Describe the concept of the “equity risk premium” in your own words. ANSWER: Wha

Question

Describe the concept of the “equity risk premium” in your own words.

ANSWER:

What have been the historic range of U.S. stock returns, over inflation, over the very, very long term? Have there been periods of time when U.S. stocks failed to outperform inflation for a significantly long period of time? If so, when? (The textbook provides the answer to this question.)

ANSWER:

Eugene Fama, Sr. (Nobel prize winner in economics) and Kenneth French published a paper in 1992, which over the past 23 years as easily been the most influential academic paper in the field of investments. What two risk factors did Fama and French identify in this paper, other than the basic risk of the market itself (“market risk”)? Describe these two risk factors.

ANSWER:

Rick Ferri states: “Historically, small-cap value stocks have added more return with less risk than microcap stocks, Nonetheless, I believe it is worth having both in a portfolio.” He also states: “Over a 30-year period, a mix of 70 percent in the total market and 30 percent in the small-cap value index would have increased U.S. equity returns by 2.0 percent with very little increase in observed portfolio risk.”

If you were to construct an investment portfolio of U.S. large cap stocks, U.S. microcap stocks, U.S. small cap value stocks, and U.S. short-term Treasury notes, for investing a 22-year old college graduate’s 401(k) contributions (which cannot be withdrawn without paying income taxes and a 10% penalty for at least 33 years) how would you construct it? What percentages would you have in each asset class? Please complete this chart (note – there is no “one” right answer!)

(A)

ASSET CLASS

(B)

EXPECTED AVERAGE ANNUALIZED RETURN

(per Professor Rhoades, over next 15 years)

(C)

YOUR ASSET ALLOCATION PERCENTAGE

(D) = B (as a decimal) x C (as a percentage)

COMPUTE THE CONTRIBUTION OF THE ASSET CLASS TO THE PORTFOLIO’S RETURN

U.S. Large Cap Stocks

6%

%

%

U.S. Micro Cap Stocks

8%

%

%

U.S. Small Cap Value Stocks

10%

%

%

U.S. Treasury 5-year notes

3%

%

%

(ADD IT UP!) EXPECTED PORTFOLIO RETURN:

%

What is the (Fama-French) “three-factor model”? Has the three-factor model been tested in both U.S. and overseas markets, and if so, what is the result?

ANSWER:

Describe the “momentum effect” in your own words. Give an example, in your own words.

ANSWER:

Why might the “momentum effect” be difficult to capture, if you were to personally trade stocks? (Critical thinking question.)

ANSWER:

The newest major factor, the “profitability factor,” has also been applied in mutual fund construction. Describe the “profitability factor” in your own words.

ANSWER:

Please describe the “investment factor” in your own words.

ANSWER:

CRITICAL THINKING QUESTION: Why might the “profitability factor” be useful in an investment portfolio that is already “value-tilted” to take advantage of the “value risk premium” (a.k.a., “value factor)?

ANSWER:

Describe the concept of the “equity risk premium” in your own words.

ANSWER:

What have been the historic range of U.S. stock returns, over inflation, over the very, very long term? Have there been periods of time when U.S. stocks failed to outperform inflation for a significantly long period of time? If so, when? (The textbook provides the answer to this question.)

ANSWER:

Eugene Fama, Sr. (Nobel prize winner in economics) and Kenneth French published a paper in 1992, which over the past 23 years as easily been the most influential academic paper in the field of investments. What two risk factors did Fama and French identify in this paper, other than the basic risk of the market itself (“market risk”)? Describe these two risk factors.

ANSWER:

Explanation / Answer

(1) Equity Risk Premium stems from the concept of a direct relationship between risk and return of financial investments. The risk-return relationship states that investments with greater risks will inordinately beget greater returns. Continuing our logic along the aforementioned lines, a risk-free asset (practically impossible though) such as a US Treasury bond will give low returns and the same is known as the risk-free rate (of return). Investing in the equity markets is understandably riskier than investing in US Treasury Bonds, thereby begetting a higher return as compared to the risk-free rate. The difference between the higher but riskier equity returns and the lower but less risky risk-free returns is known as the equity risk premium. It signifies the premium or additional return made by equity investors as compensation for taking up the greater risk (as compared to US Treasury Bonds) of investing in equity.

NOTE: Please raise separate queries for solutions to the remaining unrelated questions.

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