A case study
Dr. Felix D. Cena, Phd
Jose Farley Y. Tagle
Lalaine D. Cosadio
Cherryl L. Villaruel
Raymund S. Belleza
July 17, 2011
Assume that you recently graduated with a major in finance. You just landed a job as a financial planner with China Development Industrial bank (CDIB), a large financial services corporation. Your first assignment is to invest $100,000 for a client. Because the funds to be invested in a business at the end of 1 year, you have been instructed to plan a 1-year holding period. Further, your boss has restricted you to the investment alternatives in the following table, shown ith their probabilities and associated outcomes.
RETURNS ON ALTERNATIVE INVESTMENTS
ESTIMATED RATE OF RETURN
State Of the EconomyProbabilityT-billsHigh TechCollectionsU.S. RubberMarket Portfolio2-stock-portfolio
r(hat) - expected return1.00%9.80%10.50%
σ (std deviation)0.0%13.20%18.80%15.20%3.40%
CDIB’s economic forecasting staff has developed probability estimates for the state of the economy; and its security analysts have developed a sophisticated computer program, which as used to estimate the rate of return on each alternative under each state of the economy. High Tech Inc. is an electronics firm, collection Inc. collects past due debts, and U.S. Rubber manufactures tires and various other rubber and plastic products.
a.(1)Why is the T-bill’s return independent of the state of the economy? Do T-bills promise a completely risk-free return? Explain.
The estimated rate of return on T-bill which is 5.5% does not depend on the state of the economy because the treasury must (and will) redeem the bills at par regardless of the state of the economy. T-bill is a short-term debt obligation backed by the government with a maturity of less than one year. T-bills commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks). T-bills are purchased for a price that is less than their par (face) value; when they mature, the government pays the holder the full par value. Effectively, your interest is the difference between the purchase price of the security and what you get at maturity. For example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would earn $200 on your investment. Therefore, you will be earning a fixed amount when it matures regardless of the state of the economy. There are no risk-free investments because even the safest investments, such as bank savings account, come with the risk of bank failure or the risk of not earning enough interest to keep up with the rate of inflation. Treasury bills are regarded as extremely safe. However, if you are forced to sell Treasuries prior to maturity, there’s always a chance they may have dropped in price. The t-bills are risk-free in the default risk sense because the 5.5 percent return will be realized in all possible economic states. However, it is essential to note that this return is composed of the real risk-free rate, plus an inflation premium. Since there is uncertainty about inflation, it is possible that the realized real rate of return would equal the expected 5.5 percent. For example, if inflation averaged 3.5 percent over the year, then the realized real return would only be 5.5% - 3.5% = 2%. Therefore, t-bills are not totally riskless in terms of purchasing power.
(2) Why are High Tech’s returns expected to move with the economy, whereas Collections’ are expected to move counter the economy?
The given data shows that during recession High Tech’s estimated rate of return is negative and as the economy improves, the...