Risk Management and Financial Institutions, + Web Site, 3rd Edition

Answers to Questions and Problems

CHAPTER 1

1.1 The expected return is 12.5%. The standard deviation of returns is 17.07%.

1.2 From equations (1.1) and (1.2), expected return is 12.5%. SD of return is

or 12.94%.

1.3

1.4 Nonsystematic risk can be diversified; systematic risk cannot. Systematic risk is most important to an equity investor. Either type of risk can lead to the bankruptcy of a corporation.

1.5 We assume that investors trade off mean return and standard deviation of return. For a given mean return, they want to minimize standard deviation of returns. All make the same estimates of means, standard deviations, and coefficients of correlation for returns on individual investments. Furthermore, they can borrow or lend at the risk-free rate. The result is that they all want to be on the “new efficient frontier” in Figure 1.4. They choose the same portfolio of risky investments combined with borrowing or lending at the risk-free rate.

1.6 (a) 7.2%, (b) 9%, (c) 14.4%.

1.7 The capital asset pricing theory assumes that there is one factor driving returns. Arbitrage pricing theory assumes multiple factors.

1.8 In many jurisdictions, interest on debt is deductible to the corporation whereas dividends are not deductible. It can therefore be more tax-efficient for a company to fund ...