Study Questions _ 1. (Related to Regardless of Your Major: Using Statistics ) In the Regardless of Your Ma- Jor feature, we note that statisticians analyze data. Moreover, in your statistics class ‘you Tearned about how to describe random outcomes using siatistical measures such as expected values and the varianee. How does our knowledge of basic statistics help us evaluate investment opportunities? Describe in words the concept of a realized rate of return, Assume that you are trying to deseribe the concept to your grandfather, who has never had a finance class! How do cash dividends affect the realized rate of return from investing in shares of ‘common stock? 4. How does the expected rate of return concept differ from that of the realized rate of return? 5 Describe the concept of an expected rate of return as if you were explaining it to your 10-year-old niece. 6. Why is the volatility or variance in an investment’ rate of return a reasonable indication ofthe risk of the investment? 7. Describe the five-step process used to calculate the variance in the rate of return for an investment. 8. Describe the information contained in Figure 2 identifying which securities have per~ formed the best over long periods of time. Some investors with long investment time horizons invest exclusively in bonds. Why do you think that is so? 9. What is the equity risk premium, and how is it calculated? 10, What does Figure 3 tell us about how the U.S. stock market has performed when ‘compared to all the alternatives included in the figure over the period 1980-2011? 11. What can you conclude about the relative risk of investing in the United States ‘versus the Pacific region from Figure 3? 12. Whats the relationship between the geometric average rate of return and compound interest? 13. Under what circumstances would you prefer to use the geometric average rate of return as opposed to the arithmetic average? 14, (Related to The Business of Life: Determining Your Tolerance for Risk ) What is your tolerance for risk? Take the risk tolerance quiz referenced in The Business of Life: Determining Your Tolerance for Risk feature and found at the website www rce.rut- ‘gers.edu/moneylriskquiz 15, What is the efficient markets hypothesis? Explain this concept in your own words, 16, Compare and contrast the notions of weak-form, semi-strong-form, and strong-form, market efficiency. 17. Do you think thatthe capital markets are completely efficient, efficient most of the time, or completely inefficient? Support your position as if you were talking to your favorite nephew who is only 10 years old, 18 Whatis the “behavioral view” of market efficiency? Study Problems MyFinanceLab Realized and Expected Rates of Return and Risk Golo wwww.myfinancelab.com 1, (Related to Checkpoint 1 ) (Calculating rates of return) On December 24, to complete these exercises ore 22007, the common stock of Google Inc. (GOOG) was trading for $700.73. and got instant feedback ‘One year later the shares sold for only $298.02, Google has never paid 2366. 7. a. common stock dividend. What rate of return would you have eared on your in- vestment had you purchased the shares on December 24, 2007? (Calculating rates of return) The S&P stock index represents a portfolio com- prised of 500 large publicly traded companies. On December 24, 2007, the index had a value of 1,410 and on December 23, 2008, the index was approximately 890, If the average dividend paid on the stocks in the index is approximately 4 percent of the value of the index at the beginning of the year, what is the rate of return earned on the S&P index? What is your assessment of the relative riskiness of the Google investment (analyzed in the previous problem) compared to investing in the S&P index? (Calculating rates of return) The common stock of Placo Enterprises had a market price of $12 on the day you purchased it just one year ago. During the past year the stock had paid a $1 dividend and closed at a price of $14, What rate of return did you earn on your investment in Placo’s stock? (Calculating rates of return) Blaxo Balloons manufactures and distributes birthday balloons. At the beginning of the year Blaxo’s common stock was selling for $20 but by year end it was only $18. If the firm paid a total cash dividend of $2 during the year, what rate of return would you have earned if you had purchased the stock exactly one year ago? What would your rate of return have been if the firm had paid no cash dividend? (Computing rates of return) From the following price data, compute the annual rates of return for Asman and Salinas. 1 $10 $30 2 12. 28 = i 32, 4 13 as How would you interpret the meaning of the annual rates of return? (Related to Checkpoint 1 ) (Expected rate of return and risk) B. J. Gautney Enterprises is evaluating a security. One-year Treasury bills are currently paying 2.9 percent. Calculate the following investment’s expected return and its standard deviation. Should Gautney invest in this security? AAS a 30 2% 40 4% ala 6% (Expected rate of return and risk) Syntex, Inc. is considering an investment in one of two common stocks. Given the information that follows, which investment is bet- ter, based on risk (as measured by the standard deviation) and return?Geometric vs. Arithmetic Average Rates of Return 8. (Related to Checkpoint 2 ) (Calculating the geometric and arithmetic average rate of return) Caswell Enterprises had the following end-of-year stock prices over the last five years and paid no cash dividends: i $10 2. 