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Resources.

Average nominal return = .1602, or 16.02%

–

.1602)2 + (.127 – .1602)2] / 5

Variance = .010595

Standard deviation = .1029, or 10.29%

[(1.161

/ 1.017) – 1] + [(1.331 / 1.015) – 1] + [(1.127 /

1.008) – 1]} / 5

Average real return = .1412, or 14.12%

Est. Time: 01 – 05

2. Ms. Sauros:

Average return = .1998, or 19.98%

–

.1998)2 + (.152 – .1998)2] / 5

Variance = .019485

Standard deviation = .1396, or 13.96%

S&P 500:

Average return = .1602, or 16.02%

–

.1602)2 + (.127 – .1602)2

Variance = .010595

Standard deviation = .1029, or 10.29%

Est. Time: 01 – 05

reduces variability and therefore reduces risk. However, the diversification

of an individual company does not necessarily make it less risky.

to obtain diversification benefits.

risk surrounding an individual company or industry. Market risk will still

exist in a fully diversified portfolio.

stocks are uncorrelated. However, most stocks tend to move in the

same direction. There are still benefits to diversification any time stocks

are less than perfectly positively correlated.

the stock to the market as a whole.

market portfolio. Part of that risk will be market risk and part will be

specific risk.

Est. Time: 01 – 05

4. Perfect negative correlation does the most to reduce risks because the stocks

always move in opposite directions. When one goes up, the other goes down,

and vice versa.

Est. Time: 01 – 05

5.

Est. Time: 01 – 05

βp = 1.3

Est. Time: 01 – 05

safe in terms of the dollars received. However, the price of the bond

fluctuates as interest rates change, and the rate at which coupon

payments received can be invested also changes as interest rates

change. And, of course, the payments are all in nominal dollars, so

inflation risk must also be considered.

b. It is true that stocks offer higher long-run rates of return than do bonds,

but it is also true that stocks have a higher standard deviation of return.

So, which investment is preferable depends on the amount of risk one

is willing to tolerate. This is a complicated issue and depends on

numerous factors, one of which is the investment time horizon. If the

investor has a short time horizon, then stocks are generally not

preferred.

of time for estimating average rates of return. Thus, using either a 5- or

10-year average is likely to be misleading.

Est. Time: 06 – 10

single security that matters is the security’s contribution to the overall portfolio

risk. This contribution is measured by beta. Lonesome Gulch is the safer

investment for a diversified investor because its beta of .10 is lower than the

beta of Amalgamated Copper of .66. For a diversified investor, the standard

deviations are irrelevant.

Est. Time: 01 – 05

σP2 = .0196

b. σP2 = .602 × .102 + .402 × .202 + 2(.60 × .40 × .50 × .10 × .20)

σP2 = .0148

σP2= .0100

Est. Time: 06 – 10

10. a-1. Change in stock’s rate of return = .05 × –.25 = –.0125, or –1.25%

invested in typical securities, the portfolio beta is approximately one.

The largest reduction in beta is achieved by investing the $20,000 in a

stock with the negative beta.

Est. Time: 06 – 10

σp = .2433, or 24.33%

Est. Time: 06 – 10

12. a. In general:

Thus:

P = .2331, or 23.31%

b. We can think of this in terms of Figure 7.13 in the text, with three

securities. One of these securities, T-bills, has zero risk and, hence,

zero standard deviation. Thus:

.2100].5

P = .1554, or 15.54%

T-Bills and two-thirds a portfolio which is half Bank of America and half

Starbucks. Because the risk of T-bills is zero, the portfolio standard

deviation is two-thirds of the standard deviation computed in Part (a)

above:

P = (2/3) × 23.31% = 15.54%

c. With 50% margin, the investor invests twice as much money in the

portfolio as he had to begin with. Thus, the risk is twice that found in

Part (a) when the investor is investing only his own money:

P = 2 23.31% = 46.62%

d. With 100 stocks, the portfolio is well diversified, and hence the portfolio

standard deviation depends almost entirely on the average covariance

of the securities in the portfolio (measured by beta) and on the

standard deviation of the market portfolio. Thus, for a portfolio made

up of 100 stocks each with Bank of America’s beta of 1.57, the portfolio

standard deviation is approximately:

Est. Time: 11 – 15

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