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# solution finance

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10/15/2013

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Chapter 05 - Risk and Return: Past and Prologue5-1
CHAPTER 05RISK AND RETURN: PAST AND PROLOGUE
1.

T
he 1% VaR will be less than -30%. As percentile or probability of a return declines sodoes the magnitude of that return.
T
hus, a 1 percentile probability will produce asmaller VaR than a 5 percentile probability.2.

T
he geometric return represents a compounding growth number and will artificiallyinflate the annual performance of the portfolio.3.

No. Since all items are presented in nominal figures, the input should also use nominaldata.4.

Decrease.
T
ypically, standard deviation exceeds return.
T
hus, a reduction of 4% in eachwill artificially decrease the return per unit of risk.
T
o return to the proper risk returnrelationship the portfolio will need to decrease the amount of risk free investments.5.

E(r) = [0.3
v
44%] + [0.4
v
14%] + [0.3
v
(±16%)] = 14%
W
2
= [0.3
v
(44 ± 14)
2
] + [0.4
v
(14 ± 14)
2
] + [0.3
v
(±16 ± 14)
2
] = 540
W
= 23.24%
T
he mean is unchanged, but the standard deviation has increased.6.

a.

T
he holding period returns for the three scenarios are:Boom: (50 ± 40 + 2)/40 = 0.30 = 30.00% Normal: (43 ± 40 + 1)/40 = 0.10 = 10.00%Recession: (34 ± 40 + 0.50)/40 = ±0.1375 = ±13.75%E(HPR) = [(1/3)
v
30%] + [(1/3)
v
10%] + [(1/3)
v
(±13.75%)] = 8.75%
W
2
(HPR) = [(1/3)
v
(30 ± 8.75)
2
] + [(1/3)
v
(10 ± 8.75)
2
] + [(1/3)
v
(±13.75 ± 8.75)
2
]= 319.79
W
=
79.319
= 17.88% b.

E(r) = (0.5
v
8.75%) + (0.5
v
4%) = 6.375%
W
= 0.5
v
17.88% = 8.94%

Chapter 05 - Risk and Return: Past and Prologue5-2
7.

a.

T
ime-weighted average returns are based on year-by-year rates of return.Year Return = [(capital gains + dividend)/price]2007-2008 (110 ± 100 + 4)/100 = 14.00%2008-2009 (90 ± 110 + 4)/110 = ±14.55%2009-2010 (95 ± 90 + 4)/90 = 10.00%Arithmetic mean: 3.15%Geometric mean: 2.33% b.

T
ime Cash flow Explanation0 -300 Purchase of three shares at \$100 per share1 -208 Purchase of two shares at \$110, plus dividend income on three shares held2 110 Dividends on five shares, plus sale of one share at \$903 396 Dividends on four shares, plus sale of four shares at \$95 per shareDollar-weighted return = Internal rate of return = ±0.1661%396||||110 || || |Date: 1/1/07 1/1/08 1/1/09 1/1/10 | || || || || 208300

Chapter 05 - Risk and Return: Past and Prologue5-3
8.

a.

E(r
P
) ± r
= ½A
W
P2
= ½
v
4
v
(0.20)
= 0.08 = 8.0% b.

0.09 = ½A
W
P2
= ½
v
A
v
(0.20)

A = 0.09/( ½
v
0.04) = 4.5c.

Increased risk tolerance means decreased risk aversion (A), which results in adecline in risk premiums.9.

For the period 1926 ± 2008, the mean annual risk premium for large stocks over
T
- bills is 9.34%E(r) = Risk-free rate + Risk premium = 5% + 7.68% =12.68%10.

In the table below, we use data from
T
able 5.2. Excess returns are real returns since therisk free rate incorporates inflation.Large Stocks: 7.68%Small Stocks: 13.51%Long-
T
erm
T
-Bonds: 1.85%
T
-Bills: 0.66 % (table 5.4)11.

a.

T
he expected cash flow is: (0.5
v
\$50,000) + (0.5
v
\$150,000) = \$100,000With a risk premium of 10%, the required rate of return is 15%.
T
herefore, if the value of the portfolio is X, then, in order to earn a 15% expected return:X(1.15) = \$100,000
X = \$86,957 b.

If the portfolio is purchased at \$86,957, and the expected payoff is \$100,000, thenthe expected rate of return, E(r), is:957,86\$ 957,86\$000,100\$
= 0.15 = 15.0%
T
he portfolio price is set to equate the expected return with the requiredrate of return.c.

T
-bills is now 15%, then the required return is:5% + 15% = 20%
T
he value of the portfolio (X) must satisfy:X(1.20) = \$100, 000
X = \$83,333d.

For a given expected cash flow, portfolios that command greater risk premia mustsell at lower prices.
T
he extra discount from expected value is a penalty for risk.