How to Calculate Expected Rate of Return

¶ … represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning.

There's a substantial unexpected increase in inflation.

The big issue with inflation is that the same amount of cash becomes worth less. For example, $100 in 1980 was worth a lot more than $100 is now. Some inflation is expected, normal and actually a good thing. However, deflation and stagflation are both less than desirable. As far as investments, whether massive inflation is a bad thing depends on the investment in question. Since variances in inflation/deflation smooth out over time, the bigger issue is usually the fact that returns on investment, revenues and so forth will be inflated in an inflation-heavy period as compared to times when inflation is not an issue. However, people that are on fixed incomes and invest are usually hit quite hard by inflation because their fixed income amounts are worth less than they were even if the dollar amount has not changed. A way to mitigate this problem is to use investments that are indexed against inflation. Many bonds are like that with Treasury inflation-protected securities being one of them (Investopedia, 2003).

b. There's a major recession in the U.S.

The two bad things about recessions is that people are usually much tighter with their money and investment performance in general is less than good much of the time. Some businesses buck expectations and do well even when times are tight but this is not the norm and, thus, stock market indices tend to go down at least some, if not a lot.

c. A major lawsuit is filed against one large publicly traded corporation.

It would certainly impact investors and their decisions about that firm. It might also affect other businesses in that industry. However, the damages to investor confidence and actions would probably not be anything beyond that unless there is something like the late 90's tech bubble or the Enron (or similar) scandals going on.

2.Use the CAPM to answer the following questions:

a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.

The answer to that question would be the risk free rate (we shall use "R" for that item) plus the beta multiplied against the return on asset minus the risk free rate. In other words, the formula and answer would be:

I = 4 + 1.2(12-4) = 13.6% (Investopedia, 2008).

b. Find the Risk-Free Rate given that the Expected Rate of Return on Asset "j" is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset "j" is 0.8.

The formula for this question would be risk free rate plus the beta times expected market return minus the risk free rate. That formula would be the Expected Return.

9 = R + 0.8(10 -- R)

9 = R + 8-0.8R

1 = 0.2R

R = 5 -- The risk free rate is five percent. (Investopedia, 2003)

c. What do you think the Beta (?) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.

If the stocks were picked at random, the beta should be 1 or very close to it. This is because the beta should be average for the market and that is what a beta of 1 represents (Investopedia, 2012). If the stocks are not random, it should still be very close to 1 but would NOT be one because some stocks would have lower betas and some would have higher betas. Even so, picking one half of all stocks would smooth out a lot of the outliers.

3.In one page explain what you think is the main 'message' of the Capital Asset Pricing Model to corporations and what is the main message of the CAPM to investors?

The main "message" behind the Capital Asset Pricing Model (which is what CAPM stands for) is that investors should be compensated in one of two ways, those being time value of money and risk. The time value of money is defined by the risk free rate in a given formula that is meant to compensate vendors for putting money into an investment over time. The other part of this overall formula is the risk and how investors are compensated for taking on the additional risk. This is where the beta comes in. The bate compares the returns on the asset to the market over a period of time and to the premium for that same market.