Chapter 2

Chapter 2

Exercise 1

Mr Woolly is choosing between two possible investment opportunities:

a. A government bond which will mature in exactly one year and on that date the nominal amount (£100) and a 3% interest payment will be made. The price of £100 nominal of this stock is £98 today.

b. 100 shares costing 98p each in a company specialising in software for personal computers. The return on the shares is uncertain but the investor has read a report on the company which estimates the one-year return to be as follows, subject to how the economy behaves and how the company's products are received by the market:

|Reception of |Economic situation |

|new products | |

| |Growth |Recession |

|Good |r = 30% |r = 15% |

| |p = 0.2 |p = 0.3 |

|Bad |r = 10% |r = -10% |

| |p = 0.3 |p = 0.2 |

where r = total rate of return and p = probability

i) Using expected values and standard deviations, calculate the expected return and risk of the two investments.

ii) Bearing in mind that inflation is expected to be 5% in the next twelve months, which investment would you advise Mr Woolly to make?

iii) What other factors would you take into consideration?

Solution to Exercise 1(i)

The expected return on the government bond is 5.10% pa, calculated as follows (see p41 for full explanation):

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If we assume that the bond...