INTRODUCTION TO RISK, RETURN, AND THE

OPPORTUNITY COST OF CAPITAL

Q1 ) Risk Premiums. Here are stock market and Treasury bill returns between
1997 and 2001:
Year
1997
1998
1999
2000
2001

Stock Market
Return
31.29
23.43
23.56
-10.89
-10.97

T-Bill
Return
5.26
4.86
4.68
5.89
3.83

a. What was the risk premium on the S&P 500 in each year?
b. What was the average risk premium?
c. What was the standard deviation of the risk premium?

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Q2). Scenario Analysis. The common stock of Escapist Films sells for $25 a share
and offers the following payoffs next year:

Boom
Normal
Recessi
on

Divide
nd
0
$1

Stock
Price
$18
$26

$3

$34

Calculate the expected return and standard deviation of Escapist. All three scenarios
are equally likely. Then calculate the expected return and standard deviation of a
portfolio half invested in Escapist and half in Leaning Tower of Pita (from problem
14). Show that the portfolio standard deviation is lower than either stocks. Explain
why this happens.

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Q3) Scenario Analysis. Consider the following scenario analysis:

Rate of Return
Probabili
ty
Stocks Bonds
Recessi
on
Normal
Boom

0.20
0.60
0.20

-5%
15%
25%

14%
8%
4%

a. Is it reasonable to assume that Treasury bonds will provide higher returns in

recessions
than in booms?
b. Calculate the expected rate of return and standard deviation for each investment.
c. Which investment would you prefer?

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Q4) Portfolio Analysis. Use the data in the previous problem and consider a
portfolio with weights of .60 in stocks and .40 in bonds.
a. What is the rate of return on the portfolio in each scenario?
b. What is the expected rate of return and standard deviation of the portfolio?
c. Would you prefer to invest in the portfolio, in stocks only, or in bonds only?

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