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Tutorial 1 - Risk and Return

The document discusses various financial concepts including the Fisher equation's implications on real interest rates, investment alternatives for a $5,000 investment, risk assessment between different investment strategies, and calculations of mean and standard deviation for stock returns. It also addresses the impact of inflation on nominal returns, the relationship between economic recovery and real interest rates, and provides a scenario analysis for expected returns and risks of two stocks. Overall, it emphasizes the importance of understanding interest rates, risk premiums, and market conditions in investment decisions.

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Ram
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6 views2 pages

Tutorial 1 - Risk and Return

The document discusses various financial concepts including the Fisher equation's implications on real interest rates, investment alternatives for a $5,000 investment, risk assessment between different investment strategies, and calculations of mean and standard deviation for stock returns. It also addresses the impact of inflation on nominal returns, the relationship between economic recovery and real interest rates, and provides a scenario analysis for expected returns and risks of two stocks. Overall, it emphasizes the importance of understanding interest rates, risk premiums, and market conditions in investment decisions.

Uploaded by

Ram
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

1.

The Fisher equation tells us that the real interest rate approximately equals the nominal rate
minus the inflation rate. Suppose the inflation rate increases from 3% to 5%. Does the Fisher
equation imply that this increase will result in a fall in the real rate of interest? Explain.

2. You have $5,000 to invest for the next year and are considering three alternatives:
a. A money market fund with an average maturity of 30 days offering a current yield of 6%
per
year.
b. A 1-year savings deposit at a bank offering an interest rate of 7.5%.
c. A 20-year U.S. Treasury bond offering a yield to maturity of 9% per year.
What role does your forecast of future interest rates play in your decisions?

3. You are considering two alternative 2-year investments: You can invest in a risky asset
with a positive risk premium and returns in each of the 2 years that will be identically
distributed and uncorrelated, or you can invest in the risky asset for only 1 year and then
invest the proceeds in a risk-free asset. Which of the following statements about the first
investment alternative (compared with the second) are true?
a. Its 2-year risk premium is the same as the second alternative.
b. The standard deviation of its 2-year return is the same.
c. Its annualized standard deviation is lower.
d. Its Sharpe ratio is higher.
e. It is relatively more attractive to investors who have lower degrees of risk aversion.

4. You have $5,000 to invest for the next year and are considering three alternatives:
a. A money market fund with an average maturity of 30 days offering a current yield of 6%
per
year.
b. A 1-year savings deposit at a bank offering an interest rate of 7.5%.
c. A 20-year U.S. Treasury bond offering a yield to maturity of 9% per year.
5. Given the table below, compute the mean and standard deviation of the HPR on stocks.
State of the Economy Probability Ending Price HPR (including dividends)
Boom 0.35 $140 44.5%
Normal growth 0.30 $110 14%
Recession 0.35 $80 -16.5%

6. What is the standard deviation of a random variable q with the following probability
distribution:
Value of q Probability
0 0.25
1 0.25
2 0.50

7. During a period of severe inflation, a bond offered a nominal HPR of 80% per year. The
inflation rate was 70% per year.
a. What was the real HPR on the bond over the year?
b. Compare this real HPR to the approximation r ~ R-i.
8. An economy is making a rapid recovery from steep recession and businesses foresee a
need for large amounts of capital investment. Why would this development affect real interest
rates?

9. Use the following scenario analysis for stocks X and Y to answer the questions below.

Bear Market Normal Market Bull Market


Probability 0.2 0.5 0.3
Stock X -20% 18% 50%
Stock Y -15% 20% 10%

a. What are the expected rates of return for stocks X and Y?


b. What are the standard deviations of returns on stocks X and Y?
c. Assume that of your $10000 portfolio, you invest $9000 in stock X and $1000 in
stock Y. What is the expected return on your portfolio?

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