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CHAPTER 9 ? CHARACTERIZING RISK AND RETURN

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Question;CHAPTER 9 ?;CHARACTERIZING RISK AND RETURN;questions;LG1 1. Why is the percentage return a more useful;measure than the dollar return?;LG2 2. Characterize the historical return, risk, and;risk-return relationship of the stock, bond and cash markets.;LG3 3. How do we define risk in this chapter and how;do we measure it?;LG3 4. What are the two components of total risk?;Which component is part of the risk-return relationship? Why?;LG3 5. What?s the source of firm-specific risk?;What?s the source of market risk?;LG3 6. Which company is;likely to have lower total risk, General Electric or Coca-Cola? Why?;LG3 7. Can a company change;its total risk level over time? How?;LG4 8. What does the coefficient of variation;measure? Why is a lower value better for the investor?;LG4 9. You receive an investment newsletter;advertisement in the mail. The letter;claims that you should invest in a stock that has doubled the return of the;S&P 500 Index over the last three months. It also claims that this stock is;a surefire safe bet for the future. Explain how these two claims are;inconsistent with finance theory.;LG5 10. What does diversification do to the risk and;return characteristics of a portfolio?;LG5 11. Describe the diversification potential of two;assets with a?0.8 correlation. What?s;the potential if the correlation is +0.8?;LG5 12. You are a risk adverse investor with a;low-risk portfolio of bonds. How is it;possible that adding some stocks (which are riskier than bonds) to the;portfolio can lower the total risk of the portfolio?;LG5 13. You own only two stocks in your portfolio but;want to add more. When you add a third;stock, the total risk of your portfolio declines. When you add a tenth stock to the portfolio;the total risk declines. Adding which stock, the third or the tenth, likely;reduced the total risk more? Why?;LG5 14. Many employees believe that their employer?s;stock is less likely to lose half of its value than a well diversified;portfolio of stocks. Explain why this belief is erroneous.;LG6 15. Explain what we mean when we say that one;portfolio dominates another portfolio?;LG6 16. Explain what the efficient frontier is and;why it is important to investors.;LG6 17. If an investor?s desired risk level changes;over time, should the investor change the composition of his or her portfolio?;How?;LG7 18. Say you own 200;shares of Mattel and 100 shares of RadioShack. Would your portfolio return be;different if you instead owned 100 shares of Mattel and 200 shares of;RadioShack? Why?;problems;basic problems;LG1 9-1;Investment Return FedEx Corp stock ended the previous year at $103.39;per share.;It;paid a $0.35 per share dividend last year.;It ended last year at $106.69. If you owned 300 shares of FedEx, what;was your dollar return and percent return?;LG1 9-2;Investment Return Sprint Nextel Corp stock ended the previous year at;$23.36 per share. It paid a $2.37 per;share dividend last year. It ended last;year at $18.89. If you owned 500 shares of Sprint, what was your dollar return;and percent return?;LG2 9-3 Investment;Return A corporate bond that you own at the beginning of the year is worth;$975. During the year, it pays $45 in interest payments and ends the year;valued at $965. What was your dollar return and percent return?;LG2 9-4 Investment Return A Treasury;bond that you own at the beginning of the year is worth $1,055. During the;year, it pays $35 in interest payments and ends the year valued at $1,065. What;was your dollar return and percent return?;LG3 9-5;Total RiskRank the following three stocks by their level of total risk;highest