Ceos like to Hide Bad Information from the Financial Market, What’s the Consequence?

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Chapter 7

11.

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A.Although Expected Return of stock is higher than gold, Standard Deviation of stock is smaller than gold, it seems that stocks is dominate, gold still be an important part of a portfolio. When the correlation between gold and stocks is sufficiently low, gold will become a part of the portfolio.

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B.When the correlation equals 1 between gold and stocks, stocks and gold will be a straight line that has a negative slope. It means no one wants to hold gold, because gold has a lower expected return and a bigger risk. But the situation is not permanent, the reason for this is that when people don’t purchase gold, the gold price would fall, and the expected return will be increased until it became sufficiently attractive to include in a portfolio.

12. Suppose that there are many stocks in the security market and that the characteristics of stocks A and B are given as follows:

Stock Expected Return Standard Deviation

A 10% 5%

B 15% 10%

Correlation=-1

Suppose that it is possible to borrow at the risk-free rate, rf. What must be the value of the risk-free rate? (Hint: Think about constructing a risk-free portfolio from stocks A and B.)

created, and the rate of return will be the risk-free rate. Set the standard deviation equal to zero, so WA = σB / σA+σB = 1 – WB.

WA = σB / σA+σB = 10%/10%+5% = 2/3 = 0.67

WB = 1 – WA = 0.33

Er = WA*ErA+WB*ErB = 10%*0.67+15%*0.33 = 11.65%

So the risk-free rate is 11.65%

16. Suppose that you have $1 million and the following two opportunities from which to construct a portfolio: A.Risk-free asset earning 12% per year. B.Risky asset with expected return of 30% per year and standard deviation of 40%. If you construct a portfolio with a standard deviation of 30%, what is its expected rate of return?σP2=wA2σA2+wB2σB2 +2wA wB Cov(rA ,rB ),Cov(rA,rB) = ρABσAσB,Because of σA = 0.So σP= wBσB σP = wBσB , WB = σP/ σB = 30%/40% = 0.75 Erp = WAErA + WBErB = ErA + WB(ErB –ErA) =12%+0.75*(30%-12%)=25.5% Chapter 94. Here are data on two companies. The T-bill rate is 4% and the market risk premium is 6%. Company

$1 Discount Store(1) Everything $5(2)

Forecasted return 12% 11%

Standard deviation of returns 8% 10%

Beta 1.5 1.0

What would be the fair return for each company, according to the capital asset pricing model (CAPM)? E(ri) = rf + βi *[E(rm) – rf] E(r1)=4%+1.5*6%=13% E(r2)=4%+1.0*6%=10% 5. Characterize each company in the previous problem as underpriced, overpriced, or properly priced. The security of $1 Discount stores is overpriced, the reason for this is that E(r1) is 13% that is higher than the forecasted return(12%).The security of Everything $5 is underpriced, because E(r2) is 10% that is lower than the forecasted return(11%)17. For Problems 17 assume that the risk-free rate of interest is 6% and the expected rate of return on the market is 16%.A share of stock sells for $50 today. It will pay a dividend of $6 per share at the end of the year. Its beta is 1.2. What do investors expect the stock to sell for at the end of the year? E(ri) = rf + βi *[E(rm) – rf]=6%+1.2*(16%-6%)=18% E(r) = (D1+P1 – P0)/P0 = 0.18 P1 = 0.18*$50 +$50 -$6=$53