Chapter 3

Risks and Returns

Answers to Think It Over (p.70)

1 This is because the risk of investing in a corporate bond is generally higher than the risk associated with a bank deposit. A bank deposit is a very safe form of investment, with minimal risk of loss. On the other hand, a corporate bond is a debt instrument issued by a firm to finance its operation. Thus, it is riskier than a bank deposit. To compensate for the higher risk, corporate bonds have to offer a higher interest rate. 2 This is because an equity mutual fund invests in a large number of stocks which have different risk levels: some are high-risk stocks and some are low-risk stocks. Therefore an equity mutual fund can diversify the risk of loss. The risk of investing in an equity mutual fund is lower than investing in a single stock. Thus, an equity mutual fund is likely to earn a lower return than a single stock because of its risk diversification. Stock or equity mutual fund. I have $10,000 and the study trip costs $13,000. This means that I have to earn $3,000 in one year. In this case, the stock and the equity mutual fund are the financial products whose rates of return are equal to or more than 30%. Therefore I may choose the stock or the equity mutual fund. However, among the stock and the equity mutual fund, I will choose the mutual fund because the risk involved is lower than that for the stock.

Check Your Progress

Q1 Return on Stock A =
$48 $52 $52

= -7.69% Return on Stock B =

$124 $102 $102

= 21.57% Q2 It assumes that the investment is held for the entire period without any buying and selling in between. Both the arithmetic return method and the geometric return method assume that the investor buys and sells the stock between the beginning and the end of the periods. These two methods are not appropriate for calculating returns if the investor holds the stock for the entire period. Instead, the holding period return method (which assumes the investment is held for the entire period without buying and selling in between) can give a more accurate result.
Pearson Education Asia Limited 2009 19

Q3

NSS BAFS: Basics of Personal Financial Management Answers to textbook exercises

Q4

Risk averse means that when choosing among investments with similar expected returns, an investor will prefer the one with the lowest risk. For example, one can take two paths of equal distance to walk back home. The first is safe and the other is dangerous. Since both paths achieve the same goal and require the same effort, you will surely choose the safe path. Firm-specific risk is risk that is specific to a firm (e.g., a strike or bankruptcy). This kind of risk can be diversified. Market risk is the risk from the overall financial market. This kind of risk cannot be diversified. Standard deviation is used to measure the uncertainty of not getting the expected outcome. The mean value, which has the highest chance of occurrence, is considered as the expected return. The deviations (differences) between the actual values (i.e., actual returns) and mean value (expected returns) are a measure of risk. The larger the standard deviation, the higher the uncertainty and the risk. Using standard deviation to measure risk is more objective while the potential maximum loss method is more subjective. This is because the potential maximum loss method considers the risk perception of investors.

Q5

Q6

Q7

Q8

The higher return offered by risky products compensates investors for bearing greater risk. It is also a means of persuading more investors to take a greater risk. The risk tolerance level is an indicator of the level of investment risk an investor is willing to assume. An investor who is totally risk averse will not invest in any financial products with an uncertain return. If an investor does not mind taking an acceptable level of risk, he may consider buying some low-risk financial products, such as the stocks of large firms and government bonds. If an investor accepts a high level of risk, he may invest in high-risk financial products, such as the stocks of small companies and warrants.

Q9

Q10 When the market is inefficient, the positive relationship between risk and return does not hold. Q11 Major asset classes include cash (usually in the form of money market instruments), fixed-income securities and equity securities. Money market instruments are shortterm debts issued by corporations and governments with a maturity of less than one year. They are safe and highly liquid. Fixed-income securities are interest-bearing securities with a fixed percentage of return. Equity securities are securities that entitle holders to part of the ownership of listed companies.

NSS BAFS: Basics of Personal Financial Management Answers to textbook exercises

Pearson Education Asia Limited 2009 20

Q12 Most investors will still be strongly affected by their disastrous losses. For the same level of risk, investors would demand a higher return on their investment to compensate for their stronger aversion to risk. Q13 This is because investors can reduce the risk of loss by doing so. When investors combine high-risk securities with low-risk securities that are not correlated, some of the firm-specific risks of the securities will cancel each other out. As a result, the overall risk of the investment is reduced. Q14 A

Assessment
MCQ
1 2 3 4 5 6 7 8 9 10 C A C B C B C C A D Arithmetic return over the two years = 8% + 12% = 20% Geometric return over the two years = [1 + (-5%)) (1 + 10%)]1 = 4.5% The return over the two years = ($120$100)/$100 = 20% Given the same rate of expected returns, investors would choose the lower-risk financial product (risk averse).

Market risk cannot be diversified.

Short Questions
11 As the risks and expected returns of the two stocks are different, it is difficult to determine which stock is a better choice for an investor. The decision may depend on the investors risk tolerance level. A more risk averse investor will prefer stock A, but an investor who is willing to take a risk will choose stock B. By investing in various high and low-risk financial products, investors can avoid some firm-specific risks. Values of high-risk and low-risk securities do not move up and down together all the time. When we combine high-risk securities with low-risk securities that are not correlated, some of the firm-specific risks of the securities will cancel each other out. As a result, the overall risk of our investment is reduced.

