Intermediate Financial Management
14th Edition
ISBN: 9780357516782
Author: Brigham, Eugene F., Daves, Phillip R.
Publisher: Cengage Learning
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Textbook Question
Chapter 3, Problem 3MC
You have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions:
Suppose a risk-free asset has an expected return of 5%. By definition, its standard deviation is zero, and its correlation with any other asset is also zero. Using only Asset A and the risk-free asset, plot the attainable portfolios.
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You are an investment analyst at an asset management firm. Your colleague, the in-house economist, has analyzed all the
risky securities in your economy - A, B and C. He provides you with the following statistics:
A B C
Risk-Free
Securities
Expected Returns
Standard Deviation 0.25 0.20 0.12
0.12 0.11 0.08 0.01
The Correlation between A and B is 0.25, between B and C is 0.75, and between A and C is 0.5.
What is the slope of the capital market line in this economy?
Group of answer choices
0.27
0.58
0.62
0.66
052
You are an investment analyst at an asset management firm. Your colleague, the in-house economist,
has analyzed all the risky securities in your economy - A, B and C. He provides you with the following
statistics:
Securities
Expected Returns
Standard Deviation 0.35 0.25 0.18
A B C
0.15 0.10 0.075 0.03
Risk-Free
The Correlation between A and B is 0.2, between B and C is 0.5, and between A and C is 0.3. The
prevailing risk-free rate is 3%.
What is the Sharpe ratio of the market portfolio in this economy?
In a seminal article on portfolio theory, Markowitz (1952) illustrated that investors are not compensated for taking on firm specific or idiosyncratic risk; however, they are compensated for taking market or systemic risk. Use your understanding of the Capital Asset Pricing Model (CAPM), statistical concepts such as standard deviation and variance, and our ideas about market efficiency and indicate whether you believe that this is a good theory. Include at least two citations that support your response.
Chapter 3 Solutions
Intermediate Financial Management
Ch. 3 - Security A has an expected rate of return of 6%, a...Ch. 3 - The standard deviation of stock returns for Stock...Ch. 3 - APT
An analyst has modeled the stock of Crisp...Ch. 3 - Two-Asset Portfolio
Stock A has an expected return...Ch. 3 - Prob. 4PCh. 3 - You have been hired at the investment firm of...Ch. 3 - You have been hired at the investment firm of...Ch. 3 - You have been hired at the investment firm of...Ch. 3 - You have been hired at the investment firm of...Ch. 3 - You have been hired at the investment firm of...
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- You have been hired at the investment firm of Bowers Noon. One of its clients doesnt understand the value of diversification or why stocks with the biggest standard deviations dont always have the highest expected returns. Your assignment is to address the clients concerns by showing the client how to answer the following questions: Add a set of indifference curves to the graph created for part b. What do these curves represent? What is the optimal portfolio for this investor? Add a second set of indifference curves that leads to the selection of a different optimal portfolio. Why do the two investors choose different portfolios?arrow_forwardYou have been hired at the investment firm of Bowers Noon. One of its clients doesnt understand the value of diversification or why stocks with the biggest standard deviations dont always have the highest expected returns. Your assignment is to address the clients concerns by showing the client how to answer the following questions: e. Add a set of indifference curves to the graph created for part b. What do these curves represent? What is the optimal portfolio for this investor? Add a second set of indifference curves that leads to the selection of a different optimal portfolio. Why do the two investors choose different portfolios?arrow_forwardYou have been hired at the investment firm of Bowers & Noon. One of its clients doesn’t understand the value of diversification or why stocks with the biggest standard deviations don’t always have the highest expected returns. Your assignment is to address the client’s concerns by showing the client how to answer the following questions: Construct a plausible graph that shows risk (as measured by portfolio standard deviation) on the x-axis and expected rate of return on the y-axis. Now add an illustrative feasible (or attainable) set of portfolios and show what portion of the feasible set is efficient. What makes a particular portfolio efficient? Don’t worry about specific values when constructing the graph—merely illustrate how things look with “reasonable” data.arrow_forward
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- Sharon Smith, the financial manager for Barnett Corporation, wishes to select one of three prospective investments: X, Y, and Z. Assume that the measure of risk Sharon cares about is an asset's standard deviation. The expected returns and standard deviations of the investments are as follows: Investment Expected return Standard deviation X 17% 7% Y 17% 8% Z 17% 9% a. If Sharon were risk neutral, which investment would she select? Explain why. b. If she were risk averse, which investment would she select? Why? c. If she were risk seeking, which investments would she select? Why? d. Suppose a fourth investment, W, is available. It offers an expected return of 18%,and it has a standard deviation of 9%. If Sharon is risk averse, can you say which investment she will choose? Why or why not? Are there any investments that you are certain she will not choose?arrow_forwardAnswer whether each of the following statements is correct and explain your argument. \ (a) According to CAPM, the expected return of a risky asset is larger than the risk free rate. (b) According to CAPM, the expected return of a risky asset increases with its variance. (c) According to the separation property, the optimal risky portfolio for an investor dependson the investor’s personal preference. (d) A less risk-averse investor has a steeper indifference curve for the utility function.arrow_forwardWhat is the answer to this question? For this question I have seen 2 answers. So im not sure whats right. Answer 1: The most relevant figure is (a) that reflects the risk-return characteristics of stock A and stock B. an effective frontier is called relationship between risk (standard deviation) and expected return. The shape of risk-return features is curved because for each incremental risk incurred there are raising marginal returns. Therefore, for each unit of risk, the standard deviation applied to the portfolio provides an extremely low amount of return. Also we can see that the SD of stock B is higher than that of A. Figure b) is incorrect because the returns don’t rise in proportion to the risk assumed. Figure c) is incorrect since both stocks stock A and stock B are risky, and thus a finite return cannot occur at standard deviation = 0 Answer 2 Answer - Graph B Correlation = Covariance / (Standard deviation of A x Standard deviation of B) Correlation = 0.0014 / (0.032 x 0.044)…arrow_forward
- Suppose that an asset has a CAPM beta of 1.5. Which one of the following statements is correct? O A. The asset price will move in the same direction as the market portfolio on average but by half as much. O B. The asset price will move in the opposite direction as the market portfolio on average but by half as much. OC. The asset has an unsystematic risk of 1.5. OD. This asset would be classed as aggressive.arrow_forwardBart Campbell, CFA, is a portfolio manager who has recently met with a prospective client, Jane Black. After conducting a survey market line (SML) performance analysis using the Dow Jones Industrial Average as her market proxy, Black claims that her portfolio has experienced superior performance. Campbell uses the capital asset pricing model as an investment performance measure and finds that Black’s portfolio plots below the SML. Campbell concludes that Black’s apparent superior performance is a function of an incorrectly specified market proxy, not superior investment management. Justify Campbell’s conclusion by addressing the likely effects of an incorrectly specified market proxy on both beta and the slope of the SML.arrow_forwardYour friend’s portfolio consistently plots above the Security Market Line. As a result, your friend claims to know how to earn abnormal returns. Thus, your friend tries to convince you that the market is not efficient. How should you respond? A) You should totally agree; this is direct evidence against market efficiency B) Tell your friend that this should be expected due to the Momentum effect C) Tell your friend that it is hard to measure risk (Joint Hypothesis Problem); maybe the market is efficient, or maybe risk is being measured improperlyarrow_forward
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