PRINCIPLES OF CORPORATE FINANCE
13th Edition
ISBN: 9781264052059
Author: BREALEY
Publisher: MCG
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Textbook Question
Chapter 7, Problem 5PS
Risk Premium Suppose that in year 2030, investors become much more willing than before to bear risk. As a result, they require a return of 8% to invest in common stocks rather than the 10% that they had required in the past. This shift in risk aversion causes a 15% change in the value of the market portfolio.
- a. Do stock prices rise by 15% or fall?
- b. If you now use past returns to estimate the expected risk premium, will the inclusion of data for 2030 cause you to underestimate or overestimate the return that investors required in the past?
- c. Will the inclusion of data for 2030 cause you to underestimate or overestimate the return that investors require in the future?
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Consider a three-factor APT model. The factors and associated risk premiums are:
Factor
Risk Premium (%)
Change in gross national product (GNP)
+6.9
Change in energy prices
0.4
Change in long-term interest rates
+2.6
Calculate expected rates of return on the following stocks. The risk-free interest rate is 4.8%.
A stock whose return is uncorrelated with all three factors. (Enter your answer as a percent rounded to 1 decimal place.)
A stock with average exposure to each factor (i.e., with b = 1 for each). (Enter your answer as a percent rounded to 1 decimal place.)
A pure-play energy stock with high exposure to the energy factor (b = 1.9) but zero exposure to the other two factors. (Enter your answer as a percent rounded to 2 decimal places.)
An aluminum company stock with average sensitivity to changes in interest rates and GNP, but negative exposure of b = –1.9 to the energy factor. (The aluminum company is energy-intensive and suffers when energy prices…
5. Risk Premium (S7.1) Suppose that in year 2030, investors become much more willing than before to bear risk. As a result,
they require a return of 8% to invest in common stocks rather than the 10% that they had required in the past. This shift in risk
aversion causes a 15% change in the value of the market portfolio.
a. Do stock prices rise by 15% or fall?
b. If you now use past returns to estimate the expected risk premium, will the inclusion of data for 2030 cause you to
underestimate or overestimate the return that investors required in the past?
c. Will the inclusion of data for 2030 cause you to underestimate or overestimate the return that investors require in the future?
Consider a three-factor APT model. The factors and associated risk premiums are: Factor Risk Premium (%) Change in gross national product (GNP) + 6.5 Change in energy prices 0.5 Change in long-term interest rates +2.9 Calculate expected rates of return on the following stocks. The risk - free interest rate is 6.8%. A stock whose return is uncorrelated with all three factors
Chapter 7 Solutions
PRINCIPLES OF CORPORATE FINANCE
Ch. 7 - Rate of return The level of the Syldavia market...Ch. 7 - Real versus nominal returns The Costaguana stock...Ch. 7 - Arithmetic average and compound returns Integrated...Ch. 7 - Risk premiums Here are inflation rates and U.S....Ch. 7 - Risk Premium Suppose that in year 2030, investors...Ch. 7 - Stocks vs. bonds Each of the following statements...Ch. 7 - Expected return and standard deviation A game of...Ch. 7 - Standard deviation of returns The following table...Ch. 7 - Average returns and standard deviation During the...Ch. 7 - Prob. 10PS
Ch. 7 - Prob. 11PSCh. 7 - Diversification Here are the percentage returns on...Ch. 7 - Risk and diversification In which of the following...Ch. 7 - Prob. 14PSCh. 7 - Portfolio risk To calculate the variance of a...Ch. 7 - Portfolio risk a) How many variance terms and how...Ch. 7 - Portfolio risk Table 7.8 shows standard deviations...Ch. 7 - Portfolio risk Hyacinth Macaw invests 60% of her...Ch. 7 - Stock betas What is the beta of each of the stocks...Ch. 7 - Stock betas There are few, if any, real companies...Ch. 7 - Portfolio betas A portfolio contains equal...Ch. 7 - Portfolio betas Suppose the standard deviation of...Ch. 7 - Portfolio risk Here are some historical data on...Ch. 7 - Portfolio risk Suppose that Treasury bills offer a...
