Reading: Investor Expectations and Fundamentals: Disappointment Ahead? by John B. Carlson and Eduard A. Pelz
Cleveland Fed Economic Commentary, May 1 , 2000.

Questions from reading:

1. What is the equity premium? What factors may have caused it to decline in recent years?
2. Explain carefully how and why a decline in the required rate of return affects stock values and returns. What paradoxical results appear?
3. Will investors expecting above-average returns in the stock market be disappointed? Why?

1. Compute the expected return for the following stock:
   
   

   Table 1: Ficticious Corp
   State of Economy	Probability	Return
   Recession	10%	-25%
   Stagnant	20%	-5
   Average	40	10
   Good	20	15
   Wow!	10	35



2. Using the data in Table 1 above, answer the following questions:
   1. Compute the standard deviation of the returns.
   2. What kind of risk is measured by the standard deviation?
   3. Is the standard deviation the appropriate measure of risk for an asset that is held by itself?
   
   

3. Why can you not compute the risk of a portfolio by finding the weighted average of individual securities' standard deviations?
   
   
4. If the risk-free rate of return is 5% and the average return on the market is 12% , what is the risk premium charged by the market? If investors become more risk averse, would the premium rise or fall. Compute the required rate of return demanded by investors for firms with a beta equal to:
   
   1. 0.5
   2. 1.0
   3. 1.5
   4. 2.5
   
   
5. Discuss the following:
   1. How is total risk measured?
   2. What two types of risk make up total risk?
   3. What is the difference between firm-specific risk and market risk?
   4. Which type of risk can be eliminated by diversifying your portfolio?
   5. Which type of risk remains after a portfolio is diversified?