Risk Solutions

Finance Practice Questions
Solutions - 1
Risk and Return

Question 6-1 (13 Marks)

You have just been hired by Jackson Investment Services. Your first task is to invest
$125,000. The following investment alternatives and other relevant data are as follows:

Correlations Investment
Alternatives
Standard
Deviations ADK BBL CRL Market
ADK 0.30 1.00 0.30 0.15 0.85
BBL 0.18 0.30 1.00 0.40 0.70
CRL 0.27 0.15 0.40 1.00 0.90
Market 0.15 0.85 0.70 0.90 1.00

In addition, the market is expected to earn a return of 11% and the Treasury Bills are
expected to earn 6%.

Required:

(a) Calculate the expected return on each stock. (6 marks)

( ) ( ) ( ) | | | |
( )
( )
( )
( ) ( )
( )
( )
( )
( ) ( )
( )
( )
( )
( ) ( ) 14.1% 0.05 1.62 0.06 r E 1.62
5 1 0.
27 0.
90 0.
10.2% 0.05 0.84 0.06 r E 0.84
5 1 0.
18 0.
70 0.
14.5% 0.05 1.70 0.06 r E 1.70
5 1 0.
30 0.
5 8 0.
MRP r r r E r r E
C C
B B
A A
J f f M J f J
M
J
JM J
= + = = = |
= + = = = |
= + = = = |
| + = | + =
|
|
.
|
\
|
o
o
= |

(b) Compute the expected return and standard deviation of a portfolio made up of
$50,000 of Stock ADK and the remainder in Stock BBL. (4 marks)

( )( ) ( )( )
( ) ( ) ( ) ( ) ( )( )( )( )( )
18.4% 0.18396
0.03384
07776 . 0 011664 . 0 0144 . 0
0.18 0.30 0.30 0.6 0.40 2 18 0. 6 0. 0.30 0.4
11.92% 0.102 0.6 + 0.145 0.4 r
0.6 x 0.4 x
P
2 2 2 2
2
P
P
B A
~ = o
=
+ + =
+ + = o
= =
= =

(c) Suppose instead that risk aversion increased sufficiently to cause the market risk
premium [E(r
M
)-r
f
] to increase by 2%. What effect would this have on the Security
Market Line and on the returns of BBL and CRL stocks? (3 marks)


Solutions - 2
The SML would become steeper, resulting in the expected or required
returns becoming greater.

( ) ( )
( ) ( )
( ) ( ) 17.34% 0.07 1.62 0.06 r E
11.88% 0.07 0.84 0.06 r E
0.07 0.06 r E
C
B
J J
= + =
= + =
| + =


You have just been hired by Golden Fleece Investment Services. Your first assignment is to
invest $2,500,000. The following investment alternatives and other relevant data are as
follows:

Correlations Investment
Alternatives
Standard
Deviations AGR BND CTK Market
AGR 0.24 1.00 0.30 0.15 0.75
BND 0.15 0.30 1.00 0.40 0.66
CTK 0.21 0.15 0.40 1.00 0.72
Market 0.09 0.75 0.66 0.72 1.00

In addition, the market risk premium is expected to be 7% and the Treasury Bills are
expected to earn 8%.

Required:

(a) Calculate the expected return on each stock. (6 marks)

( ) ( ) ( ) | | | |
( )
( )
( )
( ) ( )
( )
( )
( )
( ) ( )
( )
( )
( )
( ) ( ) % 76 . 9 1 7 0.0 8 1.6 8 0.0 r E 8 1.6
09 0.
21 0.
72 0.
% 7 . 5 1 7 0.0 10 . 1 8 0.0 r E 10 . 1
09 0.
15 0.
66 0.
% 0 . 22 7 0.0 00 . 2 8 0.0 r E 0 0 . 2
09 0.
24 0.
5 7 0.
MRP r r r E r r E
C C
B B
A A
J f f M J f J
M
J
JM J
= + = = = |
= + = = = |
= + = = = |
| + = | + =
|
|
.
|
\
|
o
o
= |

(b) Compute the expected return and standard deviation of a portfolio made up of
$750,000 of AGR stock and the remainder in BND stock. (4 marks)


Solutions - 3

.4% 4 1 14403 0.
20745 0.0
004536 . 0 011025 . 0 005184 . 0
) 5 )(0.1 24 )(0. 30 )(0. 7 )(0. 3 2(0. ) 15 (0. ) 7 (0. ) 24 (0. ) 3 (0.
% 59 . 17 ) 57 )(0.1 7 (0. + ) 22 )(0. 3 (0. r
7 0. x 3 0. x
P
2 2 2 2 2
P
P
B A
~ = o
=
+ + =
+ + = o
= =
= =

(c) Suppose that investor confidence increased such that risk aversion decreased
sufficiently to cause the market risk premium [E(r
M
)-r
f
] to decrease by 2%. What
effect would this have on the Security Market Line and on the returns of BDN and
CTK stocks? (3 marks)

The SML would become flatter, resulting in the expected or required returns
becoming lower.

