CHAPTER 1

INVESTMENT SETTING

QUESTIONS

1. Discuss the overall purpose people have for investing. Define

investment.
When an individual’s current money income exceeds his current consumption desires, he
saves the excess. Rather than keep these savings in his possession, the individual may
consider it worthwhile to forego immediate possession of the money for a larger future
amount of consumption. This trade-off of present consumption for a higher level of future
consumption is the essence of investment.

An investment is the current commitment of funds for a period of time in order to derive a
future flow of funds that will compensate the investor for the time value of money, the
expected rate of inflation over the life of the investment, and provide a premium for the
uncertainty associated with this future flow of funds.

2. As a student, are you saving or borrowing? Why?

Students in general tend to be borrowers because they are typically not employed so
have no income, but obviously consume and have expenses. The usual intent is to
invest the money borrowed in order to increase their future income stream from
employment - i.e., students expect to receive a better job and higher income due to
their investment in education

3. Divide a person’s life from ages 20 to 70 into 10-year segments and

discuss the likely saving or borrowing patterns during each period.

In the 20-30 year-old segment an individual would tend to be a net borrower since he
is in a relatively low-income bracket and has several expenditures - automobile,
durable goods, etc. In the 30-40 year-old segment again the individual would likely
dissave, or borrow, since his expenditures would increase with the advent of family
life, and conceivably, the purchase of a house. In the 40-50 year-old segment, the
individual would probably be a saver since income would have increased
 substantially with no increase in expenditures. Between the ages of 50 and 60 the
individual would typically be a strong saver since income would continue to increase
and by now the couple would be “empty-nesters.” After this, depending upon when
the individual retires, the individual would probably be a dissaver as income
decreases (transition from regular income to income from a pension).

4. Discuss why you would expect the saving-borrowing pattern to differ

by occupation (for example, for a doctor versus a plumber).

The saving-borrowing pattern would vary by profession to the extent that

compensation patterns vary by profession. For most white-collar professions (e.g.,
lawyers) income would tend to increase with age. Thus, lawyers would tend to be
borrowers in the early segments (when income is low) and savers later in life.
Alternatively, blue-collar professions (e.g., plumbers), where skill is often physical,
compensation tends to remain constant or decline with age. Thus, plumbers would
tend to be savers in the early segments and dissavers later (when their income
declines).

5. The Wall Street Journal reported that the yield on common stocks is
about 2 percent, whereas a study at the University of Chicago
contends that the annual rate of return on common stocks since 1926
has averaged about 10 percent. Reconcile these statements.

The difference is because of the definition and measurement of return. In the case of
the WSJ, they are only referring to the current dividend yield on common stocks
versus the promised yield on bonds. In the University of Chicago studies, they are
talking about the total rate of return on common stocks, which is the dividend yield
plus the capital gain or loss yield during the period. In the long run, the dividend
yield has been 4-5 percent and the capital gain yield has averaged about the same.
Therefore, it is important to compare alternative investments based upon total return.

6. Some financial theorists consider the variance of the distribution of

expected rates of return to be a good measure of uncertainty. Discuss
the reasoning behind this measure of risk and its purpose.

The variance of expected returns represents a measure of the dispersion of actual

returns around the expected value. The larger the variance is, everything else
remaining constant, the greater the dispersion of expectations and the greater the
uncertainty, or risk, of the investment. The purpose of the variance is to help measure
and analyze the risk associated with a particular investment
 7. Discuss the three components of an investor’s required rate of return
on an investment
An investor’s required rate of return is a function of the economy’s risk free rate
(RFR), an inflation premium that compensates the investor for loss of purchasing
power, and a risk premium that compensates the investor for taking the risk. The
RFR is the pure time value of money and is the compensation an individual demands
for deferring consumption. More objectively, the RFR can be measured in terms of
the long-run real growth rate in the economy since the investment opportunities
available in the economy influence the RFR. The inflation premium, which can be
conveniently measured in terms of the Consumer Price Index, is the additional
protection an individual requires to compensate for the erosion in purchasing power
resulting from increasing prices. Since the return on all investments is not certain as
it is with T-bills, the investor requires a premium for taking on additional risk. The
risk premium can be examined in terms of business risk, financial risk, liquidity risk,
exchange rate risk and country risk

8. Discuss the two major factors that determine the market nominal
risk-free rate (NRFR). Explain which of these factors would be more
volatile over the business cycle

