8. Estimating Risk and Return

Questions

In a Word document, respond to the following. Number your responses 1–2.

1. Explain why expected return is considered forward-looking. What challenges arise in using expected return?
2. Explain how differences in allocations between the risk-free security and the market portfolio can determine the level of market risk.

Use references to support your responses as needed. Be sure to cite all references using correct APA style. Your responses should be free of grammar and spelling errors, demonstrating strong written communication skills.

Problems

In either a Word document or Excel spreadsheet, complete the following problems.

• You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet.
• If you choose to solve the problems algebraically, be sure to show your computations.
• If you use a financial calculator, show your input values.
• If you use an Excel spreadsheet, show your input values and formulas.

1. Based on the probability and percentage of return for the three economic states in the table below, compute the expected return.

Economic State       Probability.     Percentage of Return

Fast Growth               0.10                     60

Slow Growth.             0.50.                    30

Recession                  0.40.                  -23

1. If the risk-free rate is 7 percent and the risk premium is 4 percent, what is the required return?
2. Suppose that the average annual return on the Standard and Poor’s 500 Index from 1969 to 2005 was 14.8 percent. The average annual T-bill yield during the same period was 5.6 percent. What was the market risk premium during these 10 years?
3. Conglomco has a beta of 0.32. If the market return is expected to be 12 percent and the risk-free rate is 5 percent, what is Conglomco’s required return? Use the capital asset pricing model (CAPM) to calculate Conglomco’s required return.
4. Calculate the beta of a portfolio that includes the following stocks: 

   Conglomco stock, which has a beta of 3.9 and comprises 35 percent of the portfolio.
   Supercorp stock, which has a beta of 1.7 and comprises 25 percent of the portfolio.
   Megaorg stock, which has a beta of 0.3 and comprises 40 percent of the portfolio.