Chapter 12 Finance

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Of what strategic use are the terms "defensive" and "aggressive" when applied to individual stocks or portfolios?

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Defensive stocks are not as sensitive to changes in market fluctuations when compared to the market portfolio.
Accordingly, these stocks would have a Beta less than 1.0. Thus, it would be expected that these securities would return
less than the market portfolio during periods when the market portfolio is offering positive returns. This might appeal to
investors who are too risk-averse to invest in the market portfolio. In times of a down market, defensive stocks would be
expected to decrease less than the market, thus providing a degree of expected protection. Aggressive stocks are more
sensitive than the market to market fluctuations. Thus, they amplify market changes. This is good when the market is
going up but can be quite detrimental when the market is going down. Portfolios may contain both aggressive and
defensive stocks, which will mute the effect of each. This is true since the portfolio Beta is a market value-weighted
average of the individual Betas in the portfolio. Investors may also choose to change the Beta of the portfolio according to
expected movements in the overall market. Thus, portfolios would become more defensive when the market is expected to
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decline. The problem with this strategy is, of course, the accuracy of the predicted market movement.

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Of what strategic use are the terms "defensive" and "aggressive" when applied to individual stocks or portfolios?

2.Discuss how Betas are measured and used for individual stocks.

To measure Betas, historic returns of the stock are plotted against returns on the market portfolio during the same period.
In practice, some broad-based index such as the S&P 500 is substituted for the market portfolio. The slope of the straight
line that is drawn to best fit the observations is the Beta of the stock. Since the returns of most stocks move together to
some degree, the slope is expected to be positive. A slope less than 1.0 indicates that the stock's returns are less volatile
than those of the market portfolio while a slope greater than 1.0 indicates that the stock's returns are more volatile than
those of the market portfolio.

3.Why is Beta thought to be a more relevant measure of risk than standard deviation for a diversified investor?

Standard deviation measures both a stock's market risk and unique risk. However, a diversified investor is no longer
concerned with unique risk, or at least not concerned over the small portion that remains after portfolio diversification.
Beta measures only the market risk of the stock, that type of risk that cannot be diversified away. The stock's returns may
be more or less volatile than the market portfolio and Beta is an indication of that sensitivity.

.Discuss the nature and uses of CAPM, including the method of determining expected returns.

The Capital Asset Pricing Model describes the relationship between risk and return such that investors who bear more
systematic risk will do so only under the expectation of greater returns. The expected return on a security is proportional
to its Beta. Thus, investors are rewarded for the time value of money (i.e., risk-free rate) and for the risk premium on the
security, which is equal to Beta times the market risk premium. There is no reward for bearing unique risk because these
risks are assumed to be diversifiable. The CAPM states that a security's return is equal to the risk-free rate plus the
individual security's risk premium. A security with a Beta of 1.0 is expected to offer the same return as the market
portfolio. Securities with Betas greater (less) than 1.0 should offer proportionately more (less) than the market portfolio.
Securities with a Beta of zero should offer the risk-free rate. The security market line can be used to graph the relationship
between expected return and Beta. Market forces should work to move all securities toward the line if they do not
currently offer the appropriate risk-return relationship. For example, those securities plotting above the line should be in
greater demand, which will bid up price and reduce expected return until the security approaches the SML

6.The manager of StarPerformer Mutual Fund expects the fund to earn a rate of return of 12% this year. The Beta of the
fund's portfolio is .8. If the rate of return available on risk-free assets is 5% and you expect the rate of return on the market
portfolio to be 15%, should you invest in StarPerformer? Can you create a portfolio with the same risk as StarPerformer
Mutual Fund, but with a higher expected rate of return? Explain why in reality, a mutual fund must be able to provide an
expected rate of return that is higher than that predicted by the security market line in order for investors to consider the
fund an attractive investment opportunity.

Explanation:
The CAPM implies that the expected rate of return that investors will demand of the portfolio is:
r = rf + β(rm-rf) = 5% + 0.8 × (15%-5%) = 13%
If the portfolio is expected to provide only a 12% rate of return, it is an unattractive investment. The portfolio does not
provide an expected return that is sufficiently high relative to its risk.
A portfolio that is invested 80% in a stock index mutual fund (with a Beta of 1.0) and 20% in Treasury bills or a money
market mutual fund (with a Beta of zero) would have the same Beta as StarPerformer Mutual Fund:
β = (0.80 × 1.0) + (0.20 × 0) = 0.80
However, the portfolio will provide an expected return of:
(0.80 × 15%) + (0.20 × 5%) = 13%
This is better than the expected return for StarPerformer Mutual Fund.
The security market line provides a benchmark expected return that an investor can earn by mixing index funds with
money market funds. Before an investor places funds with a professional mutual fund manager, the investor must be
convinced that the mutual fund can earn an expected return (net of fees) in excess of the expected return available on an
equally risky index fund strategy.

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