What is stand-alone risk?

:

Assume that you recently graduated and landed a job as a financial planner with Cicero

Services, an investment advisory company. Your first client recently inherited some assets

and has asked you to evaluate them. The client presently owns a bond portfolio with \$1

million invested in zero coupon Treasury bonds that mature in 10 years.

The client also

has \$2 million invested in the stock of Blandy, Inc., a company that produces meat-andpotatoes frozen dinners. Blandy’s slogan is“Solid food for shaky times.”

Unfortunately, Congress and the President are engaged in an acrimonious dispute over

the budget and the debt ceiling. The outcome of the dispute, which will not be resolved

until the end of the year, will have a big impact on interest rates one year from now. Your

first task is to determine the risk of the client’s bond portfolio. After consulting with the

economists at your firm, you have specified five possible scenarios for the resolution of thedispute at the end of the year. For each scenario, you have estimated the probability of the

scenario occurring and the impact on interest rates and bond prices if the scenario occurs.

Given this information, you have calculated the rate of return on 10-year zero coupon for

each scenario. The probabilities and returns are shown below:

 Scenario Probability of Scenario Return on 10-Year Zero Coupon Treasury Bond During the Next Year Worse Case 0.10 -14% Poor Case 0.20 -4% Most Likely 0.40 6% Good Case 0.20 16% Best Case 0.10 26% 1.00

You have also gathered historical returns for the past 10 years for Blandy, Gourmange

Corporation (a producer of gourmet specialty foods), and the stock market.

 Historical Stock Returns Year Market Blandy Gourmange 1 30% 26% 47% 2 7.00 15 -54 3 18.00 -14 15 4 -22.00 -15 7 5 -14.00 2 -28 6 10.00 -18 40 7 26.00 42 17 8 -10.00 30 -23 9 -3.00 -32 -4 10 38.00 28 75 Average return: 8.00% ? 9.20% Standard deviation: 20.10% ? 38.60% Correlation with the market: 1.00 ? 0.678 Beta: 1.00 ? 1.3

The risk-free rate is 4% and the market risk premium is 5%.

1. a) What are investment returns? What is the return on an investment that costs \$1,000

and is sold after 1 year for \$1,060?

2. c) Use the scenario data to calculate the expected rate of return for the 10 year zero

coupon Treasury bonds during the next year.

3. d)   What is stand-alone risk? Use the scenario data to calculate the standard deviation

of the bond’s return for the next year.

4. i)   (1) Should portfolio effects influence how investors think about the risk of individual

stocks? (2) If you decided to hold a one-stock portfolio and consequently were

exposed to more risk than diversified investors, could you expect to be compensated

for all of your risk; that is, could you earn a risk premium on that part of your risk

that you could have eliminated by diversifying?

5. j)  According to the Capital Asset Pricing Model, what measures the amount of risk

that an individual stock contributes to a well-diversified portfolio? Define this

6. q)  What does market equilibrium mean? If equilibrium does not exist, how will it be

established?

7. r)  What is the Efficient Markets Hypothesis (EMH) and what are its three forms?

What evidence supports the EMH? What evidence casts doubt on the EMH?

The following cases from CengageCompose cover many of the concepts discussed in this

chapter and are available at compose.cengage.com.

Klein-Brigham Series:

Case 2,“Peachtree Securities, Inc. (A).”

Brigham-Buzzard Series:

Case 2,“Powerline Network Corporation (Risk and Return).”

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