Three factors that influence the nominal RFR are the real growth rate of the economy,
liquidity (i.e., supply and demand for capital in the economy) and the expected rate of
inflation. Obviously, the influence of liquidity on the RFR is an inverse relationship, while
the real growth rate and inflationary expectations have positive relationships with the
nominal RFR - i.e., the higher the real growth rate, the higher the nominal RFR and the
higher the expected level of inflation, the higher the nominal RFR.
It is unlikely that the economy’s long-run real growth rate will change dramatically during
a business cycle. However, liquidity depends upon the government’s monetary policy and
would change depending upon what the government considers to be the appropriate
stimulus. Besides, the demand for business loans would be greatest during the early and
middle part of the business cycle

9. Briefly discuss the five fundamental factors that influence the risk
premium of an investment

The five factors that influence the risk premium on an investment are business risk,
financial risk, liquidity risk, exchange rate risk, and country risk

Business risk is a function of sales volatility and operating leverage and the
combined effect of the two variables can be quantified in terms of the coefficient of
variation of operating earnings. Financial risk is a function of the uncertainty
 introduced by the financing mix. The inherent risk involved is the inability to meet
future contractual payments (interest on bonds, etc.) or the threat of bankruptcy.
Financial risk is measured in terms of a debt ratio (e.g., debt/equity ratio) and/or the
interest coverage ratio. Liquidity risk is the uncertainty an individual faces when he
decides to buy or sell an investment. The two uncertainties involved are: (1) how
long it will take to buy or sell this asset, and (2) what price will be received. The
liquidity risk on different investments can vary substantially (e.g., real estate vs. T-
bills). Exchange rate risk is the uncertainty of returns on securities acquired in a
different currency. The risk applies to the global investor or multinational corporate
manager who must anticipate returns on securities in light of uncertain future
exchange rates. A good measure of this uncertainty would be the absolute volatility
of the exchange rate or its beta with a composite exchange rate. Country risk is the
uncertainty of returns caused by the possibility of a major change in the political or
economic environment of a country. The analysis of country risk is much more
subjective and must be based upon the history and current environment in the
country

10. You own stock in the Gentry Company, and you read in the financial
press that a recent bond offering has raised the firm’s debt/equity
ratio from 35 percent to 55 percent. Discuss the effect of this change
on the variability of the firm’s net income stream, other factors being
constant. Discuss how this change would affect your required rate of
return on the common stock of the Gentry Company

The increased use of debt increases the fixed interest payment. Since this fixed
contractual payment will increase, the residual earnings (net income) will become
more variable. The required rate of return on the stock will change since the financial
risk (as measured by the debt/equity ratio) has increased

11. Draw a properly labeled graph of the security market line (SML) and
indicate where you would expect the following investments to fall
along that line. Discuss your reasoning. a. Common stock of large
firms
b. U.S. government bonds
c. U.K. government bonds
d. Low-grade corporate bonds
e. Common stock of a Japanese firm

According to the Capital Asset Pricing Model, all securities are located on the Security Market
Line with securities’ risk on the horizontal axis and securities’ expected return on its vertical axis.
As to the locations of the five types of investments on the line, the U.S. government bonds should
be located to the left of the other four, followed by United Kingdom government bonds, low-grade
 corporate bonds, common stock of large firms, and common stocks of Japanese firms. U.S.
government bonds have the lowest risk and required rate of return simply because they virtually
have no default risk at all. U.K. Government bonds are perceived to be default risk-free but expose
the U.S. investor to exchange rate risk. Low grade corporates contain business, financial, and
liquidity risk but should be lower in risk than equities. Japanese stocks are riskier than U.S. stocks
due to exchange rate risk.

12. Explain why you would change your nominal required rate of return
if you expected the rate of inflation to go from 0 (no inflation) to 4
percent. Give an example of what would happen if you did not change
your required rate of return under these conditions

If a market’s real RFR is, say, 3 percent, the investor will require a 3 percent return on an
investment since this will compensate him for deferring consumption. However, if the
inflation rate is 4 percent, the investor would be worse off in real terms if he invests at a
rate of return of 4 percent - e.g., you would receive $103, but the cost of $100 worth of
goods at the beginning of the year would be $104 at the end of the year, which means you
could consume less real goods. Thus, for an investment to be desirable, it should have a
return of 7.12 percent [(1.03 x 1.04) - 1], or an approximate return of 7 percent (3% + 4%).

