8 – 23 MERRILL FINCH INC. RISK AND RETURN

a. (1) Why is T-bill’s return independent of the state of the economy? Do T-bill’s promise a completely risk-free return? Explain

(2) Why are High Tech’s returns expected to move with the economy, whereas, Collections’ are expected to move counter to the economy?

1. The 5.5% T-bill return does not depend on the state of the economy because the Treasury must redeem the bills at par regardless of the state of the economy; therefore, T-bills are risk-free in the default risk sense because the 5.5% return will be realized in all possible economic states. Consequently, this return is composed of the real risk-free rate, (i.e. 3%, plus an inflation premium, say 2.5%). As the economy is
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Calculate the missing CVs and fill in the blanks on the row for CV in the table. Does the CV produce the same risk rankings as the standard deviation? Explain

The coefficient of variation (CV) is a standardized measure of dispersion about the expected value; it shows the amount of risk per unit of return. CV = /. CVT-bills = 0.0%/5.5% = 0.0. CVHigh Tech = 20.0%/12.4% = 1.6. CVCollections = 13.2%/1.0% = 13.2. CVU.S. Rubber = 18.8%/9.8% = 1.9. CVM = 15.2%/10.5% = 1.4.

When we measure risk per unit of return, Collections, with its low expected return, becomes the most risky stock. The CV is a better measure of an asset’s stand-alone risk than because CV considers both the expected value and the dispersion of a distribution—a security with a low expected return and a low standard deviation could have a higher chance of a loss than one with a high but a high .

e. Suppose you created a two-stock portfolio by investing $50,000 in High Tech and $50,000 in Collections. (1) Calculate the expected return (rp), the standard deviation (p), and the coefficient of variation (CVp) for this portfolio and fill in the appropriate blanks in the table. (2) How does the riskiness of this two-stock portfolio compare with the riskiness of the individual stocks if they were held in isolation?

1. To find the expected

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