Solution Pages: 11
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Questions Covered in the Solution
Prepare a two pages brief by reading each topic mentioned in Learning Objective (mentioned above), and Read Wells Fargo: Branched Out making a list of the issues suggested in the article
1. How do the models (Efficient Frontier and Capital Asset Pricing Model) discussed in this week’s material define risk? …define return? HINT: Dig out the specific definitions for each model to demonstrate the similarities and differences in the definitions between models.
2. Look at the Efficient Frontier diagram on pages 7 (bottom of 2nd box) or 16, and explain how you might use it to make investment decisions. HINT: Briefly state what the diagram tells you, then make a judgment about its practical application to investing for investors who are risk averse but still want to maximize their rates of return.
3. If the rate of return on the S&P 500 index was 23% for 2009, and the risk-free rate at the end of 2009 was 1%, calculate the equity risk premium for 2009? Recalculate the equity risk premium using 1981 data, when the risk free rate was 15% and the S&P 500 index
return was minus 10%. What are the implications of different equity risk premia numbers for different time periods? HINT: When you use the CAPM, you must enter an equity risk premium. Therefore, how do you do that accurately when data for different years produce
different equity risk premia?
4. As of early September 2010, Wal-Mart’s (WMT) beta is 0.33 and Target Stores (TGT) beta is 1.02. Discuss the meaning of these two betas, analytically, by briefly setting forth the process for calculating beta and the inputs to the calculations where beta is the output, i.e., the slope of the characteristic line. Be guided by the diagram on pages 7 (left side of bottom box) or 20 or 22: the line shown is called the characteristic line. HINT: What makes the two betas different?
5. The risk free-rate as of early September 2010 was the yield on a 10-year Treasury bond, 2.8%. Assuming that the long-term historical rate of return (and the expectation for the future as well) on the S&P 500 Index is 9%, apply the CAPM equation and calculate the expected rate of return for Wal-Mart and Target Stores stock, using the betas in Question 4 above. What do the results your calculations tell you?
6. Explain why the beta of the S&P 500 Index is 1.0. HINT: Look at the characteristic line diagram on pages 7, 20, or 22 and imagine that the same S&P 500 Index data was on both the x-axis and the y-axis. Where would the characteristic line fall in that case?
7. Look at the Security Market Line (pages 7 or 19). Its positive slope and steepness comes from two points, the point where a beta of 1.0 intersects with an expected return of 12% (the stock market return), and the point where the 5% risk-free rate intersects with a beta of 0. The line can be flatter or steeper, depending on the variables. What happens to the Security Market Line if we assume a stagflation period when the expected S&P 500 Index return is 2% and the risk free rate is 8%? HINT: Draw that line on a piece of paper so you can interpret it.
8. Think about, and list the key points, for a talk your boss wants you to make about the relevance of financial market theory to practice.
Sample of Solution
The financial ecosystem has been volatile since the socialization of finance and the dissemination of globalization. Although with the greater inclusion, the financial institutions are actively intruded in the financial cycles of locals. There have also been certain challenges which are aroused with such boundless expansions of the financial institutions. These challenges include the confrontations for not only the managers but also the regulators of the financial institutions. For managers, it has becoming harder to maintain the exclusivity of their financial institutions due to increased rivalry and competition. While, regulators have to ensure the smooth execution of their business operations, despite their sophisticated existence. Moreover, the realization of the impact of risk materialization, which can be perceived from the global crisis of 2008, signifies the responsibility of financial regulators. Whereas, the rigorous targets set by the executives provoke the managers to indulge in the gray shaded activities. Which again, raise concerns for the regulators.
- How do the models (Efficient Frontier and Capital Asset Pricing Model) discussed in this week’s material define risk? …define return? HINT: Dig out the specific definitions for each model to demonstrate the similarities and differences in the definitions between models.
The efficient frontier defines the optimal point of investment portfolio which can earn the maximum return for any given level of risk. While at the same time it identifies the lowest risk portfolio for any given level of return. Essentially, efficient frontier serves the whole spectrum of investor’s risk appetite, ranging from risk-averse behavior to risk taking behavior. Moreover, the risk can be declared as the diversifiable risk which essentially reduces as the number of different securities in the portfolio increases. Moreover, the risk in the efficient frontier is defined by the standard deviation while the calculation of return considers, security specific credentials, like return average, variance, and correlation. Hence, the determination of efficient portfolio is leveraged by the correlation among securities and their return variances.
- Look at the Efficient Frontier diagram on pages 7 (bottom of the 2nd box) or 16, and explain how you might use it to make investment decisions. HINT: Briefly state what the diagram tells you, then make a judgment about its practical application to investing for investors who are risk averse but still want to maximize their rates of return.
The Efficient Frontier, proposed by the Markowitz, is the ultimate model for portfolio selection to maximize returns. The efficient frontier is effectively the relation of risk and reward, which can be used to evaluate the investment portfolios. The region below the efficient frontier line defines the pool of possible portfolios which can be held by the investors as per their risk appetite. For instance, the young investors may be willing to accept greater risk for the sake of earning greater returns, hence their choice of portfolios would lie at the right end of the graph.