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Chapter 1 A Brief History of Risk and Return Concept Questions

• For both risk and return, increasing order is b, c, a, d. On average, the higher the risk of an investment,

the higher is its expected return.

• Since the price didn’t change, the capital gains yield was zero. If the total return was four percent, then

the dividend yield must be four percent.

• It is impossible to lose more than –100 percent of your investment. Therefore, return distributions are

cut off on the lower tail at –100 percent; if returns were truly normally distributed, you could lose much more.

• To calculate an arithmetic return, you sum the returns and divide by the number of returns. As such,

arithmetic returns do not account for the effects of compounding (and, in particular, the effect of volatility). Geometric returns do account for the effects of compounding and for changes in the base used for each year’s calculation of returns. As an investor, the more important return of an asset is the geometric return.

• Blume’s formula uses the arithmetic and geometric returns along with the number of observations to

approximate a holding period return. When predicting a holding period return, the arithmetic return will tend to be too high and the geometric return will tend to be too low. Blume’s formula adjusts these returns for different holding period expected returns.

• T-bill rates were highest in the early eighties since inflation at the time was relatively high. As we

discuss in our chapter on interest rates, rates on T-bills will almost always be slightly higher than the expected rate of inflation.

• Risk premiums are about the same regardless of whether we account for inflation. The reason is that

risk premiums are the difference between two returns, so inflation essentially nets out.

• Returns, risk premiums, and volatility would all be lower than we estimated because aftertax returns

are smaller than pretax returns.

• We have seen that T-bills barely kept up with inflation before taxes. After taxes, investors in T-bills

actually lost ground (assuming anything other than a very low tax rate). Thus, an all T-bill strategy will probably lose money in real dollars for a taxable investor.

• It is important not to lose sight of the fact that the results we have discussed cover over 80 years, well

beyond the investing lifetime for most of us. There have been extended periods during which small stocks have done terribly. Thus, one reason most investors will choose not to pursue a 100 percent stock (particularly small-cap stocks) strategy is that many investors have relatively short horizons, and high volatility investments may be very inappropriate in such cases. There are other reasons, but we will defer discussion of these to later chapters.(Fundamentals of Investments Valuation and Management, 10e By Bradford Jordan, Thomas Miller, Steve Dolvin) (Solution Manual, For Complete File, Download link at the end of this File) 1 / 4

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Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem.Core Questions

• Total dollar return = 100($41 – $37 + $.28) = $428.00

Whether you choose to sell the stock does not affect the gain or loss for the year; your stock is worth what it would bring if you sold it. Whether you choose to do so or not is irrelevant (ignoring commissions and taxes).

• ( )Capital gains yield $41 – $37 / $37 .1081, or 10.81%== Dividend yield $.28 / $37 .0076, or .76%==

Total rate of return 10.81% .76% 11.57%= + =

• Dollar return = 500($34 – $37 + $.28) = –$1,360 ( )Capital gains yield $34 – $37 / $37 –.0811, or –8.11%==

Dividend yield $.28 / $37 .0076, or .76%==

Total rate of return = –8.11% + .76% = –7.35% 4.

• average return = 6.0%, average risk premium = 2.7%
• average return = 3.3%, average risk premium = 0%
• average return = 12.3%, average risk premium = 9.0%
• average return = 16.3%, average risk premium = 13.0%
• ()Cherry average return 17% 11% – 2% 3% 14% / 5 8.60%= + + + = ()Straw average return 16% 18% – 6% 1% 22% / 5 10.20%= + + + =

• A

Cherry: R 8.60%= ( )( )( )( )( )

2 2 2 2 2

Var 1/ 4 .17 – .086 .11 – .086 –.02 – .08 6 .03 – .086 .14 – .086 .00623= + + + + =

 ( )

1/ 2 Standard deviation .00623 .0789, or 7.89%== B

Straw: R 10.20%=

( )( )( )( )( )

