...gains that is made on the value of a portfolio over a specific evaluation period. This takes into consideration any earnings generated by each of the assets contained in the portfolio, as well as any losses that were incurred as a result of a shift in the value of the individual assets. It is possible to identify the realized return associated with each asset that is held in the portfolio. Components of realized return are expected return, changes in expectations about future cash flows and changes in expectations about future discount rate. Employing the calculation of realized return helps an investor make decisions about what assets to hold for a little longer, which ones to sell immediately, and when to acquire additional shares of a given investment. Measuring the rate of return over time helps to determine if the goals set for the investment are being met. It also impacts the buying and selling of assets on reaching the goals of the firm. The realized return is used as a management tool, and knowing this return for successive periods can help an investor arrange his or her assets to best effect, and position to move onward to the next level. Contrast systematic and unsystematic return. Systematic risk is risk that influences a large number of assets called market risk. Where as unsystematic risk is a risk that influences a single company of a small group of companies, also called unique risk. Unsystematic risk is eliminated by diversification, so a portfolio with...
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...happens during a specific period (Jonathan Berk, 2010, p. 388).” The components consist of the stock price that it was bought, the price it was sold, and also the dividend. To calculate the stock’s realized return begin by dividing the dividend by amount that it was bought and adding it to the difference between the amount that it was sold by the amount that it was bought and finally dividing that by the amount that it was bought (Jonathan Berk, 2010, pp. 338-341). This will be the last component to a realized return. Contrast systematic and unsystematic risk. “Unsystematic risk is fluctuations of a stock’s return that are due to company or industry specific news” (Jonathan Berk, 2010, p. 353). This is associated with random causes that can be eliminated through diversification. It’s attributed to firm-specific events such as strikes, lawsuit, regulatory actions, or a loss of a key account. Unsystematic risk is due to factors specific to an industry like labor unions, product category, research and development, pricing, or marketing On the other hand, systematic risk occurs when fluctuations of the stocks returns are changed because of market wide news (Jonathan Berk, 2010, p. 353). These market factors may include situations such as war, inflation, international incidents, or political events. It may be eliminated through diversification and the combination of a security’s non-diversifiable risk and diversifiable risk is called total risk. Systematic risk is beyond the control...
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...Theory and Multifactor Models of Risk and Return Multiple Choice Questions 1. ___________ a relationship between expected return and risk. A. APT stipulates B. CAPM stipulates C. Both CAPM and APT stipulate D. Neither CAPM nor APT stipulate E. No pricing model has found Both models attempt to explain asset pricing based on risk/return relationships. Difficulty: Easy 2. ___________ a relationship between expected return and risk. A. APT stipulates B. CAPM stipulates C. CCAPM stipulates D. APT, CAPM, and CCAPM stipulate E. No pricing model has found APT, CAPM, and CCAPM models attempt to explain asset pricing based on risk/return relationships. Difficulty: Easy 3. In a multi-factor APT model, the coefficients on the macro factors are often called ______. A. systemic risk B. factor sensitivities C. idiosyncratic risk D. factor betas E. B and D The coefficients are called factor betas, factor sensitivities, or factor loadings. Difficulty: Easy 6. Which pricing model provides no guidance concerning the determination of the risk premium on factor portfolios? A. The CAPM B. The multifactor APT C. Both the CAPM and the multifactor APT D. Neither the CAPM nor the multifactor APT E. None of the above is a true statement. The multifactor APT provides no guidance as to the determination of the risk premium on the various factors. The CAPM assumes that the excess market return over the risk-free rate is the market premium in...
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...Lecture Handouts for Chapter 5 Chapter 5 is covered in lectures 31 and 32. Risk and Return The return from an investment is the change in market price, plus any cash payments received due to ownership, divided by the beginning price. The risk of a security can be viewed as the variability of returns from those that are expected. Measurement of Risk The expected return is simply a weighted average of the possible returns, with the weights being the probabilities of occurrence. The conventional measure of dispersion, or variability, around an expected value is the standard deviation σ. The square of the standard deviation σ2 is known as the variance (σ2). The standard deviation can sometimes be misleading in comparing the risk, or uncertainty, surrounding alternative investments if they differ in size. To adjust for the size, or scale, problem, the standard deviation can be divided by the expected return to compute the coefficient of variation (CV) – a measure of “risk per unit of expected return.” Investor’s Attitude towards Risk Investors have different attitudes while deciding between the risk and return in an investment. Investors are, by and large, risk averse. This implies that they demand a higher expected return, the higher the risk. The expected return from a portfolio The expected return from a portfolio (or group) of investments is simply a weighted average of the expected returns of the securities comprising that portfolio. The weights are equal to the proportion...