to lowest. Rail Haul has an average return of 12 percent and standard;deviation of 25 percent. The average;return and standard deviation of Idol Staff are 15 percent and 35 percent, and;of Poker-R-Us are 9 percent and 20 percent.;LG3 9-6;Total RiskRank the following three stocks by their total risk level;highest to lowest. Night Ryder has an average return of 12 percent and standard;deviation of 32 percent. The average;return and standard deviation of WholeMart are 11 percent and 25 percent, and;of Fruit Fly are 16 percent and 40 percent.;LG4 9-7;Risk versus ReturnRank the following three stocks by their risk-return;relationship, best to worst. Rail Haul has an average return of 12 percent and;standard deviation of 25 percent. The;average return and standard deviation of Idol Staff are 15 percent and 35;percent, and of Poker-R-Us are 9 percent and 20 percent.;LG4 9-8;Risk versus ReturnRank the following three stocks by their risk-return;relationship, best to worst. Night Ryder has an average return of 12 percent;and standard deviation of 32 percent.;The average return and standard deviation of WholeMart are 11 percent;and 25 percent, and of Fruit Fly are 16 percent and 40 percent.;LG6 9-9;Dominant PortfoliosDetermine which one of these three portfolios;dominates another. Name the dominated;portfolio and the portfolio that dominates it.;Portfolio Blue has an expected return of 12 percent and risk of 18;percent. The expected return and risk of;portfolio Yellow are 15 percent and 17 percent, and for the Purple portfolio;are 14 percent and 21 percent.;LG6 9-10;Dominant PortfoliosDetermine which one of the three portfolios;dominates another. Name the dominated;portfolio and the portfolio that dominates it.;Portfolio Green has an expected return of 15 percent and risk of 21;percent. The expected return and risk of;portfolio Red are 13 percent and 17 percent, and for the Orange portfolio are;13 percent and 16 percent.;LG7 9-11;Portfolio WeightsAn investor owns $4,000 of Adobe Systems stock, $5,000;of Dow Chemical, and $5,000 of Office Depot.;What are the portfolio weights of each stock?;LG7 9-12;Portfolio WeightsAn investor owns $3,000 of Adobe Systems stock, $6,000;of Dow Chemical, and $7,000 of Office Depot.;What are the portfolio weights of each stock?;LG7 9-13;Portfolio Return Year-to-date, Oracle had earned a?1.34 percent;return. During the same time period;Valero Energy earned 7.96 percent and McDonalds earned 0.88 percent. If;you have a portfolio made up of 30 percent;Oracle, 25 percent Valero Energy, and 45 percent McDonalds, what is your;portfolio return?;LG7 9-14;Portfolio Return Year to date, Yum Brands had earned a 3.80 percent;return. During the same time period;Raytheon earned 4.26 percent and Coca-Cola earned?0.46 percent. If you have a portfolio made up of 30 percent;Yum Brands, 30 percent Raytheon, and 40 percent Coca-Cola, what is your;portfolio return?;LG1 9-15;Average Return The past five monthly returns for Kohl?s are 3.54;percent, 3.62 percent,?1.68 percent, 9.25 percent, and?2.56 percent. What is;the average monthly;return?;LG1 9-16;Average Return The past five monthly returns for PG&E are?3.17;percent, 3.88 percent, 3.77 percent, 6.47 percent, and 3.58 percent. What is;the average monthly return?;LG3 9-17;Standard Deviation Compute the standard deviation of Kohls? monthly;returns shown in Problem 9-15.;LG3 9-18;Standard Deviation Compute the standard deviation of PG&E?s monthly;returns shown in Problem 9-16.;LG2&4 9-19;Risk versus Return in Bonds Assess the risk-return relationship of the;bond market (see Tables 9.2 and 9.4) during each decade since 1950.;Compute the coefficient of variation for each decade using;the standard deviation and average