( ) ( )
( ) ( )
( ) ( ) % 4 . 6 1 5 0.0 8 1.6 8 0.0 r E
% 5 . 3 1 5 0.0 10 . 1 8 0.0 r E
5 0.0 8 0.0 r E
C
B
J J
= + =
= + =
| + =


You are supplied with information about three investment funds and the market, shown in
Table 6-3. In addition, treasury bills yield 7% and the market is expected to earn 5% more
than t-bills.

Table 6-3
Correlation with:
Standard
Deviation
Paragon Quixotic Resolute Market
Paragon Fund 0.20 1.00 0.50 0.80 0.49
Quixotic Fund 0.30 0.50 1.00 0.70 0.28
Resolute Fund 0.10 0.80 0.70 1.00 0.63
Market 0.07 0.49 0.28 0.63 1.00

Required:

(a) Compute the beta and expected return of each fund. (6 marks)


Solutions - 4

( ) ( ) ( ) | | | |
( )
( )
( )
( ) ( )
( )
( )
( )
( ) ( )
( )
( )
( )
( ) ( ) % 5 . 1 1 5 0.0 90 . 0 7 0.0 r E 90 . 0
07 0.
10 0.
63 0.
% 0 . 3 1 5 0.0 20 . 1 7 0.0 r E 20 . 1
07 0.
30 0.
28 0.
% 0 . 14 5 0.0 40 . 1 7 0.0 r E 0 4 . 1
07 0.
20 0.
49 0.
MRP r r r E r r E
R R
Q Q
P P
J f f M J f J
M
J
JM J
= + = = = |
= + = = = |
= + = = = |
| + = | + =
|
|
.
|
\
|
o
o
= |

(b) How would you describe the risk of each fund? When is it appropriate to use
standard deviation, and when is it appropriate to use beta? (5 marks)

With a beta of 1.4, Paragon would be described as aggressive, while
Quixotic's beta of 1.2 would suggest it is moderately aggressive. Resolute's
beta of 0.9 is only slightly less than the market's beta of 1.0, so it would be
described as only slightly less risky than the market.

Standard deviation is used to measure total risk, while beta is used to
measure systematic risk.

(c) What would be the expected return and standard deviation of a portfolio that
invested 30% of its funds in Paragon Fund, 20% in Quixotic and 50% in Resolute?
(5 marks)

( )( ) ( )( ) ( )( )
( ) ( ) ( ) ( ) ( ) ( ) ( )( )( )( )( )
( )( )( )( )( ) ( )( )( )( )( )
14.9% 0.14933
0.0223
0042 . 0 0048 . 0 0036 . 0 0025 . 0 0036 . 0 0036 . 0
1 0. 0.3 7 0. 5 0. 2 0. 2 1 0. 2 0. 8 0. 5 0. 0.3 2
0.3 2 0. 5 0. 2 0. 0.3 2 1 0. 5 0. 0.3 2 0. 2 0. 0.3
12.55% 115 0. 5 0. + 3 1 0. 2 0. + 14 0. 0.3 r
0.5 x 0.2 x 0.3 x
PORT
2 2 2 2 2 2
2
PORT
PORT
Q R P
~ = o
=
+ + + + + =
+ +
+ + + = o
= =
= = =


Marathon Investments has a $30 million portfolio invested in five stocks as shown in Table
6-4.1. The current yield on Treasury bills is 7 percent and the market return has a
probability distribution that is given in Table 6-4.2.