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...Idiosyncratic risk is a firm-specific risk that affects the price change of a security. It is also known as unsystematic risk. This risk is unique to the specific security and affects a single asset or small group of assets. In contrast to systematic risk, which is the market risk that affects the larger number of assets. Unsystematic risk of a portfolio can be brought down to zero through diversification whereas systematic risk cannot be diversified. This can be further elaborated with the help of an example. A sudden rise in inflation affects all the companies by lowering the real return of all investments thus creating systematic risk whereas an oil strike by a company affects the specific company or few other companies bur does not affect the world oil market. These are firm specific news creating unsystematic risk. The total risk of any investment is a sum total of both the risk taken together. The risk premium for idiosyncratic risk is zero. This risk can be diversified and therefore it is not rewarded. Rational investors will not bear this risk hence it is eliminated. Risk premium of a systematic risk can be captured through beta coefficient. Beta measures the volatility of the stock. However, it determines the sensitivity of the stock return to the systematic risk and not the total risk. If beta is 1 then the risk premium of the stock equals that of market. With a greater beta the investors expect a greater risk premium to compensate them for the additional risk taken and...
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...0.01, and Y has an expected rate of return of 0.10 and a variance of 0.0081. If you want to form a portfolio with an expected rate of return of 0.11, what percentages of your money must you invest in the T-bill and P, respectively? A. 0.25; 0.75 B. 0.19; 0.81 C. 0.65; 0.35 D. 0.50; 0.50 E. cannot be determined 2. You are considering investing $1,000 in a T-bill that pays 0.05 and a risky portfolio, P, constructed with 2 risky securities, X and Y. The weights of X and Y in P are 0.60 and 0.40, respectively. X has an expected rate of return of 0.14 and variance of 0.01, and Y has an expected rate of return of 0.10 and a variance of 0.0081. If you want to form a portfolio with an expected rate of return of 0.10, what percentages of your money must you invest in the T-bill, X, and Y, respectively if you keep X and Y in the same proportions to each other as in portfolio P? A. 0.25; 0.45; 0.30 B. 0.19; 0.49; 0.32 C. 0.32; 0.41; 0.27 D. 0.50; 0.30; 0.20 E. cannot be determined 3. You are considering investing $1,000 in a T-bill that pays 0.05 and a risky portfolio, P, constructed with 2 risky securities, X and Y. The weights of X and Y in P are 0.60 and 0.40, respectively. X has an expected rate of return of 0.14 and variance of 0.01, and Y has an expected rate of return of 0.10 and a variance of 0.0081. What would be the dollar values of your positions in X and Y, respectively, if you decide to hold 40% percent of your money in the risky portfolio and 60%...
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...over a specific evaluation period. The components of a stock are realized return is dividends, distributions, and share price appreciation. Dividends play a very important role in stock realized dividends may be in the form of cash, stock or property. Most secure and stable companies offer dividends to their stockholders. High growth companies will not likely offer dividends, because all of their profits are reinvested to help sustain higher than average growth. Distribution in realized stock is either money a mutual fund pays its shareholder from the dividends or interest it earns or from capital gains, it realizes on the sale of securities in its portfolio. The term distribution is also used to describe certain actions a corporation takes. Share price appreciates is when a share increases in value, it appreciates (Anderson, 2001). Contrast systematic and unsystematic risk. Systematic risk is also known as the non-diversifiable risk. There is a relevant portion of an assist’s risk attributable to market factors that have an effect on all firms such as war, inflation, international incidents, and political events. Unsystematic risk also known as diversifiable risk represents the portion of an asset that is associated with random causes that can eliminated through diversification. Systematic risk cannot be eliminated through diversification and the combination of a security’s non-diversifiable risk and diversifiable risk is known as a total risk. Systematic risk is due...
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...BKM CHAPTER 7 1. Which of the following factors reflect pure market risk for a given corporation? a. Increased short-term interest rates b. Fire in the corporate warehouse c. Increased insurance costs d. Death of the CEO, e. Increased labor costs) (a) and (e) – The other three do not affect all participants in the economy. 2. When adding real estate to an asset allocation program that currently includes only stocks, bonds, and cash alternatives (risk-free-money market investments), which of the properties of real estate returns affect portfolio risk? Explain. a. Standard Deviation b. Expected Return c. Correlation with the returns of other assets (a) and (c). The portfolio risk (standard deviation) calculation now includes the variance of real estate returns and correlation between real estate and stocks the correlation between real estate and bonds. The correlation between real estate and money markets will be zero. Not (b) since the E(r) of real estate does not affect the portfolio’s risk. Note: The question refers to correlation (ρij) between real estate and the other assets. Since correlation is defined as the covariance between two assets’ returns divided by the product of the standard deviations of the assets returns (ρij = σij/σiσj), the portfolio risk formula can be stated in terms of either correlation or covariance. 3. Which of the following statements about the minimum variance portfolio of all risky...
