RiskandReturn-LeedsSchoolofBusiness.docVIP

Chapter 6 (11ed. Ch.)4 Risk and Return: The Basics MINI CASE Assume that you recently graduated with a major in finance, and you just landed a job as a financial planner with Barney Smith Inc., a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds are to be invested in a business at the end of one year, you have been instructed to plan for a one-year holding period. Further, your boss has restricted you to the following investment alternatives, shown with their probabilities and associated outcomes. (Disregard for now the items at the bottom of the data; you will fill in the blanks later.) Returns On Alternative Investments Estimated Rate Of Return State of the T- Alta Repo Am. Market 2-stock economy prob. Bills Inds Men Foam portfolio portfolio Recession 0.1 8.0% -22.0% 28.0% 10.0%* -13.0% 3.0% Below avg 0.2 8.0 -2.0 14.7 -10.0 1.0 Average 0.4 8.0 20.0 0.0 7.0 15.0 10.0 Above avg 0.2 8.0 35.0 -10.0 45.0 29.0 Boom 0.1 8.0 50.0 -20.0 30.0 43.0 15.0 r-hat () 1.7% 13.8% 15.0% Std dev (σ) 0.0 13.4 18.8 15.3 Coef of var (cv) 7.9 1.4 1.0 beta (b) -0.86 0.68 *Note that the estimated returns of American Foam do not always move in the same direction as the overall economy. For example, when the economy is below average, consumers purchase fewer mattresses than they would if the economy was stronger. However, if the economy is in a flat-out recession, a large number of consumers who were planning to purchase a more expensive inner spring mattress may purchase, instead, a cheaper foam mattress. Under these circumstances, we would expect American Foam’s stock price to be higher if there is a recession than if the economy was just below average. Barney Smith’s economic forecasting staff has developed probability estimates for the state of the economy, and its security analysts have