13. Assume the expected long-run growth rate of the economy increased
by 1 percent and the expected rate of inflation increased by 4 percent.
What would happen to the required rates of return on government
bonds and common stocks? Show graphically how the effects of these
changes would differ between these alternative investment
Both changes cause an increase in the required return on all investments. Specifically, an increase in the
real growth rate will cause an increase in the economy’s RFR because of a higher level of investment
opportunities. In addition, the increase in the rate of inflation will result in an increase in the nominal RFR.
Because both changes affect the nominal RFR, they will cause an equal increase in the required return on all
investments of 5 percent.

The graph should show a parallel shift upward in the capital market line of 5 percent.

NRFR*
NRFR

14. You see in The Wall Street Journal that the yield spread between Baa
corporate bonds and Aaa corporate bonds has gone from 350 basis
points (3.5 percent) to 200 basis points (2 percent). Show graphically
the effect of this change in yield spread on the SML and discuss its
effect on the required rate of return for common stocks

Such a change in the yield spread would imply a change in the market risk premium because, although the
risk levels of bonds remain relatively constant, investors have changed the spreads they demand to accept
this risk. In this case, because the yield spread (risk premium) declined, it implies a decline in the slope of
the SML as shown in the following graph

15. Give an example of a liquid investment and an illiquid investment.

Discuss why you consider each of them to be liquid or illiquid.
The ability to buy or sell an investment quickly without a substantial price concession is
known as liquidity.
An example of a liquid investment asset would be a United States Government Treasury Bill.
A Treasury Bills can be bought or sold in minutes at a price almost identical to the
quoted price. In contrast, an example
of an illiquid asset would be a specialized machine or a parcel of real estate in a remote area.
In both cases, it might take a considerable period of time to find a potential seller or buyer
and the actual selling price could vary substantially from expectations.

PROBLEMS

1. On February 1, you bought 100 shares of stock in the Francesca

Corporation for $34 a share and a year later you sold it for $39 a share.
During the year, you received a cash dividend of $1.50 a share.
Compute your HPR and HPY on this Francesca stock investment.

Ending Value of Investment ( including Cash Flows )

1. HPR =
Beginning Value of Investment
39 + 1 .50 40 . 50
= = =1 . 191
34 34
HPY = HPR - 1 = 1 .191 - 1 =.191= 19 . 1%

2. On August 15, you purchased 100 shares of stock in the Cara Cotton
Company at $65 a share and a year later you sold it for $61 a share.
During the year, you received dividends of $3 a share. Compute your
HPR and HPY on your investment in Cara Cotton

61 + 3 64
2. HPR = = =−. 985
65 65
HPY = HPR - 1 =. 985 - 1 = - .015= -1 .5%

3. At the beginning of last year, you invested $4,000 in 80 shares of the

Chang Corporation. During the year, Chang paid dividends of $5 per
share. At the end of the year, you sold the 80 shares for $59 a share.
Compute your total HPY on these shares and indicate how.

$4,000 used to purchase 80 shares = $50 per share

HPR (59 xIncrease

(Price x 80))=459,720+400
80)+(5Alone x 80 4 ,720
= =5 , =1 120. 180
HPR = = =1. 280
4 , 000 44,000
,000 4 ,000 4 , 000
HPY (=Price
HPRIncrease
- 1 = 1Alone)= 1 . 180 -=1 28%
.280 - 1 =.280 =. 180 = 18%
 Therefore: HPY (Total) = HPY (Price Increase) + HPY (Div)
.280 = .180 + HPY (Div)
.10 = HPY (Dividends)

4. The rates of return computed in Problems 1, 2, and 3 are nominal rates

of return. Assuming that the rate of inflation during the year was 4
percent, compute the real rates of return on these investments.
Compute the real rates of return if the rate of inflation was 8 percent

Holding Period Return

4. Real Rate of Return = −1
1+Rate of Inflation

For Problem #1: HPR = 1.191

1. 191 1.191
at 4% inflation: −1= −1=1 .145−1=. 145=14 . 5%
1 +.04 1.04
1. 191 1. 191
at 8% inflation: −1= −1=1.103−1=.103=10 .3%
1+. 08 1. 08

For Problem #2: HPR = .985

. 985
at 4% inflation: −1=.947−1=−.053=−5 . 3 %
1. 04
. 985
at 8% inflation: −1=. 912−1=−. 088=−8. 8 %
1. 08