return;Decade;CoV;1950s;NA;1960s;3.88;1970s;1.19;1980s;1.12;1990s;1.35;2000s;1.29;LG2&4 9-20;Risk versus Return in T-bills Assess the risk-return relationship in;T-bills (see Tables 9.2 and 9.4) during each decade since 1950.;Compute the coefficient of variation for each decade using;the standard deviation and average return;Decade;CoV;1950s;0.40;1960s;0.33;1970s;0.29;1980s;0.29;1990s;0.24;2000s;0.68;LG4&5 9-21;Diversifying Consider the characteristics of the following three;stocks;Expected Return;Standard Deviation;Thumb Devices;13%;23%;Air Comfort;10;19;Sport Garb;10;17;LG4&5 9-22;Diversifying Consider the characteristics of the following three;stocks;Expected Return;Standard Deviation;Pic Image;11%;19%;Tax Help;9;19;Warm Wear;14;25;LG7 9-23;Portfolio Weights If you own 300 shares of Alaska Air at $42.88, 350;shares of Best Buy at $51.32, and 250 shares of Ford Motor at $8.51, what are;the portfolio weights of each stock?;LG7 9-24;Portfolio Weights If you own 400 shares of Xerox at $17.34, 500 shares;of Qwest at $8.15, and 350 shares of Liz Claiborne at $44.73, what are the;portfolio weights of each stock?;LG7 9-25;Portfolio Return At the beginning of the month, you owned $5,500 of;General Dynamics, $7,500 of Starbucks, and $8,000 of Nike. The monthly returns for General Dynamics;Starbucks, and Nike were 6.80 percent,?1.36 percent, and?0.54 percent. What is your portfolio return?;LG7 9-26;Portfolio Return At the beginning of the month, you owned $6,000 of News;Corp, $5,000 of First Data, and $8,500 of Whirlpool. The monthly returns for News Corp, First;Data, and Whirlpool were 8.24 percent,?2.59 percent, and 10.13 percent. What?s your portfolio return?;LG2&5 9-27;Asset Allocation You have a portfolio with an asset allocation of 50;percent stocks;40;percent long-term Treasury bonds, and 10 percent T-bills. Use these weights and;the returns in Table 9.2 to compute the return of the portfolio in the year;2000 and each year since. Then compute;the average annual return and standard deviation of the portfolio and compare;them with the risk and return profile of each individual asset class.;LG2&5 9-28;Asset Allocation You have a portfolio with an asset allocation of 35;percent stocks, 55 percent long-term Treasury bonds, and 10 percent T-bills.;Use these weights and the returns in Table 9.2 to compute the return of the;portfolio in the year 2000 and each year since.;Then compute the average annual return and standard deviation of the;portfolio and compare them with the risk and return profile of each individual;asset class.;LG7 9-29;Portfolio Weights You have $15,000 to invest. You want to purchase shares of Alaska Air at;$42.88, Best Buy at $51.32, and Ford Motor at $8.51. How many shares of each company should you;purchase so that your portfolio consists of 30 percent Alaska Air, 40 percent;Best Buy, and 30 percent Ford Motor? Report only whole stock shares.;LG7 9-30;Portfolio Weights You have $20,000 to invest. You want to purchase shares of Xerox at;$17.34, Qwest at $8.15, and Liz Claiborne at $44.73. How many shares of each company should you;purchase so that your portfolio consists of 25 percent Xerox, 40 percent Qwest;and 35 percent Liz Claiborne? Report only whole stock shares.;LG7 9-31;Portfolio Return The table below shows your stock positions at the;beginning of the year, the dividends that each stock paid during the year, and;the stock prices at the end of the year. What is your portfolio dollar return;and percentage return?;Company;Shares;Beginning of Year Price;Dividend per Share;End of Year Price;US Bank;300;$43.50;$2.06;$43.43;PepsiCo;200;59.08;1.16;62.55;JDS Uniphase;500;18.88;16.66;Duke Energy;250;27.45;1.26;33.21;Solution by spreadsheet;LG7 9-32;Portfolio Return The table below shows your stock positions at