Case 3

Question 1

The T-bond return does not depend on the state of the economy because the interest payments will be made and the bond will be redeemed by the federal government, barring global disaster. The T-bond, since its return is independent of the state of the economy, is risk-free, but only in the nominal sense. An investor is “guaranteed” an 8.0 percent nominal return. However, the real realized return will depend on inflation over the next year. Thus, the real return, which counts most, is uncertain. Also, if interest rates rise, the bond’s price will decline (slightly, for a l-year bond, and if you must sell it to raise cash, you would suffer a slight loss (a large loss on a long-term bond).

Question 2

Expected kTECO = 0.1 (-8.0%) + 0.2(.0$) + 0.4(14.0%) + 0.(25.0%) + 0.1(33.0%) = 13.5%.
Expected kT-bond = 8.0%.
Expected kGH = 8.8%.
Expected kT-S$P 500 = 15.0%.

Looking solely at expected rates of return, the S$P 500 looks best with a return of 15.0% while the T-bonds, at 8.0 percent, look the worst.

Question 3

VarianceTECO = [pic]P1 (ki - k)2 = 0.1(-8 - 13.5) 2 + 0.2(2 - 13.5) 2 + 0.4(14 - 13.5) 2 + 0.2(25 - 13.5) 2 + 0.1(33 - 13.5) 2 = 137.3.
[pic] = [pic]=[pic] = 11.7%
CV = [pic]/Expected value = 11.7%/13.5% = 0.87.
[pic]T-BOND = 0.0%.
CV T-BOND = 0.00.
[pic]GH = 9.1%
CV GH = 1.03.
[pic]S&P 50 = 16.4%.
CV S&P 50 = 1.10.

Standard deviation and coefficient of variation are measures of dispersion about the mean, and hence measure total risk. Total risk is the relevant measure of risk only for assets held in isolation. Of the two total risk measures, coefficient of variation is the better one because it relates risk to the expected rate of return; that is, it standardizes the measure. (Note that a measure such as semivariance, which measures