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...format similar to Spreadsheet 6.2. Confirm your intuition from part (a) | A | B | C | D | E | F | G | 1 | Scenario | Probability | Rate of Return | Col. B X Col. C | Deviation from Expected Return | Squared Deviation | Col. B X Col. F | 2 | Severe recession | 0.10 | -37 | -3.7 | -46.5 | 2162.25 | 216.225 | 3 | Mild recession | 0.20 | -11 | -2.2 | -20.5 | 420.25 | 84.05 | 4 | Normal growth | 0.35 | 14 | 4.9 | 4.5 | 20.25 | 7.0875 | 5 | Boom | 0.35 | 30 | 10.5 | 20.5 | 420.25 | 147.0875 | 6 | | Expected Return = | 9.5 | Variance = Sum | 454.45 | 7 | | | Standard Deviation = SQRT (Variance) | 21.3178 | (c) Calculate the new value of the covariance between the stock and bond funds using a format similar to Spreadsheet 6.4. Explain intuitively the change in the covariance. | A | B | C | D | E | F | 1 | | | Deviation from Mean Return | Covariance | 2 | Scenario | Probability | Stock Fund | Bond Fund | Product of Dev | Col. B X Col. E | 3 | Severe recession | 0.1 | -46.5 | -12.15 | 564.975 | 56.4975 | 4 | Mild recession | 0.2 | -20.5 | 11.85 | -242.925 | -48.585 | 5 | Normal growth | 0.35 | 4.5 | 4.85 | 21.825 | 7.63875 | 6 | Boom | 0.35 | 20.5 | -8.15 | -167.075 | -58.47625 | 7 | | |...
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...accomplished via correlation with other assets. Covariance helps determine that number. 3. a and b will have the same impact of increasing the Sharpe ratio from .40 to .45. 4. The expected return of the portfolio will be impacted if the asset allocation is changed. Since the expected return of the portfolio is the first item in the numerator of the Sharpe ratio, the ratio will be changed. 5. Total variance = Systematic variance + Residual variance = β2 Var(rM) + Var(e) When β = 1.5 and σ(e) = .3, variance = 1.52 × .22 + .32 = .18. In the other scenarios: a. Both will have the same impact. Total variance will increase from .18 to .1989. b. Even though the increase in the total variability of the stock is the same in either scenario, the increase in residual risk will have less impact on portfolio volatility. This is because residual risk is diversifiable. In contrast, the increase in beta increases systematic risk, which is perfectly correlated with the market-index portfolio and therefore has a greater impact on portfolio risk. 6. a. Without doing any math, the severe recession is worse and the boom is better. Thus, there appears to be a higher variance, yet the mean is probably the same since the spread is equally large on both the high and low side. The mean return, however, should be higher since there is higher probability given to the higher returns. b. Calculation of mean return...
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...Project Part 2 Task 4 1. The project’s IRR is going to be 22%. The way to figure it out is going to be on the excel spreadsheet that is attached to this project 2. To calculate the NPV you are going to use the formula NPV=(1,100,000/1.15)+(1,450,000/1.15)^2+(1,300,000/1.15)^3+ (950,000/1.15)^4-3,000,000=$450,866.74. Attached is the excel spreadsheet that shows the work. 3. Based on what the NPV is for this project the company should definitely consider accepting this project because the NPV is greater than 0. Anytime the NPV is greater than 0 it means it will make the company money so therefore the company should be accepting the project. 4. Well first to answer the question you have to know what depreciation is a non-cash expense that reduces the value of an asset over time. So now knowing that, depreciation is not considered a cash flow but it does generally reduces a company’s tax liability. Anytime you reduce a company’s tax liability it will cause an increase to the present value of the project. 5. So first thing we need to do is explain what each one of these means and then we can relate them to the project. * Sunk Cost: Sunk costs are cost to the company that have already been incurred and cannot be recovered by any means. In this example Air Jet hired a group to come in and evaluate the feasibility and the utility of acquiring a new machine for them to use. Even if the company does not get the machine the money that they spent has already...
