Pages: 5 (1283 words) Published: March 9, 2013

Question:

1.

(a)

Frodo Baggins has RM1,500 to invest. His investment counselor suggests an investment that pays no stated interest but will return RM2,000 at the end of 3 years. (i) (ii) What annual rate of return will Frodo earn with this investment? Frodo is considering another investment, of equal risk, that earns an annual return of 8%. Which investment should he make and why?

(b)

Samwise Gamgee was seriously injured in an industrial accident. He sued the responsible parties and was awarded a judgment of RM2,000,000. Today, he and his attorney are attending a settlement conference with the defendants. The defendants have made an initial offer of RM156,000 per year for 25 years. Samwise plans to counteroffer at RM255,000 per year for 25 years. Both the offer and the counteroffer have a present value of RM2,000,000. Assume both payments are at the end of each year. (i) (ii) (iii) What interest rate assumption have the defendants used in their offer (rounded to the nearest whole percent)? What interest rate assumption have Samwise and his lawyer used in their counteroffer (rounded to the nearest whole percent)? Samwise is willing to settle for an annuity that carries an interest rate assumption of 9%. What annual payment would be acceptable to him?

2.

Gandalf Enterprise must consider several investment projects, A through E using the capital asset pricing model (CAPM) and its graphical representation, the security market line (SML). Relevant information is presented in the following table. Item Risk-free asset Market portfolio Project A Project B Project C Project D Project E (a) (b) (c) Rate of return (9%) 9 14 Beta, b 0.00 1.00 1.50 0.75 2.00 0.00 -0.50

Calculate: (i) the required rate of return and (ii) the risk premium for each project, given its level of nondiversifiable risk. Use your findings in part (a) to draw the SML (required return relative to nondiversifiable risk). Discuss the relative nondiversifiable risk of projects A through E.

(d) Assume that recent economic events have caused investors to become less riskaverse causing the market return to decline by 2% to 12%. Calculate the new required returns for assets A through E and draw the new SML on the same set of axes that you used in part (b). Compare your findings in part (a) and (b) with those in part (d). What conclusion can you draw about the impact of a decline in investor risk aversion on the required returns of risky assets?

(e)

3.

A recent study of inflationary expectations has revealed that the consensus among economic forecasters yields the following average annual rates of inflation expected over the periods noted. (Note: Assume that the risk the future interest rate movements will affect longer maturities more than shorter maturities is zero, i.e. there is no maturity risk). Period 3 months 2 years 5 years 10 years 20 years (a) Average annual rate of inflation (5%) 5.0 6.0 8.0 8.5 9.0

4.

If the real of interest is currently 2.5%, find the nominal rate of interest on each of the following bond; 20-year bond, 3-month bill, 2-year bond and 5-year bond. (b) If the real rate of interest suddenly dropped to 2% without any change in inflationary expectations, what effect, if any, would this have on your answers in part (a)? Explain. (c) Using your findings in part (a), draw a yield curve for each bond. Describe the general shape and expectations reflected by the curve. (d) What would a follower of the liquidity preference theory say about how the preferences of lenders and borrowers tend to affect the shape of the yield curve drawn in part (c)? Illustrate that effect by placing on your graph a dotted line that approximates the yield curve without the effect of liquidity preference. (e) What would a follower of the market segmentation theory say about the supply and demand for long term loans versus the supply and demand for short-term loans given the yield...