Chapter 15 Part 4

Question 1

The risk premium is the

Answer 1

difference between the expected return of an investment and the risk-free rate.

Question 2

An investor purchases 1,000 shares of VPN at $25 per share. VPN has an expected retum of 6%. If the T-bill rate is 2%–the risk free rate, what is VPN’s risk premium?

Answer 2

To determine VPN’s risk-adjusted rate, the number of shares purchased and the price per share is not required. The two components necessary are the expected return and the risk-free rate. VPN’s expected return is 6%. Unless otherwise indicated, the T-bill rate is used for the risk-free rate. Using the formula given, the risk premium would be 4% (6% - 2% = 4%). In other words, the expected return exceeds the risk-free return by 4%.

Question 3

For example, if Bz = 1.5, the expected market return is 11 %, and the risk-free rate is 5%, then Z’s expected return is

Answer 3

5% + 1.5(11% - 5%) = 14%

Question 4

alpha represents the

Answer 4

difference between an asset’s expected return and its actual return (also referred to as its risk-adjusted return).

Question 5

The Sharpe ratio is the

Answer 5

risk-adjusted return measurement that was developed by Nobel Laureate William Sharpe. It indicates the amount of return earned per unit of risk. The basic idea is to see how much additional return you are receiving for the additional volatility of holding a risky asset over a risk-free asset. The ratio is calculated by first subtracting the risk-free rate from the return of the portfolio, then dividing by the standard deviation of the portfolio.

Question 6

Sharpe Ratio =

Answer 6

R1-Rrf / r1 R1= the portfolio’s return from period 1, Rrf= the risk free rate of return for period 1, r1= the standard deviation of the portfolio during period 1

Question 7

Remember, a portfolio or fund may achieve higher returns than others, but it is only a good investment if

Answer 7

those higher returns do not come with too much additional risk.

Question 8

The greater a portfolio’s Sharpe ratio, the

Answer 8

better its risk adjusted performance has been. A negative Sharpe ratio indicates that a riskless asset would perform better than the security being analyzed.

Question 9

The Sharpe ratio is often used to rank the

Answer 9

risk-adjusted performance of various portfolios over the same period, such as the performance of mutual funds with similar objectives. This ratio is included in the information provided by mutual fund ranking services, such as Morningstar and Value Linc.

Question 10

Fund A produces a return of 25% with a standard deuiation of 10. Fund B produces a return of 30% with a standard deuiation of 13. Assuming a T-bill (risk-free) return of 5%, which fund has the better risk-adjusted performance?

Answer 10

Fund A’s Sharpe ratio is (25 - 5) + 10 = 2.0, while Fund B’s Sharpe Ratio is (30 - 5) + 13 = 1.92. Fund A has the higher Sharpe Ratio. Therefore, Fund A has a greater risk-adjusted return.

Question 11

Systematic (nondiversifiable) risk is caused by factors that affect

Answer 11

the prices of virtually all securities. Interest rates, recession, and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. The following arc the different types of systematic risk: market, interest rate, inflation, event risk.

Question 12

Market risk represents the

Answer 12

day-to-day potential for an investor to experience losses due to market fluctuations in securities’ prices.

Question 13

Interest-rate risk primarily affects

Answer 13

current bondholders, since the market value
of their investments may decline if interest rates rise. New potential investors will not be interested in purchasing existing bonds at par ($1,000) since they can obtain higher yields by purchasing new issues with higher coupon rates. The price of existing bonds will need to be lowered to attract purchasers.

Question 14

A diversified portfolio of bonds from different issuers with different coupon rates, maturity dates, and geographic locations will provide protection against some risks, but not against interest-rate risk. ln other words, since interest-rate risk is systematic for bonds,

Answer 14

all bonds have some exposure to it. Bonds with longer maturities tend to be more vulnerable to interest-rate risk than bonds with shorter maturities. Also, bonds with lower interest rates are more sensitive to interest-rate risk than bonds with similar maturities and with higher coupon rates. Zero-coupon bonds, since they are generally long-term and have no interest payment, are extremely vulnerable to interest-rate risk.

Question 15

Inflation (purchasing-power) risk exists when an investment

Answer 15

pays the sa1ne amount. however, as the price of goods and services increases as measured by the Consumer Price Index (CPI), inflation diminishes the real value of a dollar by decreasing its purchasing power.

Question 16

to address purchasing power risk

Answer 16

The U.S. government has created Treasury lnflation-Protected Securities (TIPS) to address purchasing power risk. As with all securities issued by the Treasury Department, TIPS are backed by the U.S. government and have little risk of default. TIPS pay a fixed rate of interest semiannually, but the principal of each bond is automatically adjusted upward or downward based on changes in the CPI. the semiannual interest payments are then calculated based on the adjusted principal. At maturity, the investor receives the adjusted principal or the original principal-whichever is greater.

Question 17

Gary and Laura purchased TIPS with a $10,000 principal amount and a 3% coupon. The CPI increased 1% in the first six months they held the bond. What is the semiannual coupon payment Gmy and Laura will receive?

Answer 17

The principal amount of TIPS is automatically adjusted based on the change of the CPI. In this example, the CPI increased by 1 %. This will result in the $10,000 principal amount increasing by 1% or $10,100. The annual coupon on the TIPS is 3% of the new principal amount. 3% of $10,100 is $303.00. Since the question asks you to compute the semiannual coupon, the answer is $151.50.

Question 18

When answering questions about TIPS, make sure you are careful. Remember, the principal and coupon payment of TIPS will increase or decrease based on the CPL Since the principal and the coupon payments will be adjusted, the

Answer 18

rate of return stays the same.

Question 19

event risk is the risk that

Answer 19

a significant event will cause a substantial decline in the market value of a specific security (e.g., the 9/11 attack).

Question 20

In contrast to systematic risk, unsystemaatic risk is based on circumstances that are

Answer 20

unique to a specific security and may be managed by diversifying the assets in a portfolio (i.e., by selecting stocks possessing different risk-return characteristics).