the;beginning of the year, the dividends that each stock paid during the year, and the stock prices at the;end of the year. What is your portfolio dollar return and percentage return?;Company;Shares;Beginning of Year Price;Dividend per Share;End of Year Price;Johnson Controls;350;$72.91;$1.17;$85.92;Medtronic;200;57.57;0.41;53.51;Direct TV;500;24.94;24.39;Qualcomm;250;43.08;0.45;38.92;LG3&4 9-33;Risk, Return, and Their Relationship Consider the following annual;returns of Estee Lauder and Lowe?s Companies;Estee Lauder;Lowe?s Companies;Year 1;23.4%;?6.0%;Year 2;?26.0;16.1;Year 3;17.6;4.2;Year 4;49.9;48.0;Year 5;?16.8;?19.0;LG3&4 9-34;Risk, Return, and Their Relationship Consider the following annual;returns of Molson Coors and International Paper;Molson Coors;International Paper;Year 1;16.3%;4.5%;Year 2;?9.7;?17.5;Year 3;36.5;?0.2;Year 4;?6.9;26.6;Year 5;16.2;?11.1;Compute each stock?s average return, standard deviation;and coefficient of variation. Which;stock appears better? Why?;9-35;Excel Problem Below are the monthly returns for May 2005 to October 2010;of three international stock indices, All Ordinaries of Australia, Nikkei 225;of Japan, and FTSE 100 of England.;Date;All;Ordinaries;NIKKEI;225;FTSE;October-10;2.08%;-1.78%;2.28%;September-10;4.46%;6.18%;6.19%;August-10;-1.52%;-7.48%;-0.62%;July-10;4.22%;1.65%;6.94%;June-10;-2.89%;-3.95%;-5.23%;May-10;-7.87%;-11.65%;-6.57%;April-10;-1.21%;-0.29%;-2.22%;March-10;5.20%;9.52%;6.07%;February-10;1.18%;-0.71%;3.20%;January-10;-5.85%;-3.30%;-4.15%;December-09;3.55%;12.85%;4.28%;November-09;1.48%;-6.87%;2.90%;October-09;-1.95%;-0.97%;-1.74%;September-09;5.69%;-3.42%;4.58%;August-09;5.52%;1.31%;6.52%;July-09;7.64%;4.00%;8.45%;June-09;3.53%;4.58%;-3.82%;May-09;1.83%;7.86%;4.10%;April-09;6.01%;8.86%;8.09%;March-09;7.14%;7.15%;2.51%;February-09;-5.21%;-5.32%;-7.70%;January-09;-4.95%;-9.77%;-6.42%;December-08;-0.36%;4.08%;3.41%;November-08;-7.78%;-0.75%;-2.04%;October-08;-14.00%;-23.83%;-10.71%;September-08;-11.20%;-13.87%;-13.02%;August-08;3.22%;-2.27%;4.15%;July-08;-5.26%;-0.78%;-3.80%;June-08;-7.64%;-5.98%;-7.06%;May-08;2.07%;3.53%;-0.56%;April-08;4.57%;10.57%;6.76%;March-08;-4.67%;-7.92%;-3.10%;February-08;-0.39%;0.08%;0.08%;January-08;-11.28%;-11.21%;-8.94%;December-07;-2.62%;-2.38%;0.38%;November-07;-2.74%;-6.31%;-4.30%;October-07;3.01%;-0.29%;3.94%;September-07;5.32%;1.31%;2.59%;August-07;0.98%;-3.94%;-0.89%;July-07;-1.95%;-4.90%;-3.75%;June-07;-0.49%;1.47%;-0.20%;May-07;2.98%;2.73%;2.67%;April-07;3.00%;0.65%;2.24%;March-07;2.79%;-1.80%;2.21%;February-07;1.02%;1.27%;-0.51%;January-07;2.01%;0.91%;-0.28%;December-06;3.35%;5.85%;2.84%;November-06;2.03%;-0.76%;-1.31%;October-06;4.69%;1.69%;2.83%;September-06;0.65%;-0.08%;0.93%;August-06;2.48%;4.42%;-0.37%;July-06;-1.53%;-0.31%;1.63%;June-06;1.24%;0.24%;1.91%;May-06;-4.51%;-8.51%;-4.97%;April-06;2.35%;-0.90%;0.98%;March-06;4.28%;5.27%;2.99%;February-06;-0.04%;-2.67%;0.54%;January-06;3.64%;3.34%;2.52%;December-05;2.73%;8.33%;3.61%;November-05;3.87%;9.30%;1.99%;October-05;-3.92%;0.24%;-2.93%;September-05;4.06%;9.35%;3.41%;August-05;1.54%;4.32%;0.28%;July-05;2.76%;2.72%;3.31%;June-05;3.92%;2.73%;3.01%;May-05;3.23%;2.43%;3.38%;A. Compute and compare each indices? monthly average return;and standard deviation.;B. Compute the;correlation between i) All Ordinaries and Nikkei 225, ii) All Ordinaries and;FTSE 100, and iii) Nikkei 225 and FTSE 100, and compare them.;C. Form a portfolio consisting of one third of each of the;indices and show the portfolio return each year, and the portfolio?s return and;standard deviation.;research it!;Following a Portfolio;Following stocks in a portfolio is easier than ever. Many financial Web sites have the capability;to follow the stocks in your portfolio over time. Just enter