Solutions - 5
Table 6-4.1 Table 6-4.2
Amount Stock Market
Stock (millions) | Probability Return

Adams $9.0 0.5 0.1 8%
Bosco 7.5 2.0 0.2 10%
Chimo 4.5 4.0 0.4 12%
Dryco 6.0 1.0 0.2 14%
Emron 3.0 3.0 0.1 16%

Required:

(a) What is the estimated equation of the security market line? (2 marks)

E(r
M
) = 12% SML: r
J
= 0.07 + |
J
(0.05)

(b) What is the required return for the portfolio? How risky is the portfolio? (4 marks)

$ Wt | r
J
Wt x |

A 9.0 0.30 0.5 0.095 0.15
B 7.5 0.25 2.0 0.170 0.50
C 4.5 0.15 4.0 0.270 0.60
D 6.0 0.20 1.0 0.120 0.20
E 3.0 0.10 3.0 0.220 0.30

r
P
= 0.07 + 1.75(.05) = 15.75%
|
P
= 1.75

A beta of 1.75 indicates this portfolio is very risky or aggressive.

(c) Consider a new stock, N, which has an estimated beta of 2.5 and an expected return
of 16%. Should this stock be purchased? At what rate of return would MI's
management be indifferent to purchasing the stock? (3 marks)

|
N
= 2.5
*
N
r = 0.07 + 2.5(0.05) = 19.5% > 16%

The new stock's expected return is not high enough to compensate for its
risk. It would have to be 19.5% before we would be indifferent about
investing in it.


Lever Investments Ltd. has $16 million of which $12 is invested in Portfolio F. Lever wants
to invest the remaining funds in either Stock G or Stock H. The correlation coefficient is
-0.8 between Portfolio F and Stock G and 0.8 between Stock H and Portfolio F. The other
relevant data is summarized as follows:


Solutions - 6
Expected
Investment Variance Return

Portfolio F 0.0144 0.09
Stock G 0.0625 0.07
Stock H 0.0196 0.07

Required:

Which stock do you recommend? Why?

Let 1 indicate F+G and 2 indicate F+H:

( )( ) ( )( )
( ) ( ) ( ) ( ) ( )( )( )( )( )
5.48% 0.0548
0.00300625
0.25 0.12 0.80 - 5 2 0. 0.75 2 .0625 0 5 2 0. 0.0144 0.75
8.5% 0.07 0.25 0.09 0.75 r
1
2 2
2
1
1
= = o
=
+ + =
o
= + =

( )( ) ( )( )
( ) ( ) ( ) ( ) ( )( )( )( )( )
% 985 . 11 11985 0.
14365 0.0
14 0. 0.12 0.80 5 2 0. 0.75 2 196 .0 0 5 2 0. 0.0144 0.75
8.5% 0.07 0.25 0.09 0.75 r
2
2 2
2
2
2
= = o
=
+ + =
o
= + =

Choose stock G since it results in a portfolio with lower risk, with the same
return.


You are managing the Canadian Aggressive Allocation Portfolio, which invests in two
funds: the Canadian Equity Growth Fund and the Canadian High Yield Bond Fund. The
correlation between the funds is 0.1. The expected returns and standard deviations of these
two funds as estimated by your Market Analytics Group as shown below:

E(r) o
Canadian Equity Growth Fund 20% 40%
Canadian High Yield Bond Fund 10% 25%

Required:

(a) Calculate the expected return and standard deviation of the Canadian Aggressive
Allocation Portfolio if 75% is invested in the Canadian Equity Growth Fund and
25% in the Canadian High Yield Bond Fund. (5 marks)


Solutions - 7
E(r
P
) = (0.75)(0.20)+(0.25)(0.10)=17.5%
o
P
2
= (0.75)
2
(0.40)
2
+ (0.25)
2
(0.25)
2

+ 2(0.75)(0.25)(0.10)(0.40)(0.25)
= 0.09 + 0.00390625 + 0.00375
= 0.09765625
o
P
= 0.3125 = 31.25%

(b) Calculate the expected return and standard deviation if a client invests 40% of their
money in treasury bills yielding 6% and the balance in the Canadian Aggressive
Allocation Portfolio as constituted in part (a). (5 marks)

E(r
P
) = (0.40)(0.06)+(0.60)(0.175)=12.9%
o
P
2
= (0.40)
2
(0)
2
+ (0.60)
2
(0.3125)
2
+ 2(0.40)(0.60)()(0)(0.3125)
= 0.0 + 0.03515625 + 0.0
= 0.03515625
o
P
= 0.1875 = 18.75%
or
o
P
= (0.6)(0.3125) = 0.1875 = 18.75%

Question 6-7 (20 marks)

You are supplied with information about three investment funds and the market, shown in
Table 6-7.1. In addition, treasury bills yield 4% and the market risk premium is 7.5%.

