State of the Economy Probability 1-Year T-Bond TECO Gold Hill S&P 500 Fund Recession 0.1 0.08 -0.08 0.18 -0.15 Below Average 0.2 0.08 0.02 0.23 0 Average 0.4 0.08 0.14 0.07 0.15 Avbove Average 0.2 0.08 0.25 -0.03 0.3 Boom 0.1 0.08 0.33 0.02 0.45 Total 1 0.4 0.66 0.47 0.75 

QUESTIONS

1. Why is the T-bond return in Table 1 shown to be independent of the state of the economy? Is

the return on a 1-year T-bond risk-free?

2. Calculate the expected rate of return on each of the four alternatives listed in Table 1. Based

solely on expected returns, which of the potential investments appears best?

3. Now calculate the standard deviations and coefficients of variation of returns for the four

alternatives. What type of risk do these statistics measure? Is the standard deviation or the

coefficient of variation the better measure? How do the alternatives compare when risk is

considered? (Hint: For the S&P 500, the standard deviation = 16.4%; for Gold Hill, the

standard deviation = 9.1%.)

4. Suppose an investor forms a stock portfolio by investing $10,000 in Gold Hill and $10,000 in

TECO.

a. What would be the portfolio's expected rate of return, standard deviation, and coefficient of

variation? How does this compare with values for the individual stocks? What

characteristic of the two investments makes risk reduction possible?

b. What do you think would happen to the portfolio's expected rate of return and standard

deviation if the portfolio contained 75 percent Gold Hill? If it contained 75 percent TECO?

Use a spreadsheet model for this case to calculate the expected returns and standard

deviations for a portfolio mix of 0 percent TECO, 10 percent TECO, 20 percent TECO, and

so on, up to 100 percent TECO.

5. Now consider a portfolio consisting of $10,000 in TECO and $10,000 in the S&P 500 Fund.

Would this portfolio have the same risk-reducing effect as the Gold Hill-TECO portfolio

considered in Question 4? Explain. Use a spreadsheet model to construct a portfolio using

portfolio mix of 0 percent TECO, 10 percent TECO, 20 percent TECO, and so on, up to 100

percent TECO?

6. Suppose an investor starts with a portfolio consisting of one randomly selected stock.

a. What would happen to the portfolio's risk if more and more randomly selected stocks were

added?

b. What are the implications for investors? Do portfolio effects impact the way investors

should think about the riskiness of individual securities? Would you expect this to affect

companies' costs of capital?

c. Explain the differences between total risk, diversifiable (company-specific) risk, and

market risk.

d. Assume that you choose to hold a single stock portfolio. Should you expect to be

compensated for all of the risk that you bear?

7. Now change Table 1 by crossing out the state of the economy and probability columns and

replacing them with Year 1, Year 2, Year 3, Year 4, and Year 5. Then, plot three lines on a

scatter diagram which shows the returns on the S&P 500 (the market) on the X axis and (1) T-

bond returns, (2) TECO returns, and (3) Gold Hill returns on the Y axis. What are these lines

called? Estimate the slope coefficient of each line. What is the slope coefficient called, and

what is its significance? What is the significance of the distance between the plot points and

the regression line, i.e., the errors? (Note: If you have a calculator with statistical functions, use

linear regression to find the slope coefficients.)

8. Plot the Security Market Line. (Hint: Use Table 1 data to obtain the risk-free rate and the

required rate of return on the market.) What is the required rate of return on TECO's stock

using Value Line's beta estimate of 0.6 as reported in Figure 1? Based on the CAPM analysis,

should investors buy TECO stock?

Answer rating: 100% (QA)

Answers to Finance Questions 1 TBond Return and RiskFree Rate Tbond returns are shown independent of the economic state because they are considered relatively riskfreeThe government guarantees the pri... View the full answer