your stocks, the number of shares;your purchase price, and your commission cost and you can see how your;portfolio is doing. These portfolio managers will update your portfolio as;stock prices change, minute to minute. Yahoo! Finance has a portfolio management;tool. Go to the site and start a portfolio to watch (which requires free;registration). Try entering symbols EBAY, T, LMT, DUK, and GSK. As a start, assume you own 200 shares of;each. You can watch the value of the portfolio change and see how each stock is;doing every day. (http://www.finance.yahoo.com/);The portfolio might;look something like this;integrated minicase:Diversifying with Other Asset;Classes;Many more types of investments are available besides stocks, bonds;and cash securities. Many people invest;in real estate and in precious metals, primarily gold. What are the risk and;return characteristics of these investments and do they provide diversification;opportunities to the typical stock investor?;You can invest in;real estate in many ways. You can build;properties, own rental units, and trade raw land. These activities take enormous time and;expertise. One of the easiest ways to invest in real estate is through real;estate investment trusts (REITs) that trade;like stocks on the stock exchanges.;A REIT represents ownership in a portfolio consisting of a pool of real;estate assets. An index of all REITs is a good measure of the performance of;the real estate market. The table below;shows the annual returns for the All REITs Index alongside the returns of the;S&P 500 Index.;S&P 500;Index;All REITs;Index;Gold Price;1975;37.2%;36.3%;-19.9%;1976;23.8;49.0;-4.1;1977;-7.2;19.1;22.6;1978;6.6;-1.6;37.0;1979;18.4;30.5;126.5;1980;32.4;28.0;15.2;1981;-4.9;8.6;-32.6;1982;21.4;31.6;14.9;1983;22.5;25.5;-16.3;1984;6.3;14.8;-19.2;1985;32.2;5.9;5.7;1986;18.5;19.2;21.3;1987;5.2;-10.7;22.2;1988;16.8;11.4;-15.3;1989;31.5;-1.8;-2.8;1990;-3.2;-17.3;-1.5;1991;30.6;35.7;-10.1;1992;7.7;12.2;-5.7;1993;10.0;18.5;17.7;1994;1.3;0.8;-2.2;1995;37.4;18.3;1.0;1996;23.1;35.8;-4.6;1997;33.4;18.9;-21.4;1998;28.6;-18.8;-0.8;1999;21.0;-6.5;0.9;2000;-9.1;25.9;-5.4;2001;-11.9;15.5;0.7;2002;-22.1;5.2;25.6;2003;28.7;38.5;19.9;2004;10.9;30.4;4.6;2005;4.9;8.3;17.8;2006;15.8;34.4;24.0;2007;3.5;-17.8;31.1;2008;-35.5;-40.0;4.3;2009;23.45;20.9;25.0;Gold has been a highly sought-after asset all over the world, and;has retained at least some economic value over thousands of years. The United;States has had a very chaotic;history with gold. Americans;have sought to ?strike it rich? through gold rushes in North Carolina (early;1800s), California and Nevada (mid-1800s), and Alaska (late 1800s). Struggling in the Great Depression, President;Franklin D. Roosevelt ordered U.S. citizens to hand in all the gold they;possessed. The ban on U.S. citizens owning gold was not lifted until the end of;1974. The table also shows the return from gold prices.;The returns for stocks, real estate;and gold are all volatile. However;during many years, the return of one asset is up while the others are down.;This looks promising for diversification opportunities.;a. Using a spreadsheet, compute the average return and standard;deviation of each of the three asset classes.;b. Compute the annual returns of a portfolio consisting of 50%;stocks / 40% real estate / 10% gold.;What is the average return and standard deviation of this;portfolio? Also compute the average;return and standard deviation of the following portfolios: 75%/20%/5% and;80%/5%/15%. How do these portfolios perform compared to owning just stocks?;c. Plot the average return and standard deviation of the three;assets and the three portfolios on a risk-return graph like Figure 9.3.

 

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