Discuss Specific versus Market Risk

10.  Real versus Nominal Returns. The inflation rate in the United States has averaged 3% a year since 1900. What was the average real rate of return on Treasury bills, Treasury bonds, and common stocks in that period? Use the data in Table 11.1. (LO11-2 )

12. Market Indexes. In February 2009, the Dow Jones Industrial Average was at a level of about 8,000. In mid-2018, it was about 24,500. Would you expect the Dow in 2018 to be more or less likely to move up or down by more than 40 points in a day than in 2009? Does this mean the market was riskier in 2018 than it was in 2009? (LO11-2)

13. Scenario Analysis. Consider the following scenario analysis: (LO11-2)

Scenario             Probability    Stocks      Bonds

Recession              0.20          −5%          +14%

Normal economy    0.60         +15             +8

Boom                     0.20          +25            +4

a.  Is it reasonable to assume that Treasury bonds will provide higher returns in recessions than in booms?

b.  Calculate the expected rate of return and standard deviation for each investment.c.  Which investment would you prefer?

1.  Diversifiable Risk. In light of what you’ve learned about market versus diversifiable (specific) risks, explain why an insurance company has no problem in selling life insurance to individuals but is reluctant to issue policies insuring against flood damage to residents of coastal areas. Why don’t the insurance companies simply charge coastal residents a premium that reflects the actuarial probability of damage from hurricanes and other storms? (LO12-1)

2.  Specific versus Market Risk. Figure 12.10 plots monthly rates of return from 2014 to 2018 for the Snake Oil mutual fund. Was this fund fully diversified? (LO12-1)

3.  Using Beta. A stock with a beta of .8 has an expected rate of return of 12%. If the market return this year turns out to be 5 percentage points below expectations, what is your best guess as to the rate of return on the stock? (LO12-1)

4.  Specific versus Market Risk. Figure 12.11 shows plots of monthly rates of return on three stocks versus the stock market index. (The plots are similar to those in Figure 12.2.) The beta and standard deviation of each stock are given beside its plot. (LO12-1)

a.  Which stock is safest for a diversified investor?

b.  Which stock is safest for an undiversified investor who puts all her funds in one of these stocks?

c.  Consider a portfolio with equal investments in each stock. What would this portfolio’s beta have been?

d.  Consider a well-diversified portfolio made up of stocks with the same beta as Intel. What are the beta and standard deviation of this portfolio’s return? The standard deviation of the mar-ket portfolio’s return is 20%.

e.  What is the expected rate of return on each stock? Use the capital asset pricing model with a market risk premium of 8%. The risk-free rate of interest is 4%.  Specific versus Market Risk