Bodie2-IM-Ch10

CHAPTER10-PrinciplesofRiskManagementEnd-of-ChapterProblems1.Supposeyouareawareofthefollowinginvestmentopportunity:Youcouldopenacoffeeshoparoundthecornerfromyourhomefor$25,000.Ifbusinessisstrong,youcouldnet$15,000inafter-taxcashflowseachyearoverthenext5years.a.Ifyouknewforcertainthebusinesswouldbeasuccess,wouldthisbeariskyinvestment?b.Nowassumethisisariskyventureandthatthereisa50%chanceitisasuccessanda50%chanceyougobankruptwithin2years.Youdecidetogoaheadandinvest.Ifthebusinesssubsequentlygoesbankrupt,didyoumakethewrongdecisionbasedontheinformationyouhadatthetime?Whyorwhynot?Solution:a.No,thisinvestmentwouldnotberisky.b.No,youdidnotmakea“wrong”decision.Whenyoumadeyourdecision,youdidnotknowforcertainthatthecompanywouldgobankrupt.Youdecidedtoinvestformanyreasons,includingthepossibilityofmakingalotofmoney.Givenyourtoleranceforriskandthefactthatyoubasedourdecisionontheinformationavailableatthetime,yourdecisionwasnotwrongandmayhavebeenoptimalatthetime.2.Supposeyournewbusinessventurewilllastonlyoneyear.For$110,000youplantopurchase20acresoffarmlandnexttoasitethatmaybedevelopedintoaretailshoppingmall.Youwillsellthelandinayearandbasedontheoutcomeofthezoninghearingthereisanequalchancethatitwillbewortheither$100,000,or$125,000,or$145,000nextyear.Thebankiswillingtomakeyouarisklessloantofinancethepurchaseofthepropertyataninterestrateof10%.Theloanbalanceintotalwillbepaidinoneyearwhenyouselltheproperty.Whatisthemostthebankwillbewillingtolend?Solution:Arisklessloanshouldbeonewherethebankexpectedfullrepaymentoftheloansoonlyloansrequiring$100,000orlessinrepaymentwouldberiskless.Thismeansaninitialborrowingofnomorethan:100000110%+90909.091=Sothemostthebankwouldlendis$90,909.093.Supposeyouareapensionfundmanagerandyouknowtodaythatyouneedtomakea$100,000paymentin3months.a.Whatwouldbearisk-freeinvestmentforyou?b.Ifyouhadtomakethatpaymentin20yearsinstead,whatwouldbeariskfreeinvestment?c.WhatdoyouconcludefromyouranswerstoPartsaandbofthisquestion?Solution:a.Arisk-freeinvestmentforyouwouldbeaTreasuryBill(defaultriskfree)whichmaturesinexactly3months.b.Arisk-freeinvestmentwouldbeazerocouponU.S.Treasurysecuritymaturingin20yearsandwhichwouldhavethesamesinglepaymentof$100,000.c.Becauseriskisdependentuponcircumstances,whatisrisk-freeforoneindividualmayberiskyforanothertoo.Therecanbeanynumberofrisk-freeinvestmentsdependinguponcircumstances.Yourinvestmenttimehorizoniscriticaltochoosingthebestrisk-freeinvestment(sopaymentsincanexactlymatchpaymentsoutsothatyouareleftwithnorisk).4.SupposeyouareaJapanesebanker,isitriskiertomakealoandenominatedindollarsorinyen?WhatifyouareanEnglishbanker?Solution:.Forpeoplewhoseincomeandexpensesaredenominatedinyen,liketheJapanesebanker,denominatingaloaninyenwouldbesaferthandenominatingitindollars.Butforsomeonewhoseincomeandexpensesaredenominatedindollars,denominatingtheloaninyenwouldbemoreriskythanindollars.IftheEnglishbankerhasassetsandliabilitiesinmanycurrenciesthenthechoicebetweenaloaninyenordollarsmightoffersimilarlevelsofrisk.Chapter10-1Copyright©2009PearsonEducation,Inc.PublishingasPrenticeHall.FinancialEconomicsSolutionsManual5.YouaretheCEOofaMexicancompanywhichtookoutadollar-denominatedloanfromanAmericanbankoneyearagowhenthepeso-dollarexchangeratewas10pesosperdollar.Youborrowed$100,000at8percentinterestandpromisedtorepaytheentirebalanceandinterestinonepaymentattheendoftheyear.Thecurrentexchangerateis9.5pesosperdollar.Whateffectivepesos-denominatedrateofinterestdidyoupayfortheloan?Solution:Theloanrequiresyoutopay$108,000forhavingborrowed$100,000ayearago.Theborrowingwasworth1,000,000pesosayearagoattheprevailingexchangerateandtodaytheloanrepaymentwillrequire1080009.5⋅1026000.000=1,026,000pesosSotheeffectpesointerestrateontheloanwas:102600010000001−0.026=2.6%Thisismuchbelowthe10%dollarratebecausethepesoappreciatedagooddealversusthedollar.Whatifthepesohaddepreciated?6.Whichriskmanagementtechniquehasbeenchosenineachofthefollowingsituations?yInstallingasmokedetectorinyourhomeyInvestingsavingsinT-billsratherthaninstocksyDecidingnottopurchasecollisioninsuranceonyourcaryPurchasingalifeinsurancepolicyforyourselfSolution:•Losspreventionandcontrol.•Riskavoidance•Riskretention•Risktransfer7.Youareconsideringachoicebetweeninvesting$1,000inaconventionalone-yearT-Billofferinganinterestrateof8%andaone-yearIndex-LinkedInflationPlusT-Billoffering3%plustherateofinflation.a.Whichisthesaferinvestment?b.Whichoffersthehigherexpectedreturn?c.WhatistherealreturnontheIndex-LinkedBond?Solution:a.Theinflation-indexedT-Billoffersafixedrealrateofreturnof3%overthelifeoftheinvestment.TherealreturnontheconventionalT-Bill'srealreturndependsupontheexpectedrateofinflationoverthelifeoftheinvestment.ThesaferinvestmentistheInflationPlusT-Bill.b.TherealrateofreturnontheconventionalT-Billdependsupontheexpectedrateofinflationoverthelifeoftheinvestment.Youdonotknowwhichexpectedreturnishigherunlessyouknowwhatinflationisexpectedtobe.c.Therealreturnontheindex-linkedT-Billis3%.8.Supposeyouareafanaticalfollowerofaparticularmajorleaguebaseballteam(e.g.,theCub