For Problem #3: HPR = 1.280

1. 280
at 4% inflation: −1=1 .231−1=. 231=23 .1 %
1. 04
1. 280
at 8% inflation: −1=1 .185−1=. 185=18 . 5 %
1. 08
 5

n HPYi
5(a ). Arithemetic Mean ( AM)=∑
i=1 n
(. 19 )+(. 08)+(−. 12)+(−. 03 )+( .15 )
AM T =
5
.27
= =. 054
5
(.08 )+(. 03 )+(−.09 )+( . 02)+(. 04 )
AM B =
5
.08
= =. 016
5

Stock T is more desirable because the arithmetic mean annual rate of return is higher.
 √∑
n
2
5(b ). Standard Deviation (σ )= [ Ri −E( Ri )] /n
i=1

Variance
Σ B=(.08−. 016 )2 +(.
T =(.19−. )2 +(.016
05403−. )2 +(−.)09−.016
08−.054 2
)2 +(. 02−.016)
+(−.12−.054 )2 +(−. 03−.
2
+(.054 )2 +(. 15−.054
04−.016 )2 )2
¿.01850+.00068+.
¿.00410+.00020+.01124 03028+.+.00002+.
00706+. 00922
00058
¿.06574
¿.01614
σ 2 =. 06574
01614/5=.01315
/5=. 00323
σ TB=√ .01314=.
.00323=.11467
05681

Standard Deviation
5(c ). Coefficient of Variation =
Expected Return
.11466
CVT = =2 .123
. 054
. 05682
CV B= =3 . 5513
. 016

By this measure, T would be preferable

5(d). Geometric Mean (GM) = 1/n – 1

where  = Product of the HRs

GMT = [(1.19) (1.08) (.88) (.97) (1.15)]1/5 -1

= [1.26160] 1/5 –1 = 1.04757 –1 = .04757

GMB = [(1.08) (1.03) (.91) (1.02) (1.04)]1/5 -1

= [1.07383] 1/5 –1 = 1.01435 – 1 = .01435

Stock T has more variability than Stock B. The greater the variability of returns, the greater the
difference between the arithmetic and geometric mean returns

6.
6. E(RMBC) = (.30) (-.10) + (.10) (0.00) + (.30) (.10) + (.30) (.25)
= (-.03) + .000 + .03 + .075 = .075

7.

E(RLCC) = (.05) (-.60) + (.20) (-.30) + (.10) (-.10) + (.30) (.20) + (.20) (.40) + (.15) (.80)
= (-.03) + (-.06) + (-.01) + .06 + .08 + .12 = .16

8. Without any formal computations, do you consider Madison Beer in

Problem 6 or Lauren Computer in Problem 7 to present greater risk?
Discuss your reasoning.
The Lauren Computer Company presents greater risk as an investment because the range
of possible returns is much wider.

9. During the past year, you had a portfolio that contained U.S.
government T-bills, longterm government bonds, and common stocks. The
rates of return on each of them were as follows: U.S. government T-bills
5.50% U.S. government long-term bonds 7.50 U.S. common stocks 11.60
During the year, the consumer price index, which measures the rate of
inflation, went from 160 to 172 (1982 – 1984 = 100). Compute the rate of
inflation during this year. Compute the real rates of return on each of the
investments in your portfolio based on the inflation rate.

CPIn+1 − CPIn
9. Rate of Inflation =
CPIn
where CPI = the Consumer Price Index
172-160 12
Rate of Inflation = = =.075
160 160
HPR
Real Rate of Return = −1
1+rate of inflation
1.055
U.S. Government T-Bills = −1=.9814−1=−.0186
1.075
1.075
U.S. Government LT bonds = −1=0
1.075
1.1160
U.S. Common Stocks = −1=1.0381−1=.0381
1.075

10. You read in BusinessWeek that a panel of economists has estimated

that the long-run real growth rate of the U.S. economy over the next five-
year period will average 3 percent. In addition, a bank newsletter
estimates that the average annual rate of inflation during this five-year
period will be about 4 percent. What nominal rate of return would you
expect on U.S. government T-bills during this period?