15 - 12 4 9 5; - 10 a. Calculate the annual rate returns for each year from this information. b, What is the arithmetic average rate of return earned by investing in Caswell’s stock over this period? ¢. What is the geometric average rate of return earned by investing in Caswell’s stock over this period? d. Considering that the beginning and ending stock prices for the five-year period ‘ are the same, which type of average rate of return best describes the average annual rate of return earned over the period (the arithmetic or geometric)? 9, (Calculating the geometric and arithmetic average rate of return) The common stock of the Brangus Cattle Company had the following end-of-year stock prices over the last five years and paid no cash dividends: L $15 2 10 3 12 4 23 Si 25 ’ a. Calculate the annual rate of return for each year from this information. b. What is the arithmetic average rate of return earned by investing in the company’s stock over this period? c. What is the geometric average rate of return earned by investing in the company’s stock over this period? d. Which type of average rate of return best describes the average annual rate of return earned over the period (the arithmetic or geometric)? Why? (Comprehensive problem) Use the following end-of-year price data to answer the following questions for the Barris and Carson Companies. 1 $10 $20 2 12 Oke 3 8 32 4 1s 21 a. Compute the annual rates of return for each time period and for both firms. b. Calculate both the arithmetic and geometric mean rates of return for the entire three-year period using your annual rates of return from part a. Note: You may assume that neither firm pays any dividends. c. Compute a three-year rate of return spanning the entire period (i.e., using the beginning price for Period 1 and ending price for Period 4). d. Because the rate of return calculated in part c is a three-year rate of return, convert it to an annual rate of return by using the following equation: (1 4. Three-Year ) aC 4 Annual Rate)? Rate of Return of Return 238e. How is the annual rate of return calculated in part d related to the geometric rate of return? When you are evaluating the performance of an investment that has been held for several years, what type of average rate of return should you use (arithmetic or geometric)? Why? Mini-Case After graduating from college last spring with a major in ac- counting and finance, Jim Hale took a job as an analyst trainee for an investment company in Chicago. His first few weeks were filled with a series of rotations throughout the firm’s vari- ous operating units, but this week he was assigned to one of the firm’s traders as an analyst. On his first day Jim’s boss called him in and told him that he wanted to do some rudimentary analysis of the investment returns of a semiconductor manu- facturer called Advanced Micro Devices, Inc. (Ticker: AMD). Specifically, Jim was given the following month-end clos- ing prices for the company spanning the November 1, 2011, through November 1, 2012: Questions _. 1. Compute the monthly realized rates of return earned by AMD for the entire year. 2, Calculate the average monthly rate of return for AMD using both the arithmetic and geometric averages. 3. Calculate the year-end price for AMD, computing the com- pound value of the beginning-of-year price of $5.69 per share for 12 months at the monthly geometric average rate of return calculated earlier: End-of-Year _ Beginning-of-Year Stock Price Stock Price (1 4 Geometric Average)" Monthly Rate of Return 4. Compute the annual rate of return for AMD using the beginning stock price for the period and the ending price (i.e., $5.69 and $1.88), Photo Credits _ Pixelbliss/Fotolia; Runzelkorn/Shutterstock LNov-1l 5.69 1Jun-12 5.73 1-Decll 5.4 23-12 4.06 3Jan-12 6.71 1-Aug-12 3.72 L-Feb-12 7.35 4Sep-12 3.37 1-Mar-12 8.02 1-Oct-12 2.05 2Apr-12 7.36 1-Nov-12 1.88 I-May-12 6.08 He was then instructed by his boss to complete the follow- ing tasks using the AMD price data (note that AMD paid no dividend during 2008). 5. Now calculate the annual rate of return using the geo- metric average monthly rate of return using the following relationship: Geometric Average B Rate of Return Monthly Rate of ra - Compound Annual _ ( 6. If you were given annual rate of return data for AMD or any other company’s stock and you were asked to estimate the average annual rate of return an investor would have earned over the sample period by holding the stock, would you use an arithmetic or geometric average of the historical rates of return? Explain your response as if you were talk- ing to a client who has had no formal training in finance or investments. Credits are listed in order of appearance,