CHAPTER4
RETURNANDRISK:ANALYZINGTHEHISTORICALRECORD
1.
Yourholdingperiodreturnforthenextyearonthemoneymarketfunddependsonwhat
30dayinterestrateswillbeeachmonthwhenitistimetorollovermaturingsecurities.
Theoneyearsavingsdepositwilloffera7.5%[Link]
forecasttherateonmoneymarketinstrumentstorisesignificantlyabovethecurrentyield
of6%,[Link]
20yearGovernmentofCanadabondsisofferingayieldtomaturityof9%peryear,
whichis150basispointshigherthantherateontheoneyearsavingsdepositatthebank,
youcouldwindupwithaoneyearHPRofmuchlessthan7.5%onthebondiflongterm
[Link]
9%duringtheyear,thenthepriceofthebondwillfall,andthecapitallosswillwipeout
someorallofthe9%returnyouwouldhavereceivedifbondyieldshadremained
unchangedoverthecourseoftheyear.
2.a.
Ifbusinessesincreasetheircapitalspendingtheyarelikelytoincreasetheirdemandfor
funds.ThiswillshiftthedemandcurveinFigure5.1totherightandincreasethe
equilibriumrealrateofinterest.
b.
Increasedhouseholdsavingwillshiftthesupplyoffundscurvetotherightandcausereal
interestratestofall.
c.
AnopenmarketsaleofTreasurysecuritiesbytheBankofCanadaisequivalenttoa
reductioninthesupplyoffunds(ashiftofthesupplycurvetotheleft).Theequilibrium
realrateofinterestwillrise.
3.a.
TheInflationPlusGICissaferbecauseitguaranteesthepurchasingpowerofthe
[Link]
inflationrate,theGICprovidesarealrateof3.5%regardlessoftheinflationrate.
b.
[Link]
rateofinflationislessthan3.5%thentheconventionalGICwillofferahigherrealreturn
thantheInflationPlusGIC;ifinflationismorethan3.5%,theoppositewillbetrue.
c.
Ifyouexpecttherateofinflationtobe4%overthenextyear,thentheconventionalGIC
offersyouanexpectedrealrateofreturnof3%,whichis0.5%lowerthantherealrateon
theinflationprotectedGIC.Butunlessyouknowthatinflationwillbe3%with
41
certainty,[Link]
[Link]
todiversifyandinvestpartofyourfundsineach.
d.
[Link](on
conventionalGICs)of7%andtherealriskfreerate(oninflationprotectedGICs)of
3.5%[Link]
associatedwiththeuncertaintysurroundingtherealrateofreturnontheconventional
GICs.Thisimpliesthattheexpectedrateofinflationislessthan3.5%peryear.
4.
E(r)=.3544%+.3014%+.35(16%)=14%.
Variance=.35(4414)2 +.30(1414)2 +.35(1614)2 =630
Standarddeviation=25.10%
Themeanisunchanged,butthestandarddeviationhasincreased,astheprobabilitiesof
thehighandlowreturnshaveincreased.
5.
Probabilitydistributionofpriceand1yearholdingperiodreturnon30yearCanada
bonds(whichwillhave29yearstomaturityatyearsend):
Economy
Boom
NormalGrowth
Recession
Probability
YTM
Price
.20
.50
.30
11.0%
8.0
7.0
$74.05
100.00
112.28
Capitalgain Coupon
$25.95
0.00
12.28
$8.00
8.00
8.00
HPR
17.95%
8.00%
20.28%
6.
TheaverageriskpremiumonS&P/TSXcompositestocksfortheperiod19572006was
4.72%peryear.Addingthistoariskfreerateof6%givesanexpectedreturnof10.72%
peryearfortheS&P/TSXIndexportfolio.
7.
Theaveragerateofreturnandstandarddeviationarequitedifferentinthesubperiods:
Mean
19572009
19571984
19852009
STOCKS
[Link].
10.72%
10.82
10.61
17.12%
17.72
16.79
42
Mean
BONDS
[Link].
8.69%
6.82
10.78
9.78%
10.39
8.99
8.a
Iwouldprefertousetheriskpremiumsandstandarddeviationsestimatedovertheperiod
19571984,becausethecurrentinflationaryexpectationsareclosertothoseof19571984
thantothemoreinflationarylaterperiod.
Realholdingperiodreturn = 1 =
= = .0588=5.88%
b.
TheapproximationgivesarealHPRof80%70%=10%,whichisclearlytoohigh.
9.
E(q)=0x.25+1x.25+2x.5=1.25;E(q2)=1x.25+22x.50=2.25Var(q)=2.251.252=0.6875
10.
a.(correspondstoplusorminustwostandarddeviations)
11.
20%,10%
12.
24%,13%
13.
19%
14.
$13,000Expecteddollarreturnonequityinvestmentis$18,000versus$5,000returnon
Tbills]
15.
10%
16.
11.4
17.
Theprobabilitythattheeconomywillbeneutralis0.50,or50%.Givenaneutral
economy,thestockwillexperiencepoorperformance30%[Link]
ofbothpoorstockperformanceandaneutraleconomyistherefore:
0.30x0.50=0.15=15%
18.a. ProbabilityDistributionofHPRontheStockMarketandPut
Stateofthe
Economy
Boom
NormalGrowth
Recession
Probability
.25
.50
.25
STOCK
Endingprice
+$4dividend HPR
$144
114
84
44%
14%
16%
43
PUT
Ending
Value
HPR
0
0
$30
100%
100%
150%
Rememberthatthecostofthestockis$100pershare,andthatoftheputis$12.
b.
Thecostofoneshareofstockplusaputis$[Link]
thestockmarketplusputis:
Stateofthe
Economy
Boom
NormalGrowth
Recession
Probability
.25
.50
.25
Stock+Put+$4dividend
EndingValue HPR
$144
28.6%
114
1.8
114
1.8
(144112)/112
(114112)/112
c.
BuyingtheputoptionguaranteesyouaminimumHPRof1.8%regardlessofwhat
happenstothestock'[Link],itoffersinsuranceagainstapricedecline.
19.
TheprobabilitydistributionofthedollarreturnonCDpluscalloptionis:
Economy
CombinedValue
Boom
NormalGrowth
Recession
Probability EndingValueCDEndingValueCall
.25$
.50
.25
114(107.55x1.06)
114
114
44
$30
0
0
$144
114
114
