DISCUSSION QUESTIONS
1 Suppose you owned a portfolio consisting of $250,000 of long-term U.S. government bonds.
a. Would your portfolio be riskless? Explain.
b. Now suppose the portfolio consists of $250,000 of 30-day Treasury bills. Every 30 days your bills mature, and you will reinvest the principal ($250,000) in a new batch of bills. You plan to live on the investment income from your portfolio, and you want to maintain a constant standard of living. Is the T-bill portfolio truly riskless? Explain.
c. What is the least risky security you can think of? Explain.
2 The probability distribution of a less risky expected return is more peaked than that of a riskier return. What shape would the probability distribution have for (a) completely certain returns and (b) completely uncertain returns?
3 A life insurance policy is a financial asset, with the premiums paid representing the investment’s cost.
a. How would you calculate the expected return on a 1-year life insurance policy?
b. Suppose the owner of a life insurance policy has no other financial assets—the person’s only other asset is “human capital,” or earnings capacity. What is the correlation coefficient between the return on the insurance policy and that on the human capital?
c. 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.
4 Is it possible to construct a portfolio of real-world stocks that has an expected return equal to the risk-free rate?
5 Stock A has an expected return of 7 percent, a standard deviation of expected returns of 35 percent, a correlation coefficient with the market of 0.3, and a beta coefficient of 0.5. Stock B has an expected return of 12 percent, a standard deviation of returns of 10 percent, a 0.7 correlation with the market, and a beta coefficient of 1.0. Which security is riskier? Why?
6 A stock had a 12 percent return last year, a year when the overall stock market declined. Does this mean that the stock has a negative beta and thus very little risk if held in a portfolio? Explain.
7 If investors’ aversion to risk increased, would the risk premium on a high-beta stock increase by more or less than that on a low-beta stock? Explain.
8 If a company’s beta were to double, would its required return also double?
9 In Chapter 7 we saw that if the market interest rate, rd, for a given bond increased, then 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) The implications of this for the use of historical risk premiums when applying the SML equation.
