Question

QUESTION FOUR you are given the following data about expected returns on a security on the US when different states of the economy have the same probability of occurrence 2014 State Return Strong growth 9.0% Normal growth 6.5% Weak growth 2.5% Recession -4.5% Required: Compute and fully interpret the following for the investment: a) The Expected retum for the security. [3 Marks] b) The volatility of the security retums using the standard deviation. [6 Marks] c) Evaluate the security's performance assuming a benchmark target rate of 3.5% [4 Marks] d) Explain the rationale behind the security performance evaluation method used in (c) above. [7 Marks] in Sortines [TOTAL: 20 Marks) 3.375 Page 4 of 5 Scanned by CamScanner

Answer 1

Attached below is the spreadsheet showing all the calculations involved in arriving at the answer

a) Expected Return 3.375% which is the arrived at by assigning a probability of 0.25 to each growth possibility

b) Calculating the Std Deviation of the four returns leads us to 5.89 as SD

c) Assuming equal probability the return as per A is 3.375% which is below the benchmark 3.5% by (0.125%)

d) A Securities performance can be measured in absolute terms or relative performance against a benchmark . The benchmark represents the broader market implying the average performance should be ideally equal to this. In this case actual performance is not yet known but by assigning equal probabilities to the 4 possible outcomes the expected return is 3.375%. Unfortunately the benchmark remains constant at 3.5% which is higher . So this mathematically calculated expected performance is actually below average.    .

Addendum spreadsheet attached

Prob Return SUM 2.25 2.25 A 9 0.25 В Mean Return 6.5 0.25 1.625 Std Deviation 2.5 0.25 0.625 5.89 -4.5 0.25 -1.125 ТОTAL 13.5 3.375 Benchmark с 3.50 Below becnhmark (0.125) Return