Question

john c hull risk management

1.4 What is the difference between systematic and nonsystematic risk? Which is more important to an equity investor? Which can lead to the bankruptcy of a corporation? 1.5 Outline the arguments leading to the conclusion that all investors should choose the same portfolio of risky investments. What are the key assumptions? 1.6 The expected return on the market portfolio is 12% and the risk-free rate is 6%. What is the expected return on an investment with a beta of (a) 0.2, (b) 0.5, and (c) 1.4? 1.7 "Arbitrage pricing theory is an extension of the capital asset pricing model.” Explain this statement. 1.8 "The capital structure decision of a company is a trade-off between bankruptcy costs and the tax advantages of debt." Explain this statement. 1.9 What is meant by risk aggregation and risk decomposition? Which requires an in-depth understanding of individual risks? Which requires a detailed knowl- edge of the correlations between risks? 1.10 A bank's operational risk includes the risk of very large losses because of em- ployee fraud, natural disasters, litigation, etc. Do you think operational risk is best handled by risk decomposition or risk aggregation? (Operational risk will be discussed in Chapter 23.) 1.11 A bank's profit next year will be normally distributed with a mean of 0.6% of assets and a standard deviation of 1.5% of assets. The bank's equity is 4% of assets. What is the probability that the bank will have a positive equity at the end of the year? Ignore taxes. 1.12 Why do you think that banks are regulated to ensure that they do not take too much risk but most other companies (for example, those in manufacturing and retailing) are not? 1.13 List the bankruptcy costs incurred by the company in Business Snapshot 1.1. 1.14 The return from the market last year was 10% and the risk-free rate was 5%. A hedge fund manager with a beta of 0.6 has an alpha of 4%. What return did the hedge fund manager earn?

Answer 1

`1.4 Systematic risk is the risk which is related to the whole market hence it cannot be minimized whereas unsystematic risk is related to a particular security or market and can be minized by making a portfolio or avoiding to invest in such security or market. systematic risk is more relevant for equity investors.

1.6 Expected Return =a. 6%+(12-6)%*0.2=7.2%

b.6%+(12-6)%*0.5=9%

c.6%+(12-6)%*1.4=14.4%

1.7 Arbitrage pricing theory involves determining the underpriced and overpriced securities and then taking advantage of such mispricing. Determining the mispricing situation existence involves usage of required rate of reurn on a particular security which can be found out by CAPM method.

1.14 r= Rf +beta*(Rm-Rf) + Alpha

so, r=5+(10-5)*0.6 + 4

=12%