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- You live in a world where assets are priced by the CAPM. The following information is given to you regarding stock X. The expected payoff from the stock X=£105.00 Expected return of stock X = 18% Risk-free rate =5% Market Risk Premium = 9% Assume there are no other changes, except that the correlation between the returns of Stock X and the market becomes twice what it is currently. How would this change affect the current price of Stock X? Explain why the change of the correlation causes the observed change in the stock price. [hint: Provide a risk-based explanation]arrow_forward. Suppose your expectations regarding the stock price are as follows: Selling price = 100 T-bills = 6% dividend = 10 per 100 value State of market Probability Ending price Вoom 0.3 140 Normal growth 0.4 110 Recession 80 0.3 Calculate the HPR for each scenario, the expected rate of return, and the risk premium on your investment, and standard deviation of excess return.arrow_forwardAssume that you are using the Capital Asset Pricing Model (CAPM) to find the expected return for a share of common stock. Your research shows the following: Beta = βi = 1.54 Risk free rate = Rf = 2.5% per year Market return = E(RM) = 6.5% per year Based on this information, answer the following: A. Based on the beta, how does the stock's risk compare to the market overall? On what do you base your answer? B. Based on the beta, how would you expect the stock's returns to react to a decrease in returns in the market overall? Why? C. According to the CAPM and the information given above, what is the expected return E(Ri) for this stock? D. If the required rate of return on this stock were 7% per year, would you invest? Why or why not?arrow_forward
- Using CAPM to determine the expected rate of return for risky assets, consider the following example stocks, assuming that you have already compute the betas Stock Beta A 0.70 B 1.00 C 1.15 D 1.40 E -0.30 Assume that we expect the economy’s RFR to be 5 percent (0.05) and the expected return on the market portfolio (E(RM)) to be 9 percent (0.09), 1, what would this imply? With these inputs, what would the be the following required rate of returns for these five stocks, show the formula for each in your calculations.arrow_forwardDuring the coming year, the market risk premium (rm− rf), is expected to remain the same, while the risk-free rate, rf, is expected to fall. Given this forecast, which of the following statements is CORRECT? Group of answer choices The required return will fall for all stocks, but it will fall less for stocks with higher betas. The required return will fall for all stocks, but it will fall more for stocks with higher betas. The required return on all stocks will remain unchanged. The required return for all stocks will fall by the same amount. The required return will increase for stocks with a beta less than 1.0 and will decrease for stocks with a beta greater than 1.0.arrow_forwardis this statement TRUE or FALSE ? A stock with price 100 kr follows a one step Binomial model and will either increase invalue to 120 kr or decrease to 90 kr in one years time. The risk free interest rate is zero.An investor consider the increase and decrease in this model to be equally likely to happen.Is it true or false that the investor is risk-averse? is this statement TRUE or FALSE ?arrow_forward
- A stock has not been fluctuating much in price. Its average price is $20/share. You expect that the stock price behaves the same way in the next year. A one-year put option is selling for $5, which has an exercise price of $20. Suppose the risk-free rate is 0.05. To make use of your expectation in the future price movement, you establish a straddle strategy to maximize your profits. If the stock price actually ends up at $20 in a year, your profit is $ . Give your answer to 2 decimal places.arrow_forwardthe risk free rate is 3% and the market premium rM rRF is 4%. stock A has a beta of 1.2, and stock B has a beta of 0.8. what is the required rate of return on each stock? assume that investors become less willing to take risk (i.e, they become more risk averse), so the market risk premium rises from 4% to 6%. Assume that the risk free rate remains constant. what effect will this have on the required rates of return on the two stocks?arrow_forwardAssume that the CAPM is a good description of stock price returns. The market expected return is 8% with 12% volatility and the risk-free rate is 4% . New news arrives that does not change any of these numbers but it does change the expected return of the following stocks: a. At current market prices, which stocks represent buying opportunities?b. On which stocks should you put a sell order in?arrow_forward
- Consider two stocks, A and B, whose returns in a boom and a recession are given below. Stock A: recession (-15%), boom (+20%). Stock B: recession (+10%), boom (-2%). Suppose that there is a 10% chance of a recession next year. How would you allocate money between these two stocks so as to minimize your risk?arrow_forwardAssume that you are given the following historical returns for the Market and Security J. Also assume that the expected risk-free rate for the coming year is 4.0 percent, while the expected market risk premium is 15.0 percent. Given this information, determine the required rate of return for Security J for the coming year, using CAPM. Year 1 2 O21.20% 3 4 5 6 O22.34% O 23.49% O24.63% O24.10% Market 10.00% 12.00% 16.00% 14.00% 12.00% 10.00% Security J 12.00% 14.00% 18.00% 22.00% 18.00% 14.00%arrow_forwardAssume that the risk-free rate, RF, is currently 8%, the market return, RM, is 12%, and asset A has a beta, of 1.10 a) Draw the security market line (SML) b) Use the CAPM to calculate the required return, on asset A. c) Assume that as a result of recent economic events, inflationary expectations have declined by 3%, lowering RF and RM to 5% and 9%, respectively. Draw the new SML on the axes in part a, and calculate and show the new required return for asset A. d) Assume that as a result of recent events, investors have become more risk averse, causing the market return to rise by 2%, to be14%. Ignoring the shift in part c, draw the new SML on the same set of axes that you used before, and calculate and show the new required return for asset A. e) From the previous changes, what conclusions can be drawn about the impact of (1) decreased inflationary expectations and (2) increased risk aversion on the required returns of risky assets?arrow_forward
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