12

NSS BAFS: Basics of Personal Financial Management Answers to textbook exercises

Pearson Education Asia Limited 2009 21

13

When a firm assumes a higher business risk, its potential profits will be higher. As a result, its stock value and consequently the returns for shareholders will increase. Therefore changes in the risk level of the firm will affect the return of the firms stock. Similarly, when a mutual fund invests in a portfolio of assets that includes riskier stocks (i.e. riskier underlying assets), its return should also be higher. Immediately after a stock market crash, most investors will still be strongly affected by their disastrous losses. For the same level of risk, investors would demand a higher return on their investment to compensate for their stronger aversion to risk. In this case, all financial products would have to pay a higher return for the same level of risk as before in order to attract investors to keep or buy them.

14

Actual return is the return an investor actually receives. Expected return is the return an investor expects to receive from an investment. Although the actual return for an investment almost always differs from the expected return, there is generally a close relationship between actual return and expected return in the long run. If investors hold fixed-income securities to maturity and the issuer of the securities does not go bankrupt, the returns on the securities are guaranteed. On the contrary, investors who hold equity securities may suffer a loss if share prices drop. As the returns of equity securities are uncertain, investing in equity securities is riskier than investing in fixed-income securities.

15

16

This is because the arithmetic method assumes that the investor buys the stock at the beginning of year one and sells it at the end of the year, and then buys the stock again at the beginning of year two and sells it at the end of the year. Thus, if we want to find the return for holding the stock for two years without selling in between, the holding period return method is more appropriate. This is because this method assumes that the investment is held for the entire period without any buying and selling in between.

17

(a)

Return over the two years = ($100 $60) $60 = 66 2 3%

(b)

Return for the first year = ($90 $60) $60 = 50% Return for the second year = ($100 $90) $90 = 11.11% Return over the two years = 50% + 11.11% = 61.11%

NSS BAFS: Basics of Personal Financial Management Answers to textbook exercises

Pearson Education Asia Limited 2009 22

(c) Return over the two years = [(1 + 0.5) (1 + 0.11)] 1 = 66.5%

Application Problems
18 (a) Nancys investment on 27 August 2007 is: 1,000 shares $136 = $136,000 The value of her investment on 21 September 2007 is: 1,000 shares $220 = $220,000 Return on investment =
$220,000 $136,000 100% $136,000

= 61.8% (b) Nancys investment on 21 September 2007 is: 1,000 shares $220 = $220,000 The value of her investment on 15 October 2007: 1,000 shares $200 = $200,000 Return (Loss) on investment =
$200,000 $220,000 100% $220,000

= -9.1% (c) Nancys investment on 27 August 2007 is: 1,000 shares $136 = $136,000 The value of her investment on 15 October 2007: 1,000 shares $200 = $200,000 Return on investment =
$200,000 $136,000 100% $136,000

= 47.1% If we simply add up the answers for (a) and (b), the combined return is 61.8% + (-9.1%) = 52.7%, which is higher than the actual return of 47.1%. This method is not preferred for calculating the return over the stated period. (d) The holding period return method assumes that Nancy holds the stock for the entire period (from 27 August 2007 to 15 October 2007) without buying and selling in between. The arithmetic return method (adding the answers of (a) and (b)) assumes that Nancy buys the stock on 27 August 2007, sells it on 21 September 2007, buys it again on the same day and sells it on 15 October 2007. If Nancy holds the stock for the whole period, the arithmetic return method is not appropriate. As the two methods imply different trading behaviour and holding periods, the answers are usually different. 19 (b) Assets chosen from each asset class are: Money market instruments: Either exchange fund bills or a money market deposit account. Fixed-income securities: Government bond Equity securities: US stocks
Pearson Education Asia Limited 2009 23

NSS BAFS: Basics of Personal Financial Management Answers to textbook exercises

20 (a) As the standard deviation of the common stock is the highest, it is most likely that its actual return will deviate from the expected return. Therefore the common stock is the riskiest investment vehicle. (b) The potential maximum loss of the government bond: $0 The potential maximum loss of mutual funds: $100,000 15% = $15,000 The potential maximum loss of common stock: $100,000 20% = $20,000 As only the potential maximum loss of the government bond is less than $10,000, Eric should choose the government bond. (c) Government bond: $100,000 (1 + 5%)3 = $115,763 Mutual funds: $100,000 (1 + 8%)3 = $125,971 Common stock: $100,000 (1 + 10%)3 = $133,100 (d) Eric can reduce his risk of investment by investing in both the government bond and common stock. The combination of the high-risk common stock and the low-risk government bond allows the two investment vehicles to cancel out their risks. The overall risk of the investment is thus reduced.

NSS BAFS: Basics of Personal Financial Management Answers to textbook exercises

Pearson Education Asia Limited 2009 24