Question 1: Portfolio risk
- How many variance terms and how many different covariance terms do you need to calculate the risk of a 100-share portfolio?
- Suppose all stocks had a standard deviation of 30% and a correlation with each other of .4.
What is the standard deviation of the returns on a portfolio that has equal holdings in 50 stocks?
- What is the standard deviation of a fully diversified portfolio of such stocks?
Question 2: Certainty equivalents
A project has a forecasted cash flow of $110 in year 1 and $121 in year 2. The interest rate is 5%, the estimated risk premium on the market is 10%, and the project has a beta of .5. If you use a constant risk-adjusted discount rate, what is
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- The PV of the project?
- The certainty-equivalent cash flow in year 1 and year 2?
- The ratio of the certainty-equivalent cash flows to the expected cash flows in years 1 and 2?
Question 3: Measuring risk
The following table shows estimates of the risk of two well-known Canadian stocks:
|R2||Beta||Standard Error of Beta|
- What proportion of each stock’s risk was market risk, and what proportion was specific risk?
- What is the variance of TDM Bank? What is the specific variance?
- If the CAPM is correct, what is the expected return on TDM Bank? Assume a risk-free interest rate of 5% and an expected market return of 12%.
- Suppose that next year the market provides a zero return. Knowing this, what return would you expect from TDM Bank?
The total market value of the common stock of the OKF Real Estate Company is $6 million, and the total value of its debt is $4 million. The treasurer estimates that the beta of the stock is currently 1.5 and that the expected risk premium on the market is 6%. The Treasury bill rate is 4%. Assume for simplicity that OKF debt is risk-free and the company does not pay tax.
- What is the required return on OKF stock?
- Estimate the company’s cost of capital.
- Suppose the company wants to diversify into the manufacture of rose-colored spectacles. The beta of unleveraged optical manufacturers is 1.2. Estimate the required return on OKF’s new venture.
Your paper should be one to two pages in length (excluding cover page and references) and formatted according to the CSU-Global Guide to Writing and APA Requirements. Be sure to discuss and reference concepts taken from the assigned textbook reading and relevant research. Review the grading rubric to see how you will be graded for this assignment.