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Chapter 17: Q5. (page 369)

Sammy buys stock in a suntan-lotion maker and also stock in an umbrella maker. One stock does well when the weather is good; the other does well when the weather is bad. Sammy’s portfolio indicates that “weather risk” is a _______ risk.

  1. diversifiable

  2. nondiversifiable

  3. automatic

Short Answer

Expert verified

The correct option is (a): diversifiable

Step by step solution

01

Step 1. Explanation

Sammy buys two stock where one performs well in good weather and one perform in bad weather. If Sammy invests all his money in one stock, the return will be low when the stock is not performing. If Sammy invests all his money in two different stocks, if one is not performing and one is performing, the return will be more than investing all money in one. Thus, Sammy is diversifying risk.

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Most popular questions from this chapter

The interest rate on short-term U.S. government bonds is 4 percent. The risk premium for any asset with a beta = 1.0 is 6 percent. What is the average expected rate of return on the market portfolio?

  1. 0 percent

  2. 4 percent

  3. 6 percent

  4. 10 percent

Next, consider another pair of assets, C and D. Asset C will make a single payment of \(150 in one year while D will make a single payment of \)200 in one year. Assume that the current price of C is \(120 and that the current price of D is \)180.

c. What are the rates of return of assets C and D at their current prices? Given these rates of return, which asset should investors buy and which asset should they sell?

d. Assume that arbitrage continues until C and D have the same expected rate of return. When arbitrage ends, will C and D have the same price?

Compare your answers to questions a through d before answering question e.

e. We know that arbitrage will equalize rates of return. Does it also guarantee to equalize prices? In what situations will it equalize prices?

Asset X is expected to deliver 3 future payments. They have present values of, respectively, \(1,000, \)2,000, and \(7,000. Asset Y is expected to deliver 10 future payments, each having a present value of \)1,000. Which of the following statements correctly describes the relationship between the current price of Asset X and the current price of Asset Y?

  1. Asset X and Asset Y should have the same current price.

  2. Asset X should have a higher current price than Asset Y.

  3. Asset X should have a lower current price than Asset Y.

What is compound interest? How does it relate to the formula Xt = (1 + i)t X0? What is present value? How does it relate to the formula Xt/(1 + i)t = X0?

Tammy can buy an asset this year for \(1,000. She is expecting to sell it next year for \)1,050. What is the asset’s anticipated percentage rate of return?

  1. 0 percent

  2. 5 percent

  3. 10 percent

  4. 15 percent
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