Q. The portfolio manager of Ludwig Company has excess cash that is to be invested for four years. He can purchase four-year Treasury notes that offer a 9 percent yield. Alternatively, he can purchase new 20-year Treasury bonds for $2.9 million that offer a par value of $3 million and an 11 percent coupon rate with annual payments. The manager expects that the required return on these same 20-year bonds will be 12 percent four years from now. What is the forecasted market value of the 20-year bonds in four years?

Which investment is expected to provide a higher yield over the four-year period?

R. Describe how bond convexity affects the theoretical linear price-yield relationship of bonds. What are the implications of bond convexity for estimating changes in bond prices?

S. Explain the difference between stand-alone risk and risk in a portfolio context. Describe how risk aversion affects a stocks required rate of return.

T. Discuss the difference between diversifiable risk and market risk, and explain how each type of risk affects well-diversified investors.

U. Describe what the CAPM is, and illustrate how it can be used to estimate a stocks required rate of return.

V. Discuss how changes in the general stock and bond markets could lead to changes in the required rate of return on a firms stock.

W. Discuss how changes in a firms operations might lead to changes in the required rate of return on the firms stock.

X Does the average investors willingness to take on risk vary over time? What do you think the average investors risk perception is now? In what types of investments do you think the average investor is investing currently? Should companies completely avoid high-risk projects?

Y. Portfolio P consists of two stocks: 50% is invested in Stock A and 50% is invested in Stock B. Stock A has a standard deviation of 25% and a beta of 1.2, and Stock B has a standard deviation of 35% and a beta of 0.80. The correlation between these stocks is 0.4. What is the standard deviation of Portfolio P? Less than 30% More than 30%

What is the beta of Portfolio P? Which stock is riskier to a diversified investor?

Z. Explain the following statement: An asset held as part of a portfolio is generally less risky than the same asset held in isolation.

AA. What is meant by perfect positive correlation, perfect negative correlation, and zero correlation?

BB. In general, can the riskiness of a portfolio be reduced to zero by increasing the number of stocks in the portfolio?

CC. What is an average-risk stock? What is the beta of such a stock?

DD. Why is it argued that beta is the best measure of a stocks risk?

EE. An investor has a two-stock portfolio with $25,000 invested in Stock X and $50,000 invested in Stock Y. Xs beta is 1.50, and Ys beta is 0.60. What is the beta of the investors portfolio?

FF. Differentiate between a stocks expected rate of return , required rate of return (r), and realized, after-the-fact historical return . Which would have to be larger to induce you to buy the stock, or r? At a given point in time, would , r, and typically be the same or different? Explain.

GG. What are the differences between the typical relative volatility graph, where betas are made, and the typical SML graph, where betas are used? Explain how both graphs are constructed and what information they convey.

HH. What is meant by the term, positive alpha? Negative alpha? How can a firm influence the size of its beta?

II. What would happen to the SML graph if expected inflation increased or decreased? What happens to the SML graph when risk aversion increases or decreases?

What would the SML look like if investors were indifferent to risk, that is, if they had zero risk aversion?

JJ. A stock has a beta of 1.2. Assume that the risk-free rate is 4.5%, and the market risk premium is 5%. What is the stocks required rate of return?

KK Explain the following statement: The stand-alone risk of an individual corporate project may be quite high, but viewed in the context of its effect on stockholders risk, the projects true risk may not be very large. How does the correlation between returns on a project and returns on the firms other assets affect the projects risk?

LL A life insurance policy is a financial asset, with the premiums paid representing the investments cost. How would you calculate the expected return on a 1-year life insurance policy?

Suppose the owner of a life insurance policy has no other financial assetsthe persons only other asset is human capital, or earnings capacity. What is the correlation coefficient between the return on the insurance policy and the return on the human capital? Life insurance companies must pay administrative costs and sales representatives commissions; hence, the expected rate of return on insurance premiums is generally low or even negative. Use portfolio concepts to explain why people buy life insurance in spite of low expected returns.

MM If the market interest rate for a given bond increased, the price of the bond would decline. Applying this same logic to stocks, explain (a) how a decrease in risk aversion would affect stocks prices and earned rates of return, (b) how this would affect risk premiums as measured by the historical difference between returns on stocks and returns on bonds, and (c) what the implications of this would be for the use of historical risk premiums when applying the SML equation.

NN HR Industries (HRI) has a beta of 1.6; LR Industriess (LRI) beta is 0.8. The risk-free rate is 6%, and the required rate of return on an average stock is 13%. The expected rate of inflation built into falls by 1.5 percentage points, the real risk-free rate remains constant, the required return on the market falls to 10.5%, and all betas remain constant. After all of these changes, what will be the difference in the required returns for HRI and LRI?