Questions Relating to Chapter 5 – Hedging and Spreading Applet Graph Instructions: - Click on the '% Invested in Firm A' box to change this value ranging between 0% and 100%.
- note: the '% Invested in Firm B is automatically calculated as 100% – % Invested in Firm A.
The next two instructions apply to Hedging:
- Use your mouse to drag the probability slider to change the probability of an Expansion
- note: pr(Recession) = 1.0 – pr(Expansion)
- Use your mouse to drag the Correlation slider completely to the left for a correlation measure of –1 or completely to the right for a correlation measure of +1.
- Click on the Hedging / Spreading toggle button to switch to an example of Spreading or back to Hedging.
- Press 'Reset' to start over.
Questions: HEDGING Suppose you have $1,000 to invest. The table above shows the payoffs you would receive by investing in one of two firms or by splitting your funds between the two firms. The payoffs of the two firms can be either negatively or positively correlated. If you choose a correlation of –1, Firm A pays off $100 per $1,000 invested when the economy is a state of expansion and pays nothing otherwise. Firm B pays off $100 per $1,000 invested when the economy is in a recession and pays nothing otherwise. If you choose a correlation of +1, both firms pay off $100 per $1,000 invested when the economy is in a state of expansion and pay nothing when the economy is in a recession. Complete the exercises below to see how the risk and return associated with your investment is affected by how you divide your funds between the two firms, by the correlation among payoffs, and by changes in the probabilities associated with a particular state of the economy. - Choose a correlation among payoffs of –1. Set the probability of expansion slider at 50 percent and set the percentage invested in Firm A to 100 percent. What is the expected value and standard deviation of this investment strategy?
- Leaving the probability of expansion and the correlation among payoffs unchanged, decrease the amount invested in Firm A to 75 percent. What happens to the expected value and standard deviation?
- Now, set the amount invested in Firm A to 50 percent. What happens to the expected value and standard deviation? What is the advantage of this investment strategy?
- Leaving the amount invested in Firm A at 50 percent, change the probability of an expansion by moving the slide bar. What happens to the expected value and standard deviation as the probability changes?
- Set the amount invested in Firm A to 100 percent and move the slide bar to change the probability of an expansion. What happens to the expected value and standard deviation of your investment as an expansion becomes more likely?
- Return the probability of expansion to 50 percent and leave the percentage invested in Firm A at 100 percent. Change the correlation among payoffs to +1. What is the expected value and standard deviation of this investment strategy?
- Now, leaving everything else unchanged, set the percentage invested in Firm A to anything less than 100 percent. What happens to the expected value and standard deviation? Explain why.
View Answers SPREADING Suppose you have $1,000 to invest. The table above shows the payoffs you would receive by investing in one of two firms or by splitting your funds between the two firms. Each firm pays off $100 per $1,000 invested half of the time and pays nothing otherwise. In this case, the payoffs of the two firms are independent of one another: Whether Firm A pays off is completely unrelated to whether Firm B pays off. - Set the percentage invested in Firm A to 100 percent. What is the expected value and standard deviation of this investment strategy?
- Now, change the percentage invested in Firm A to 50 percent. What happens to the expected value and standard deviation?
- Change the percentage invested in Firm A to 20 percent. How does the standard deviation of your investment compare with your answers to questions eight and nine?
View Answers |
