PRACTICE QUESTION 1

The Investment Environment and Asset Allocation

Reilly and Norton:
Chapter 1:

Questions:

1. Define investment. Discuss the overall purposes people have for investing.
4. Discuss why you would expect the saving-borrowing pattern to differ by
occupation (for example, for a doctor versus a plumber)
5. Explain why you would change your nominal required rate of return if you
expected the rate of inflation to go from 0 percent (no inflation) to 7 percent.
Give an example of what would happen if you did not change your required
rate of return under these conditions.
6. What is meant by the phrase, “time value of money”?
7. Explain the three components of an asset’s required rate of return.
8. If an economy’s real rate of return is 3 percent, expected inflation is 3 percent,
and the risk premium on a certain asset is 3 percent, should an investor’s
required rate of return be 9 percent? Why or why not?
9. Explain what will happen if a risky asset has an expected return o f 7 percent
while a safe asset has a expected return of 8 percent.
10. Explain why the phrase “risk drives expected returns” is true.
11. How does operational efficiency in a market differ from informational
efficiency?

Problems

1. What would be required rate of return on an investment in an economy with a

3 percent real rate of return, expected inflation of 4 percent, and a risk
premium of 4 percent? What would you expect $1,000 invested at this rate to
grow to after ten years? After twenty years?
2. Compute the required rate of return under the following scenarios:
a. Real rate = 4%, expected inflation = 6%, risk premium = 2%
b. Real rate = 3%, price level expected to rise 8%, risk premium = 3%
c. Real rate = 4%, price index expected to change from 145 to 151, risk
premium = 5%
3. The return on a tax-deferred account averages 8 percent over twenty years.
The initial investment is $10,000. Compare the investor’s after-tax value of
his portfolio if (a) he removes the savings all at once after the twenty years
and his tax bracket at the time is 25 percent; against (b) the value after twenty
years of an equivalent portfolio that earns 8 percent pre-tax in a taxable
account; the assumed tax rate on all annual investment returns is 25 percent.
4. Use the situation in Problem 3, only now assume in part (b) that tax-efficient
investing allows the investor to earn 7 percent after-tax. How does the
portfolio value compare with the after-tax value of the portfolio in part (a)?