Week 2 Assignment Questions – Prepare for Required Synchronized Session

It is recommended that you make notes with answers to the questions to properly prepare for the Synch Session. Your grade depends on your ability to engage in meaningful discussion. (The synch session is not limited to the questions above – you can bring up anything you chose.)

Use a hand-held calculator or do the simple arithmetic by hand, then type the it into your Word file.ALWAYS SHOW YOUR WORK!

  1. How do the models (Efficient Frontier and Capital Asset Pricing Model) discussed in this week’s material define risk? …define return? HINT: Dig out thespecific definitions for each model to demonstrate the similarities and differences in the definitions between models.
  2. Look at the Efficient Frontier diagram on pages 7 (bottom of 2nd box) or 16, and explain how you might use it to make investment decisions. HINT: Briefly state what the diagram tells you, then make a judgment about its practical application to investing for investors who are risk averse but still want to maximize their rates of return.
  3. If the rate of return on the S&P 500 index was 23% for 2009, and the risk-free rate at the end of 2009 was 1%, calculate the equity risk premium for 2009? Recalculate the equity risk premium using 1981 data, when the risk free rate was 15% and the S&P 500 index return was minus 10%. What are the implications of different equity risk premia numbers for different time periods? HINT: When you use the CAPM, you must enter an equity risk premium. Therefore, how do you do that accurately when data for different years produce different equity risk premia?
  4. As of early September 2010, Wal-Mart’s (WMT) beta is 0.33 and Target Stores (TGT) beta is 1.02. Discuss the meaning of these two betas, analytically, by briefly setting forth the process for calculating beta and the inputs to the calculations where beta is the output, i.e., the slope of the characteristic line. Be guided by the diagram on pages 7 (left side of bottom box) or 20 or 22: the line shown is called the characteristic line. HINT: What makes the two betas different?
  5. The risk free-rate as of early September 2010 was the yield on a 10-year Treasury bond, 2.8%. Assuming that the long-term historical rate of return (and the expectation for the future as well) on the S&P 500 Index is 9%, apply the CAPM equation and calculate the expected rate of return for Wal-Mart and Target Stores stock,using the betas in Question 4 above. What do the results your calculations tell you?
  6. Explain why the beta of the S&P 500 Index is 1.0. HINT: Look at the characteristic line diagram on pages 7, 20, or 22 and imagine that the same S&P 500 Index data was on both the x-axis and the y-axis. Where would the characteristic line fall in that case?
  7. Look at the Security Market Line (pages7 or 19). Its positive slope and steepness comes from two points, the point where a beta of 1.0 intersects with an expected return of 12% (the stock market return), and the point where the 5% risk-free rate intersects with a beta of 0. The line can be flatter or steeper, depending on the variables. What happens to the Security Market Line if we assume a stagflation period when the expected S&P 500 Index return is 2% and the risk free rate is 8%?HINT: Draw that line on a piece of paper so you can interpret it.