6.1 Let us assume a normal distribution of returns and risk-averse utility funct
ID: 2812332 • Letter: 6
Question
6.1 Let us assume a normal distribution of returns and risk-averse utility functions. Under what conditions will all investors demand the same portfolio of risky assets? 6.2 The following data have been developed for the Donovan Company, the manufacturer of an advanced line of adhesives: Market Return, Return for the Firm, State Probability -.15 .05 .15 .20 -.30 2 .3 .20 4 .50 Thenskfredrateis6%. Calculate the following: (a) The expected market return. (b) The variance of the market return. (c) The expected return for the Donovan Company.Explanation / Answer
6.2:
Expected market return:
=0.1*(-0.15)+0.3*0.05+0.4*0.15+0.2*0.20=0.10
Variance of market return:
=0.1*(-0.15-0.1)^2+0.3*(0.05-0.1)^2+0.4*(0.15-0.1)^2+0.2*(0.20-0.1)^2=0.01
Expected return for the firm:
=0.1*(-0.30)+0.3*0.00+0.4*0.20+0.2*0.50=0.15
COvariance :
=0.1*(-0.15-0.1)*(-0.3-0.15)+0.3*(0.05-0.1)*(0.00-0.15)+0.4*(0.15-0.1)*(0.20-0.15)+0.2*(0.20-0.1)*(0.50-0.15)=0.022
Equation:
return=riskfree+beta*market riskpremium=6%+beta*(10%-6%)=6%+beta*4%
beta=covariance/variance of market=0.022/0.01=2.2
Required return=6%+beta*4%=6%+2.2*4%=14.8%
Expected return is more than required return implying the firm is undervalued
P.S.: Even though I am allowed to answer only 4 questions, I have ansered 6, would be great if you could rate me
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