Overview:
Respond to two questions and solve five computational problems related to estimating risk and return.
• Competency: Evaluate the global financial environment.
o Identify challenges for practitioners in using expected return.
o Explain how different allocations between the risk-free security and the market portfolio can achieve any level of desired market risk.
o Calculate expected return, considering the possibility of differing economic states.
o Calculate required return, considering the risk-free rate and the risk premium.
o Calculate the market risk premium of the Standard and Poor’s 500 Index, showing applicable input values, computational steps, and formulas.
o Explain why expected return is considered forward-looking.
o Calculate the beta of a portfolio, showing applicable input values, computational steps, and formulas.
Competency: Define finance terminology and its application within the business environment.
o Calculate required return, using the capital asset pricing model.
Instructions:
Answer the following questions and complete the following problems:
Questions
In a Word document, respond to the following. Number your responses 1–2.
1. Explain why expected return is considered forward-looking. What challenges arise in using expected return?
2. Explain how differences in allocations between the risk-free security and the market portfolio can determine the level of market risk.
Use references to support your responses as needed. Be sure to cite all references using correct APA style.
Problems
In either a Word document or Excel spreadsheet, complete the following problems.
• You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet.
• If you choose to solve the problems algebraically, be sure to show your computations.
• If you use a financial calculator, show your input values.
• If you use an Excel spreadsheet, show your input values and formulas.
1. Based on the probability and percentage of return for the three economic states in the table below, compute the expected return.
Economic State Probability Percentage of Return
Fast Growth 0.10 60
Slow Growth 0.50 30
Recession 0.40 -23
2. If the risk-free rate is 7 percent and the risk premium is 4 percent, what is the required return?
3. Suppose that the average annual return on the Standard and Poor’s 500 Index from 1969 to 2005 was 14.8 percent. The average annual T-bill yield during the same period was 5.6 percent. What was the market risk premium during these 10 years?
4. Conglomco has a beta of 0.32. If the market return is expected to be 12 percent and the risk-free rate is 5 percent, what is Conglomco’s required return? Use the capital asset pricing model (CAPM) to calculate Conglomco’s required return.
5. Calculate the beta of a portfolio that includes the following stocks:
Conglomco stock, which has a beta of 3.9 and comprises 35 percent of the portfolio.
Supercorp stock, which has a beta of 1.7 and comprises 25 percent of the portfolio.
Megaorg stock, which has a beta of 0.3 and comprises 40 percent of the portfolio.