2 2 2 2 2

Var 1/ 4 .16 – .102 .18 – .102 –.06 – .10 2 .01 – .102 .22 – .102 .01452  = 

= + + + + ( )

1/ 2 Standard deviation .01452 .1205, or 12.05%==

• The capital gains yield is ( )$59 – $65 / $65 –.0923= , or –9.23% (notice the negative sign). With

a dividend yield of 1.2 percent, the total return is –8.03%. 2 / 4

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8. ( )( )( )( )( )

(1/5) Geometric return 1 .17 1 .11 1 .02 1 .03 1 .14 – 1 .0837, or 8.37%= + + − + +



=

• ()Arithmetic return .21 .12 .07 –.13 – .04 .26 / 6 .0817, or 8.17%= + + + = ( )( )( )( )( )( )

(1/)6 Geometric return 1 .21 1 .12 1 .07 1 – .13 1 – .04 1 .26 – 1 .0730, or 7.30%=+  + 

• + =
• / 4

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Intermediate Questions

• That’s plus or minus one standard deviation, so about two-thirds of the time, or two years out of three.

In one year out of three, you will be outside this range, implying that you will be below it one year out of six and above it one year out of six.

• You lose money if you have a negative return. With a 12 percent expected return and a 6 percent

standard deviation, a zero return is two standard deviations below the average. The odds of being outside (above or below) two standard deviations are 5 percent; the odds of being below are half that, or 2.5 percent. (It’s actually 2.28 percent.) You should expect to lose money only 2.5 years out of every 100. It’s a pretty safe investment.

• The average return is 6.0 percent, with a standard deviation of 9.8 percent, so Prob(Return < –3.8 or Return 15.8 1/ 3)

, but we are only interested in one tail; ( )Prob Return – 3.9 1/ 6 , which is half of 1/ 3 (or about 16%) .

95%: 6.0 ± 2σ = 6.0 ± 2(9.8) = –13.6% to 25.6%

99%: 6.0 ± 3σ = 6.0 ± 3(9.8) = –23.4% to 35.4%

• Expected return = 16.4%; σ = 31.2%. Doubling your money is a 100% return, so if the return

distribution is normal, ( ) 100 – 16.4 / 31.2 2.68Z== standard deviations; this is in-between two and three standard deviations, so the probability is small, somewhere between .5% and 2.5% (why?).Referring to the nearest Z table, the actual probability is = 0.369%, or less than every 100 years.Tripling your money would be ( ) 200 – 16.4 / 31.2 5.88Z== standard deviations; this corresponds to a probability of (much) less than 0.01%. (The actual answer is less than once every 1 million years, so don’t hold your breath.) 14.Year Common stocks T-bill return Risk premium

1973 –14.69% 7.29% –21.98%

1974 –26.47% 7.99% –34.46%

1975 37.23% 5.87% 31.36%

1796 23.93% 5.07% 18.86%

1977 –7.16% 5.45% –12.61%

sum 12.84% 31.67% –18.83%

• Annual risk premium = Common stock return – T-bill return (see table above).
• Average returns: Common stocks 12.84 / 5 .0257, or 2.57%; T-bills 31.67 / 5 .0633, or 6.33%= = = = Risk premium –18.83/ 5 –.0377, or – 3.77%==

• ( )( )( )
• 2 2

Common stocks: Var 1/ 4 –.1469 – .02[ 57 –.2647 – .0257 .3723 – .0257= + + + ( )( ) 22

.2393 – .0257 –.071 7 ]6 – .0257 .07233+=

• )

1/ 2 Standard deviation 0.072337 .2690, or 26.90%==

( )( )( )( )( )

2 2 2 2 2

T-bills: Var 1/ 4 .0729 – .0633 .0799 – .0633 .0587 – .0633 .0507 –.0633 .0545 – . 0633  .000156=+



+ + + = ( )

1/ 2 Standard deviation .000156 .0125, or 1.25%==

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