NRFR = (1 + .03) (1 + .04) – 1 = 1.0712 – 1 = .0712

(An approximation would be growth rate plus inflation rate or .03 + .04 = .07.)
11.
11. What would your required rate of return be on common stocks if you
wanted a 5 percent risk premium to own common stocks given what you
know from Problem 10? If common stock investors became more risk
averse, what would happen to the required rate of return on common
stocks? What would be the impact on stock prices?

Return on common stock = (1 + .0712) (1 + .05) – 1

= 1.1248 – 1 = .1248 or 12.48%
(An approximation would be .03 + .04 + .05 = .12 or 12%.)

As an investor becomes more risk averse, the investor will require a larger risk
premium to own common stock. As risk premium increases, so too will required rate
of return. In order to achieve the higher rate of return, stock prices should decline.

12. Assume that the consensus required rate of return on common stocks is
14 percent. In addition, you read in Fortune that the expected rate of
inflation is 5 percent and the estimated long-term real growth rate of the
economy is 3 percent. What interest rate would you expect on U.S.
government T-bills? What is the approximate risk premium for common
stocks implied by these data?

Nominal rate on T-bills (or risk-free rate) = (1 + .03) (1 + .05) – 1

= 1.0815 – 1 = .0815 or 8.15%
(An approximation would be .03 + .05 = .08.)

The required rate of return on common stock is equal to the risk-free rate plus a risk
premium. Therefore the approximate risk premium for common stocks implied by
these data is: .14 - .0815 = .0585 or 5.85%.

(An approximation would be .14 - .08 = .06.)

 APPENDIX PROBLEMS

1(a). Expected Return = (Probability of Return)(Possible Return)

n
E( RGDC )=∑ Pi [ Ri ]
i=1

¿( . 25)(−.10 )+( . 15)( 0 . 00 )+( .35 )( . 10)+( . 25 )(. 25 )

¿(−. 025)+( . 000 )+( . 035)+(. 0625 )
¿( . 0725)

n
σ 2 =∑ Pi [ Ri−E ( Ri )]2
i =1

¿( . 25)(−.100−. 0725)2 +( . 15)( 0 . 00−. 0725 )2 +( . 35)( . 10−. 0725 )2 +( . 25 )(. 25−.0725 )2
¿( . 25)( . 02976 )+( .15 )( . 0053)+( . 35 )( . 0008 )+( . 25)( . 0315)
¿ .0074 +. 0008+. 0003+.0079
¿ .0164

σ GDC= √ . 0164=.128

1(b). Standard deviation can be used as a good measure of relative risk between two investments that have
the same expected rate of return.

1(c). The coefficient of variation must be used to measure the relative variability of two investments if
there are major differences in the expected rates of return.

2.
2(a). E(RKCC) = (.15)(-.60) + (.10)(-.30) + (.05)(-.10) + (.40)(.20) + (.20)(.40) + (.10)(.80)
= (-.09) + (-.03) + (-.005) + .08 + .08 + .08 = .115

2 = (.15)(-.60 -.115)2 + (.10)(-.30 -.115)2

+ (.05)(-.10 -.115)2 + (.40)(.20 -.115)2
+ (.20)(.40 -.115)2 + (.10)(.80 -.115)2

= (.15)(-.715)2 + (.10)(-.415)2 + (.05)(-.215)2

+ (.40)(.085)2 + (.20)(.285)2 + (.10)(.685)2

= (.15)(.5112) + (.10)(.1722) + (.05)(.0462)

+ (.40)(.0072) + (.20)(.0812) + (.10)(.4692)

= .07668 + .01722 + .00231 + .00288 + .01624 + .04692

= .16225

σ KCC=√ .16225=. 403

2(b). Based on [E(Ri)] alone, Kayleigh Computer Company’s stock is preferable because of the higher
return available.

2(c). Based on standard deviation alone, the Gray Disc Company’s stock is preferable because of the
likelihood of obtaining the expected return since it has a lower standard deviation

3.
 . 063+. 081+. 076+. 090+ .085 . 395
3(a ). AMUS= = =. 079
5 5

. 150+.043+.374+ .192+. 106 .865

AM UK = = =. 173
5 5

Standard deviation of U.S. T-bills: 0.92% or 0.0092

Standard deviation of U.K. Common Stock: 11.2% or 0.112

3(b). The average return of U.S. Government T-Bills is lower than the average return of United Kingdom
Common Stocks because U.S. Government T-Bills are riskless, therefore their risk premium would
equal 0. The U.K. Common Stocks are subject to the following types of risk: business risk, financial
risk, liquidity risk, exchange rate risk, (and to a limited extent) country risk. The standard deviation
of the T-bills and their range (9% minus 6.3%) is much less than the standard deviation and range
(37.4% minus 4.3%) of the U.K. common stock.

