Resources • In preparation for applying investment and portfolio management concepts and techniques to your course project, complete the following problems from your Investments text: • Problems 3, 4, and 6 on page 163 of Chapter 5. Your response should i

Resources

• In preparation for applying investment and portfolio management concepts and techniques to your course project, complete the following problems from your Investments text:
• Problems 3, 4, and 6 on page 163 of Chapter 5.

Your response should include a statement of the problem and the accompanying answer. Paraphrase all responses and avoid simply restating what is written in the textbook.

For numeric solutions, provide full documentation of the process used to reach the solution. For problems that require additional analyses, use information from the textbook to inform your analysis, incorporating creativity, critical thinking, and real-life perspectives.

Pg 163

KEY EQUATIONS Arithmetic average of n returns: (r1 + r2 + … + rn)/n Geometric average of n returns: [(1 + r1) (1 + r2) … (1 + rn)]1/n − 1 Continuously compounded rate of return, rcc: ln(1 + Effective annual rate) Expected return: Σ [prob(Scenario) × Return in scenario] Variance: Σ [prob(Scenario) × (Deviation from mean in scenario)2]

Real rate of return (continuous compounding): r_nominal − Inflation rate

PROBLEM SETS

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’ve just stumbled on a new dataset that enables you to compute historical rates of return on U.S. stocks all the way back to 1880. What are the advantages and disadvantages in using these data to help estimate the expected rate of return on U.S. stocks over the coming year?

Basic

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.

Intermediate

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.

What role does your forecast of future interest rates play in your decisions?

5.  Use Figure 5.1 in the text to analyze the effect of the following on the level of real interest rates:

a.  Businesses become more pessimistic about future demand for their products and decide to reduce their capital spending.

b.  Households are induced to save more because of increased uncertainty about their future Social Security benefits.

c.  The Federal Reserve Board undertakes open-market purchases of U.S. Treasury securities in order to increase the supply of money.

6.  You are considering the choice between investing $50,000 in a conventional 1-year bank CD offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5% per year plus the rate of inflation.

a.  Which is the safer investment?

b.  Which offers the higher expected return?

c.  If you expect the rate of inflation to be 3% over the next year, which is the better investment? Why?

d.  If we observe a risk-free nominal interest rate of 5% per year and a risk-free real rate of 1.5% on inflation-indexed bonds, can we infer that the market’s expected rate of inflation is 3.5% per year?