puts all of his funds in only
one of these stocks?
2. George Stephenson’s current portfolio of $2 million is invested as follows:
Summary of Stephenson’s Current Portfolio
Value
Percent of
Total
Expected
Annual
Return
Annual
Standard
Deviation
Short-term bonds $ 200,000 10% 4.6% 1.6%
Domestic large-cap equities 600,000 30 12.4 19.5
Domestic small-cap equities 1,200,000 60 16.0 29.9
Total portfolio $2,000,000 100% 13.8% 23.1%
Stephenson soon expects to receive an additional $2 million and plans to invest the entire
amount in an index fund that best complements the current portfolio. Stephanie Coppa,
CFA, is evaluating the four index funds shown in the following table for their ability to
produce a portfolio that will meet two criteria relative to the current portfolio: (1) maintain
or enhance expected return and (2) maintain or reduce volatility
Each fund is invested in an asset class that is not substantially represented in the
current portfolio.
Index Fund Characteristics
Index Fund
Expected Annual
Return
Expected Annual
Standard Deviation
Correlation of Returns
with Current Portfolio
Fund A 15% 25% 10.80
Fund B 11 22 10.60
Fund C 16 25 10.90
Fund D 14 22 10.65
State which fund Coppa should recommend to Stephenson. Justify your choice by
describing how your chosen fund best meets both of Stephenson’s criteria. No calculations
are required.