Modern finance - Assignment Example

The formula is structured this way in order to make its analysis easier and more standardized. c. The investor in this case, by applying the model, understands the non feasibility of exercising the call option, since the price of the asset is lower than the strike price of 110. Question 2 a. Re = Ra + D/E(Ra-Rd) Firm A: 14% + 0.4(14%-9%) = 0.16 or 16% Firm B: 14% + 0.5(14%-9%) = 0.165 or 16.5% The return to equity represents the return required by shareholders. In this scenario, with all other factors constant, as the Debt to Equity ratios only differ, the results show that for Firm B, the shareholders require a 0.

5% higher return than Firm A shareholders, due to the higher leverage. b. given the data, we also know that Risk = variance = w^2(a)*sigma(a)^2 + w(b)^2*sigma(b)^2 + 2w(a)w(b)*p*sigma(a)*sigma(b) i. 0.52*0.052 + 0.52*0.062 + (2*0.5*0.5*1*0.05*0.06) = 0.00303 Std dev = 5.5% ii. 0.52*0.052 + 0.52*0.062 + (2*0.5*0.5*-1*0.05*0.06) = 0.00003 Std dev = 0.5% iii. 0.52*0.052 + 0.52*0.062 + (2*0.5*0.5*0.5*0.05*0.06) = 0.00228 Std dev = 4.77% c. . Risk averse investors will usually never invest in risky assets and will play it safe.

This means they will remain on or close to the Y axis of the graph below, taking on minimal or no risk and earning a low return. Investors with higher risk preferences will balance their portfolios with risky and risk free assets to achieve an optimal balanced portfolio which offers a return in line with risks. Their goal will be to reach the efficient frontier as shown below in the graph. Adding a risk free asset to a risk averse investors portfolio will not affect his return much. However, doing the same with a risk taking investor may reduce the return earned by the portfolio.

As money used in the risk free asset could otherwise be utilized in higher risky assets to obtain a higher return. References Botkin, S. C. (2007). Lower your taxes-big time! : wealth-building, tax reduction secrets from an IRS insider. New York, McGraw-Hill. Chriss, N. (1997). Black-Scholes and beyond option pricing models. New York, McGraw-Hill. http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=51958. JA?GER, C., & BO?Ckhaus, C. F. (2011). The Black & Scholes formula and resulting advancements derivation and interpretation with special focus on the validity of the underlying assumptions.

Aachen, Shaker. Siegel, J. G., Shim, J. K., Hartman, S., & Siegel, J. G. (1998). Schaum's quick guide to business formulas 201 decision-making tools for business, finance, and accounting students. New York, N.Y., McGraw-Hill.