MBA HEC Paris

Financial Markets Philippe Henrotte

Solution to Practice 1

Risk & Return

Question 1. (1 point) Three months corresponds to t = 0.25 year, the return over the
period t is
Pt + Div −P0 51 + 2 − 50
rt = = = 0.06 = 6%
P0 50
and the corresponding annualized return rat is given by

rat = (1 + rt )1/t − 1 = (1.06)4 − 1 = 26.248%.

The answer is therefore 0.2625.

Question 2. (1 point) For every dollar invested initially Investment A yields (1+2%) = 1.02
in one year while Investment B produces

1.98% 12
 
1+ = 1.01998.
12

We conclude that Investment A provides the better outcome.

Question 3. (1 point) The relation between the APR, which is here semi-annually com-
pounded, and the EAR is
AP R 2
 
1 + EAR = 1 +
2
therefore

AP R 2 2% 2
   
EAR = 1 + −1= 1+ − 1 = (1.01)2 − 1 = 2.01%.
2 2

The EAR is larger than 2% but smaller than 4%, and the correct answer is B.

Question 4. (1 point) The annually compounded return r solves

8, 000 = 3, 000 (1 + r)t

where t is here 10 years. We solve

r = (8, 000/3, 000)1/t − 1 = (8/3)0.1 − 1 = 10.31%

and we conclude that the right answer is A.

1
Question 5. (1 point) The time t in years needed to double an initial amount I invested
at the annually compounded rate r solves
I (1 + r)t = 2 I
or
(1 + r)t = 2
which does not depend on I. Taking the logarithm of both sides of this last equation yields
t log(1 + r) = log(2)
from which we obtain
log(2) log(2)
t= = = 17.67
log(1 + r) log(1.04)
which is larger than 15 years, the answer is therefore C.

Problem. Stock Return Analysis

Question 6. (1 point) We first compute the gross return R over the last four years by
compounding the annual returns,
R = (1 + r1 )(1 + r2 )(1 + r3 )(1 + r4 ) = (1 + 0.157)(1 + 0.065)(1 − 0.124)(1 + 0.081) = 1.166844.
The annually compounded return ra solves
(1 + ra )4 = R
therefore
ra = R1/4 − 1 = 1.1668440.25 − 1 = 3.9329%
and the answer is 0.0393.

Question 7. (1 point) We first compute the return of the stock in the two scenarios, which
we denote rgood and rbad ,
22.5 + 0.75 − 18
rgood = = 29.17%,
18
16 + 0.5 − 18
rbad = = −8.33%.
18
Since the two scenarios are equally likely with probability 0.5 each,
E(r) = 0.5 × rgood + 0.5 × rbad = 0.5 × 29.17% − 0.5 × 8.33% = 10.417%
and the answer is 0.1042.

Question 8. (1 point) We first derive the variance as the average of the squared deviations
of the returns to their mean
var(r) = 0.5 × (rgood − E(r))2 + 0.5 × (rbad − E(r))2
= 0.5 × (29.17% − 10.417%)2 + 0.5 × (−8.33% − 10.417%)2
= 0.035156.
The volatility is the standard deviation of the returns, which is the square root of the
variance p √
σr = var(r) = 0.035156 = 18.750%
and the answer is 0.1875.