Financial Management of Corporations
Type your answers to the following three questions, putting your answer to each question on a separate page. Include diagrams and / or mathematical expressions where appropriate. (Neat hand-drawn diagrams and hand-written mathematical expressions are acceptable; put them on the same page as your typed answer or else on a separate page following your typed answer.) Put your name and assigned student number in the top-right corner of every solution page.
1. (Answer in 4-6 sentences.) A capital market has a large number of (risky) capital assets. One day someone invents a risk-free asset. Investors can invest in this asset and earn the risk-free rate of return, RF. Investors can also sell the risk-free asset (equivalent to getting a loan at an interest rate of RF) and use the cash to buy risky capital assets. Explain whether investors are helped or hurt by the introduction of a risk-free asset.
2. (Answer in 4-6 sentences.) Each capital asset in the market portfolio, M, has its own beta. Explain i) what beta measures and ii) how beta is derived.
3. (Answer in 4-6 sentences.) Rational investors demand that riskier capital assets have higher expected returns. In Chapter 11 we saw several measures of an asset's risk. Not all of them relate to the asset's expected return, however. Explain i) how the risk a single capital asset relates to the asset's expected return according to the capital asset pricing model; and ii) how this relationship is derived.