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Will you please explain in detail the relationship between risk tolerance levels and macroeconomic variables?

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Risk is the uncertainty that you may not earn your expected return on your investments. For example, you may expect to earn 20% on your stock mutual fund every year. But your actual rate of return may be much lower.

For example, the S&P 500 index averaged yearly gains of about 20% for the five years that ended in 1999. In 2000, however, the index declined more than 9%. Bonds, meanwhile, performed better than stocks for the first since 1994.

Investment risk. Investment risk is the chance that your investment value will fall. Standard deviation is commonly used to measure investment risk. It shows a stock or bond's volatility, or the tendency of its price to move up and down from its average. As standard deviation increases, so does investment risk.

Risk and Macroeconomic variables
There is a direct relationship between the risk and economic variables. Macroeconomics determines the risk situation of an economy. The various variables are:

Market risk:

Market risk is the chance that the entire market where your investment trades will fall in value. Market risk cannot be diversified. ll securities are exposed to market risk including recessions, wars, structural changes in the economy, tax law changes, even changes in consumer preferences. Market risk is sometimes used synonymously with systematic risk. There are various variables in the economy, which affect it:


Demographic factors such as:
o population size and distribution
o age distribution
o education levels
o income levels
o ethnic origins
o religious affiliations
* Attitudes towards:
o materialism, capitalism, free enterprise
o individualism, role of family, role of government, collectivism
o role of church and religion

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Considerations for Investments

139 #1, 5 (under questions sections), pg. 140 #2, 3 (under problems section)
1#. Comment on the following statements:
a. "Because our new expansion project has the same systematic risk as the firm as a whole, we need do no further risk analysis on the project."

b. "Our company should accept the new potash mine project at Moosejaw. The cost of additional loans to fund the project is 12 percent, and our simulations lead us to expect a 14 percent return from the project."
c. "It is difficult to decide whether to spend $10 million to reopen our mine because the price of gold is so uncertain. However, if we assume the price of gold grows at an average of 5 percent a year with a standard deviation of 20 percent a year, simulation indicates the mine has an average NPV of $500,000. Therefore, we should reopen."
5# what is the advantage of using certainty-equivalent cash flows instead of risk-adjusted discount rates to calculate the NPV of an investment project?

#2 In early 1990, Boeing Co. decided to gamble $4 billion to build a new long-distance, 350-seat wide-body airplane called the Boeing 777. The price tag for the 777, scheduled for delivery beginning in 1995, is about $120 million apiece. Assume that Boeing's $4 billion investment is made at the rate of $800 million a year for the years 1990 through 1994 and that the present value of the tax write-off associated with these costs is $750 million. Based on estimated annual fixed costs of $100 million, variable production costs of $90 million apiece, a marginal corporate tax rate of 34 percent and a discount rate of 14 percent, what is the break-even quantity of annual unit sales over the Boeing 777's projected 15-year life? Assume that all cash inflows and outflows occur at the end of the year.

3# The recently opened Grand Hyatt Wailea Resort and Spa on Maui cost $600 million, about $800,000 per room, to build. Daily operating expenses average $135 a room if occupied and $80 a room if unoccupied (much of the labor cost of running a hotel is fixed). At an average room rate of $500 a night, a marginal tax rate of 40 percent, and a cost of capital of 11 percent, what year-round occupancy rate do the Japanese investors who financed the Grand Hyatt Wailea require to break even in economic terms on their investment over its estimated 40-year life? What is the likelihood that this investment will have a positive NPV? Assume that the $450 million expense of building the hotel can be written off straight line over a 30-year period (the other $150 million is for the land which is not depreciable) and that the present value of the hotel's terminal value will be $200 million.

Compare the assumptions underlying Arbitrage Pricing Theory with those underlying the mean-variance Capital Asset Pricing Model. Which set of assumptions seems more realistic to you? Why?

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