Finance 301 S.I.Monday March 24, 2008Catching Up/Review from Spring Break (Review of material since exam 2)1. If $5000 is invested and $6,255 is retuned after one year, what is the rate of return for this investment?Return= (amt received-amt invested)/amt invested =(6255-5000)/5000 =0.2510 or 25.10%2. What are the two types of risk and which one is most important?Standalone and portfolio/market riskPortfolio/market risk is more important3. A stock’s returns have the following distributionDemand for theproductProbability of thedemandRate of Return if thisdemandWeak 0.15 (40%)Below Average 0.22 (7%)Average 0.33 13%Above Average 0.15 28%Strong 0.15 55%a. What is the stock’s expected return?=Σ(every possible rate of return*probability of that return)=9.2%b. What is the stock’s standard deviation?=√Σ(every possible return-expected return)2(probability of outcome)=28.165c. What is the stock’s coefficient of variation?=standard deviation/expected return=3.0614. Define risk aversion and risk premium.Risk aversion: assumes that investors dislike risk, and therefore require higher rates of return to encourage them to hold riskier securities.Risk premium: the difference between the return on a risky asset and the return on a risk less asset, which serves as compensation for investors to hold risk.5. Use this information for the following question.Security Expected Return RiskA 11.5% 18.9%B 9.4% 14.1%C 8.7% 17.7%D 4.4% 0%E 0.5% 12.8%What is the portfolio’s expected return? =6.1556. What is the main benefit of diversification? When do you realize most of the benefits of diversification?Much lower risk in portfolio than risk for each individual stock.Most of the benefits of diversification come early (1st few additional stocks)The benefit asymptotically approaches a floor.7. What is the standard deviation for an average stock? Are most stocks positively or negatively correlated with the market?35%. Most are + correlated with the market b/c when the economy does well, so do stocks (in general). The correlation is not perfect.8. Define market risk and diversifiable risk. What is the sum of the two?Market risk= the part of risk you can’t get rid of with diversificationDiversifiable risk= the portion of risk that can be eliminated through diversificationStandalone risk= market risk + diversifiable