3(c). GM = 1/n – 1
US = (1.063) (1.081) (1.076) (1.090) (1.085) = 1.462

GMUS = (1.462)1/5 – 1 = 1.079 – 1 = .079

UK = (1.150) (1.043) (1.374) (1.192) (1.106) = 2.1727

GMUK = (2.1727)1/5 – 1 = 1.1679 – 1 = .1679

In the case of the U.S. Government T-Bills, the arithmetic and geometric means are approximately
equal (.079), an indicator of a small standard deviation (which as we saw in 3a equals 0.0092). The
geometric mean (.1679) of the U.K. Common Stocks is lower than the arithmetic mean (.173); this is
always the case when the standard deviation is non-zero. The difference between the arithmetic and
geometric means is larger, the larger the standard deviation of returns.
 TUTORIAL

1. What should an investor be compensated for?

The time the funds are committed.
The expected rate of inflation during this time period.
The uncertainty of the future payments

1. 2. On February 1, you bought 100 shares of stock in the

Francesca Corporation for $34 a share and a year later you
sold it for $39 a share. Compute your HPR and HPY on this
Francesca stock investment.

HPR= 39/34= 1.1471

HPY= 14.71%

2. 3. Your investment of £250 in Stock A is worth £350 in two

years while the investment of £100 in Stock B is worth £120 in
six months. What are the annual the HPYs on these two
stocks?

Stock A:
HPR=350/250=1.4
Annual HPR= (1.4)^1/2=
1.1832
Annual HPY= 1.1832-1= 18.32%

Stock B:
HPR=120/100= 1.2
Annual HPR= (1.2)^1/0.5=1.44
Annual HPY= 1.44-1= 44%

1. 4. Suppose you invested €100 three years ago and it is worth

€110.40 today. The information below shows the annual ending
values and HPR and HPY. This example illustrates the
computation of the AM and the GM over a three-year period
for an investment.
Year Beginning Value Ending Value HPR HPY
1 100 115.0 1.15 0.15
2 115 138.0 1.20 0.20
 3 138 110.4 0.80 -0.20

AM=[(0.15)+(0.20)+(-0.20)] / 3
= 0.15/3=5%
GM=[(1.15) x (1.20) x (0.80)]^1/3 –1
=(1.104)1/3 -1=1.03353 -1 =3.35%.

5. Discuss the significance of the coefficient of variation measure

Coefficient of variation is a relative risk measure that estimates the risk per
unit of return. It is useful when comparing the risks of two assets that have
different expected rates of return.

6. Assume that the mean monthly return on a T-Bill is 0.5% with a standard
deviation of 0.58%. Suppose we have another investment, say, Y with a 1.5%
mean monthly return and standard deviation of 6%.

CVtb=
0.58%/0.5%=1.16
CVy= 6%/1.5%=4

Investment Y is riskier than an investment on T-Bills.

7.

Calculate the standard deviation of stock ABC based on the following

estimates:
Possible rates Probabilities
of return
15% 0.45
12.3% 0.10
8.7% 0.35
-2.1% 0.10

E(r)= (0.45*15%) +(0.10*12.3%) +(0.35*8.7%) +(0.10*-

2.1%) = 10.82% SD=

√[(0.45)(15% − 10.82%)^2] + [(0.10)(12.3% − 10.82%)^2] + [(0.35)(8.7% −
10.82%)^2] + [(0.10)(−2.1% − 10.82%)^2]
= 0.0513

8. Identify and discuss the factors that influence the real

risk-free rate.
 Influenced by time preference of individuals for the consumption
of income Influenced by investment opportunities in the economy
Investment opportunities available are determined by the long-run
real growth rate of the economy. Thus, a positive relationship
exists between the real growth rate in the economy and the RRFR.

9. Calculate the real risk-free rate for an investment with a nominal

risk-free rate of 8.2% and an expected inflation of 3%.

(1+8.2%)/(1+3%)-1 =5.05%
(1+8.2%)/ (1+3%) -1 =5.05%

10.Explain how political instability contributes to movement along

the SML.

The fundamental risk factor increases the risk of investments, causing them to move
up the SML in order to reflect increased risk levels