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6 views4 pages

Tutorial 5 Solutions

Uploaded by

aditya.shirapure
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© © All Rights Reserved
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FINM7006: Applied Foundations of Finance

Tutorial 5 Solutions

Question One
What is a probability and how can we relate it to share returns?

Probabilities refer to the likelihood of an event happening. We can relate this concept
to share returns by considering the probability that the return on a particular share
over the next 12 months will be greater than 5%. We will be uncertain about whether
the return will actually exceed 5%, and accept that there is a chance that the return
will be 5%, or less than 5%. The greater the magnitude of the probability figure, the
greater the likelihood that the return will exceed 5%.

Question Two
Define the terms expected value and standard deviation. In providing your answer,
show how these terms relate to share prices.

The expected value of a particular share return is the average of the possible outcomes
(in terms of expected future share returns) weighted by their probability of occurring.
More specifically, it is the mean value of the probability distribution of possible
outcomes.

Standard deviation measures the variability of possible outcomes from the expected
value or mean value. In finance we use this measure of standard deviation as our
measurement of risk. The greater the standard deviation, the less certain we are about
the outcome, and thus, the greater the level of risk. We calculate standard deviation by
finding the square root of the variance.

Question Three
What do we mean when we say an investor is risk averse?

As the name would suggest, risk-averse individuals dislike risk, all other things being
equal. Risk-averse investors will only accept investments for which they are
compensated for choosing a less certain outcome over a more certain one. The
certainty of the outcome on an investment is measured by the standard deviation of
returns on the investment, a concept discussed in the solution to Question Two, above.

Question Four
You are given the following information about the possible returns from an
investment:

Return (%) Probability


12% 0.15
10% 0.65
5% 0.20

1
FINM7006: Applied Foundations of Finance

Given this information, calculate:


1. The expected return on the investment;
2. The variance of the return on the investment;
3. The standard deviation of the return on the investment; and,
4. The probability that the return on the investment is equal to or less than
8%.

The expected return of the investment described is calculated as:

The variance and standard deviation of return on the investment are calculated as:

The probability that the return on the investment is equal to or less than 8% is simply
equal to the probability of the return being 5%, or 0.20. This is because the return of
5% is the only possible outcome lower than 8%.

Question Five
You are a market analyst and have identified 4 different market conditions together
with the probability that these market conditions will occur. The information
contained in the table below relates to the return on 3 shares under each market
condition:

Market Probability Return


Condition AMP BHP CSR
Boom 0.10 5% 8% 9%
Good 0.30 0% 5% 6%
Average 0.40 -8% 2% 3%
Poor 0.20 -12% -6% -7%

Given this information, calculate:


1. The expected return on each of the three shares;
2. The standard deviation on the return of each share;
3. The probability that the return on each of the shares will exceed 8%; and,
4. The probability that the return on each share will be less than 0%.

2
FINM7006: Applied Foundations of Finance

The expected return on each of the three shares is calculated as:

The standard deviation of the return on each share is calculated as follows:

= 5.58% (mistake – should be 5.56%)

The probabilities that the return on each of the shares will exceed 8% are: 0.00 for
AMP; 0.00 for BHP; and, 0.10 for CSR.

The probabilities that the return on each of the shares will be less than 0% are: 0.60
for AMP; 0.20 for BHP; and. 0.20 for CSR.

3
FINM7006: Applied Foundations of Finance

Question Six
A supermarket is considering the purchase of one of two machines. Both should
provide benefits over a 10-year period, and each requires an initial investment of
$4,000. Management has determined the following estimates of probabilities and rates
of return for each machine under three possible scenario outcomes: Pessimistic; Most
Likely; and, Optimistic.

Machine A Machine B
Return Probability Return Probability
Pessimistic 20% 0.25 15% 0.20
Most Likely 25% 0.50 25% 0.55
Optimistic 30% 0.25 35% 0.25

a) Determine the range for the rate of return for each of the two machines.
b) Determine the expected rate of return for each machine.
c) Which machine is more risky? Why?

a. Machine Range
A 30% – 20% = 10%
B 35% – 15% = 20%

b. Possible Probability Expected Return Weighted


Outcomes Pri ki Value (%)
(ki × Pri)
Machine A Pessimistic 0.25 20 5.00
Most likely 0.50 25 12.50
Optimistic 0.25 30 7.50
1.00 Expected Return 25.00

Machine B Pessimistic 0.20 15 3.00


Most likely 0.55 25 13.75
Optimistic 0.25 35 8.75
1.00 Expected Return 25.50

c. Machine B is considered more risky than Machine A because it has a much


broader range of outcomes. The risk-return trade-off is present because
Machine B is more risky and also provides a higher return than Machine A.

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