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...Task 4 Year Cash Flow 15% Rate of Return Present Value 0 $(3,000,000.00) 1 $1,100,000.00 $956,521.74 2 $1,450,000.00 $1,260,869.57 3 $1,300,000.00 $1,130,434.78 4 $950,000.00 $826,086.96 Less Investment $(3,000,000.00) $3,450,866.74 1. IRR % IRR= 22.38% 2. NPV NPV= $3,450,866.74 3. Should the company accept this project and why? I believe the company should look into this. The IRR is greater than the Required Rate of Return and the overall NPV is a gain. There does not appear to be a loss in this asset. 4. Explain how depreciation will affect the present value of the project. Depreciation would cause the project's PV to go up. This would be a good thing when considering the amount of taxes the company would save. 5. Provide examples of at least one of the following as it relates to the project: a. Sunk Cost - costs that are non-recoverable and shouldn't be used when considering an investment decision. An example of this would be AirJet has already purchased delivery trucks to deliver parts to vendors/customers. This cost would not be taken into consideration because it has no affect on the purchase of a new machine. This was a purchase that was done prior to any decisions made about buying the new machine. b. Opportunity Cost - This is the most valuable alternative that is given up if a particular investment is undertaken. Most of the time...
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...Preface This paper is written under the assumption that the reader is aware of the basic risk premium evaluation models and theories such as the Modern Portfolio Theory and the Capital Asset Pricing Model. This article explains why there was a need for such evaluation mechanisms and why, in some way shape or form, these models were flawed and hence there was and is a need for a new mechanisms for evaluating risk premiums. Evolution of models to calculate Risk Premiums In the realm of corporate finance, investments, and valuations, the central pillar of all estimates is the risk premium associated with an asset class. Over the years, there have been many models that have been used to calculate the risk premium, each with its own assumptions and restrictions. First, let us understand why there is a need for a risk premium or for such models as a whole. When compared to the hypothetical risk free investment, each alternate investment asset has a degree of risk and an amount of return, to compensate for that risk, associated to it. There are two major factors that an investor takes into account before making an investment decision, risk aversion and macro-economic perception. In order to understand the genesis of the models and the underlying set of issues they solve and simultaneously have, let us consider a novice investor. The investor is looking at the US stock market and, for the sake of simplicity, wants to invest only in stocks. The primary question for the investor is...
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...require management to use the COSO framework for assessing internal control adequacy. ANS: F PTS: 1 4. A qualified opinion on management’s assessment of internal controls over the financial reporting system necessitates a qualified opinion on the financial statements? ANS: F PTS: 1 5. The same internal control objectives apply to manual and computer-based information systems. ANS: T PTS: 1 6. The external auditor is responsible for establishing and maintaining the internal control system. ANS: F PTS: 1 7. Segregation of duties is an example of an internal control procedure. ANS: T PTS: 1 8. Preventive controls are passive techniques designed to reduce fraud. ANS: T PTS: 1 9. The Sarbanes-Oxley Act requires only that a firm keep good records. ANS: F PTS: 1 10. A key modifying assumption in internal control is that the internal control system is the responsibility of management. ANS: T PTS: 1 11. While the Sarbanes-Oxley Act prohibits auditors from providing non-accounting services to their audit clients, they are not prohibited from performing such services for non-audit clients or privately held companies. ANS: T PTS: 1 12. The Sarbanes-Oxley Act requires the audit committee to hire and oversee the external auditors. ANS: T PTS: 1 13. Section 404 requires that corporate management (including the CEO) certify their organization’s internal controls on a quarterly and annual basis. ANS: F PTS: 1 14. Section 302 requires the management of public...
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...1 QUESTIONS 1.a. What are the various categories of multinational firms? ANSWER. Raw materials seekers, market seekers, and cost minimizers. b. What is the motivation for international expansion of firms within each category? ANSWER. The raw materials seekers go abroad to exploit the raw materials that can be found there. It just happens that nature didn't place all natural resources domestically. Market seekers go overseas to produce and sell in foreign markets. The cost minimizers invest in lower-cost production sites overseas in order to remain cost competitive both at home and abroad. In all cases, the firms involved recognize that the world is larger than the home country and provides opportunities to gain additional supplies, sell more products or find lower cost sources of production. 2.a. How does foreign competition limit the prices that domestic companies can charge and the wages and benefits that workers can demand? ANSWER. As domestic producers raise their prices, customers begin substituting less expensive goods and services supplied by foreign producers. The likelihood of losing sales limits the prices that domestic firms can charge. Foreign competition also acts to limit the wages and benefits that workers can demand. If workers demand more money, firms have two choices. Acquiesce in these demands or fight them. Absent foreign competition, the cost of acquiescence is relatively low, particularly if the industry is unionized. Since all firms will face the same...
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