ON LINE EXAM 2

on line Exam 2

on line Exam 2

Introduction

FIN 500: Case Study 1 Assignment

Notes

Your first case assignment deals with the concepts of risk and return. Please read the case questions through and give some thought to your answers before you commence. Answer all parts of the ten (10) questions presented below. Your report should be well-organized, type-written/word processed, and independently prepared. Each student's report must be his/her own original work and the write-up must also be individually prepared.

Buxton Corporation is planning to invest in a security that has several potential rates of return. Using the following probability distribution of returns during different states of the economy, what is the expected rate of return on this investment? In addition, compute the standard deviation of the returns (s). Finally, briefly explain what these numbers represent.

Probability

Expected Return

0.10

-10%

0.20

5%

0.30

10%

0.40

25%



Expected Return = [(0.10x-10) + (0.20x5) + (0.30x10) + (0.40x25)] = 13%

s2 = (0.10)(-0.10-0.13)2 + (0.20)(0.05-0.13)2 + (0.3)(0.10-0.13)2 + (0.4)(0.25-0.13)2 =

s2 = 0.00529 + 0.00128 + 0.0027 + 0.00576 = 0.01503

s = 0.122 = 12.2%



Using the capital asset pricing model (CAPM), estimate the appropriate required rate of return for the following three stocks, assuming that the risk-free rate (rRF) is 5 percent and the expected return for the market (rM) is 17 percent.

Stock

Beta (ß)

A

0.75

B

0.90

C

1.40

CAPM = Rrf + ß(Rmr - Rfr)

CAPM (A) = 0.05 + 0.75(0.17-0.05) = 14%

CAPM (B) = 0.05 + 0.90(0.17-0.05) = 15.8%

CAPM (C) = 0.05 + 1.40(0.17-0.05) = 21.8%

Based on the following table of actual (or ex post) returns for both Inquiry Corporation and the market from 2007 through 2010, calculate the average return and the standard deviation for both Inquiry and the market (keep in mind that this data is historical and not based on a probability distribution, so be sure to use the correct formulas).

Year

Inquiry Corporation

Market

2007

4%

2%

2008

6%

3%

2009

0%

1%

2010

2%

-1%



Average return for the Inquiry Corporation = [4+6+0+2/4] = 3%

Average return for the market = [2+3+1-1/4] = 1.25%

Variance of Inquiry = 0.00067

Variance of Market = 0.00292

Standard Deviation of Inquiry Corporation = 2.28%

Standard Deviation of Market = 1.70%



Derive the expected return (rP) and beta (ßP) for a portfolio based on the following information:

Stock

Percentage of Portfolio

Beta (ß)

Expected Return

1

40%

1.00

12%

2

25%

0.75

11%

3

35%

1.30

15%



Expected Return = [(0.4x0.12)+(0.25x0.11)+(0.35x0.15)] =

Expected Return = 0.048 + 0.0275 + 0.0525 = 12.8%

Given the information in the table above, present the equation for the security market line and explain where the return for this specific portfolio would lie (plot) relative to the SML (i.e., below or above the line). Assume that the risk-free rate (rRF) is 8 percent and that the expected return on the market portfolio (rM) is 12 percent.

Beta of the portfolio = (1x0.4) + (0.75x0.25) + (1.3x0.35) =

Beta of the portfolio = 0.4 + 0.1875 + 0.455 = 1.0425

CAPM = Rrf + ß(Rmr - Rfr)

CAPM (Portfolio) = 0.08 + 1.0425(0.12-0.08) = 12.17%

It is above the SML which means the portfolio is underpriced.

Reliable Printing is evaluating a security. One-year Treasury bills (rRF) are currently paying 3.1 percent. Calculate the following investment's expected return and its standard ...