BAC3684 Tutorial 6 Questions

6-1 Distinguish between historical return and expected return.

- Historical return is the actual performance of an asset over a past period. It is
calculated by subtracting the initial price from the ending price and dividing by the
initial price. It's a concrete outcome based on real data.
- Expected return in an estimated future performance of an asset. It incorporates
assumptions, forecasts, and analysis to predict what an investment might generate in
the future. It's an educated guess based on various factors.
6-2 How long must an asset be held to calculate a TR?
- The time an asset must be held to calculate a Total Return (TR) depends on the
investor's holding period. TR is typically calculated over a specific period, such as a
year, but there is no fixed rule on how long an asset must be held.
6-3 Define the components of total return. Can any of these components be negative?
- Capital appreciation: The change in the asset's price from purchase to sale (positive if
price increases, negative if price decreases).
- Income: Any periodic distributions received from the asset, such as dividends for
stocks or interest payments for bonds.
- Both components can be negative. Capital appreciation can become negative if the
asset price falls. Income can also be negative if an asset does not generate any
distributions or incurs losses.

6-4 Distinguish between TR and holding period return.

- Total Return (TR) is the overall return on an investment over a specified period,
including price appreciation, dividends, and interest. Holding period return, on the
other hand, only considers the percentage change in the asset's price over the holding
period and doesn't include income components like dividends or interest.
6-5 When should the geometric mean return be used to measure returns? Why will it always
be less than the arithmetic mean (unless the numbers are identical)?
- The geometric mean return should be used when measuring returns over multiple
periods, especially when compounding is involved. It will always be less than the
arithmetic mean unless all the return values are identical due to the compounding
effect.

6-6 When should the arithmetic mean be used in describing stock returns?
- The arithmetic mean should be used when describing stock returns for a single period.
It provides a straightforward average of the returns without considering compounding
effects.
6-8 What is an equity risk premium?
- Equity risk premium is the excess return that an individual stock or the overall stock
market provides over a risk-free rate. It reflects the additional return investors require
for taking on the risk of investing in equities. (Rm – Rf)
6-10 Distinguish between market risk and business risk. How is interest rate risk related to
inflation risk?
- Market risk is the risk associated with overall market movements, while business risk
is specific to a particular company. Interest rate risk and inflation risk are related in
the sense that changes in interest rates can affect inflation expectations and vice versa.
6-11 Classify the traditional sources of risk as to whether they are general sources of risk or
specific sources of risk.
- Systematic risk: General sources: Affect all asset classes in the market (e.g., market
risk, interest rate risk, inflation risk).
- Unsystematic risk: Specific sources: Affect individual companies or industries (e.g.,
business risk, country risk, regulatory risk, default risk).

6-12 Explain what is meant by country risk. How would you evaluate the country risk of
Canada and Mexico?
- Country risk refers to the risk associated with investing in a particular country,
including political, economic, and social factors. Evaluating country risk for Canada
and Mexico would involve assessing factors such as stability, economic indicators,
and political conditions.

6-14 Define risk. How does use of the standard deviation as a measure of risk relate to this
definition of risk?
- Risk is defined as the uncertainty or variability of returns. The use of standard
deviation as a measure of risk relates to this definition by quantifying the extent of
variability in returns. A higher standard deviation indicates higher risk.

End of Chapter Problem

6-1 Calculate the TR and the return relative for the following assets:
a. A preferred stock bought for $70 per share, held 1 year during which $5 per share
dividends are collected, and sold for $62
b. A warrant bought for $10 and sold three months later for $13
c. A 12 percent bond bought for $830, held 2 years during which interest is collected, and
sold for $920
MCQ Questions
1. An investor purchased 100 shares of a stock for $34.50 per share at the beginning of the
quarter. If the investor sold all of the shares for $30.50 per share after receiving a $51.55
dividend payment at the end of the quarter, the holding period return is closest to:
A. -13.0%.
B. -11.6%.
C. -10.1%.

2. An analyst obtains the following annual rates of return for a mutual fund:

The fund’s holding period return over the three-year period is closest to:
A. 0.18%.
B. 0.55%.
C. 0.67%.

3. An analyst observes the following annual rates of return for a hedge fund:

The hedge fund’s annual geometric mean return is closest to:

A. 0.52%.
B. 1.02%.
C. 2.67%.
4. Which of the following return calculating methods is best for evaluating the annualized
returns of a buy-and-hold strategy of an investor who has made annual deposits to an account
for each of the last five years?
A. Geometric mean return.
B. Arithmetic mean return.
C. Money-weighted return.

5. With respect to capital market theory, which of the following asset characteristics is least
likely to impact the variance of an investor’s equally weighted portfolio?
A. Return on the asset.
B. Standard deviation of the asset.
C. Covariances of the asset with the other assets in the portfolio.
PROBLEM QUESTIONS
Please refer to Table 1 to answer these questions. Please write the answers in the answer
sheets provided.

a) Calculate the Total Return for Kuala Lumpur Composite Index and each of the shares.
b) Calculate the Arithmetic Mean return for Kuala Lumpur Composite Index and each of the
shares.
c) Calculate the Standard Deviation for Kuala Lumpur Composite Index and each of the
shares.
d) Which shares do you invest in if the market has an expected return of 15 percent, and the
risk-free rate is 5 percent while beta for Telekom and TNB is 0.70 and 1.20 respectively?
Why?
TABLE 1: INDEX AND SHARE PRICES

YEAR KLCI Telekom Stock Telekom TNB Stock TNB

Price Dividend (RM) Price Dividend
(Index)
(RM)
(RM) (RM)
2012 885.70 10.00 0.45 8.00 0.50
2013 897.51 10.40 0.55 8.40 0.40
2014 923.15 9.45 0.40 8.30 0.40
2015 1182.20 10.00 0.45 11.40 0.55

Answer:
Total return KLCI Telekom TNB
2013 1.33 9.50 10.00 [(8.4 – 8.0 + 0.4)/8.0]
2014 2.86 -5.29 3.57
2015 28.06 10.58 43.98
Arithmetic Mean 10.75 4.93 19.18
(Average return)
SD 15.01 8.87 21.71
KLCI don’t need to add dividend because there’s no dividend.
Average return TM 4.93%, and RROR = 12%
Should investors buy TM shares?
- Investors should not buy TM shares, because they required 12% of return, but TM
shares average return is only 4.93%.

Should investors buy TNB shares?

- Investors required 17% of return, but TNB Average return is higher at 19.18%.
Therefore investor should buy or invest in TNB.