Table 6-7.1

Correlation with Standard
Deviation Stimson Talford Unwin Market
Stimson Fund 0.21 1.00 0.60 0.55 0.45
Talford Fund 0.20 0.60 1.00 0.35 0.63
Unwin Fund 0.30 0.55 0.35 1.00 0.14
Market 0.07 0.45 0.63 0.14 1.00

Required:

(a) Compute the beta and expected return of each fund. (6 marks)


Solutions - 8
( ) | |
( ) ( ) | |
( ) ( ) | |
( ) ( ) | | % 5 . 8 075 . 0 60 . 0 04 . 0 r E , 60 . 0
07 . 0
30 . 0
14 . 0
% 5 . 17 075 . 0 80 . 1 04 . 0 r E , 80 . 1
07 . 0
20 . 0
63 . 0
% 125 . 14 075 . 0 35 . 1 04 . 0 r E , 35 . 1
07 . 0
21 . 0
45 . 0
MRP r r E ,
U U
T T
S S
j f j
M
j
jM j
= + = = |
.
|
\
|
= |
= + = = |
.
|
\
|
= |
= + = = |
.
|
\
|
= |
| + =
o
o
= |

(b) How would you describe the risk of each fund? When is it appropriate to use
standard deviation, and when is it appropriate to use beta? (5 marks)

Stimsom: Fairly Risky, Beta > 1
Talford: Very Risky, Beta >>1
Unwin: Defensive, Beta <1

SD: Entire portfolio
Beta: Individual securities and their contribution to portfolio risk

(c) What proportion of the risk of each fund is systematic? What is the rest of the risk
called? (5 marks)

( )
( )
( ) % 96 . 1 14 . 0
% 69 . 39 63 . 0
% 25 . 20 45 . 0
2
2
U
2
2
T
2
2
S
= =
= =
= =

The rest of the risk is called diversifiable risk.

(d) What would be the expected return and standard deviation of a portfolio that
invested 45% of its funds in Stimson Fund, 25% in Talford and 30% in Unwin? (5
marks)

( ) ( ) ( ) ( )
( )( ) ( )( ) ( )( ) % 28 . 13 085 . 0 3 . 175 . 0 25 . 0 14125 . 0 45 . 0
r E x r E x r E x r E
U U T T S S PORT
= + + =
+ + =

( ) ( ) ( ) ( )
( ) ( )
U T TU U T U S SU U S
T S ST T S
2
U U
2
T T
2
S S
PORT
x x 2 x x 2
x x 2 x x x
o o + o o +
o o + o + o + o
= o

Solutions - 9

( ) ( ) ( ) ( ) ( ) ( )
( )( )( )( )( )( )
( )( )( )( )( )( )
( )( )( )( )( )( ) 30 . 0 20 . 0 35 . 0 30 . 0 25 . 0 2
30 . 0 21 . 0 55 . 0 30 . 0 45 . 0 2
20 . 0 21 . 0 6 . 0 25 . 0 45 . 0 2
30 . 30 . 0 20 . 0 25 . 0 21 . 0 45 . 0
2 2 2 2 2 2
PORT
+
+
+
+ +
= o

% 42 . 19 1942 . 0 03770575 . 0
00315 . 0 0093555 . 0 00567 . 0
0081 . 0 0025 . 0 00893025 . 0
PORT
= = =
+ + +
+ +
= o

(e) What would cause the security market line to become steeper? Give a specific
example. (2 marks)

If the market risk premium rose from 7.5% to 9%, the equation of the SML
would change to E(r
j
)=0.04+0.09(|
J
)

(f) What would cause the security market line to shift upwards? Give a specific
example. (2 marks)

If the risk free rate rose from 4% to 5%, the equation of the SML would
change to E(r
j
)=0.05+0.075(|
J
)


Consider the following table providing an analysts expected returns on two stocks under
two different market scenarios.

Market Return Aggressive Stock Defensive Stock
5.0% 2.0% 6.5%
20.0% 32.0% 14.0%

The treasury bill rate is 8%.

Required:

(a) What are the betas of the two stocks? (4 marks)

Aggressive: 2% = 8% + |
A
(5% - 8%), |
A
= 2.0
32% = 8% + |
A
(20% - 8%), |
A
= 2.0

Defensive: 6.5% = 8% + |
D
(5% - 8%), |
D
= 0.5
14% = 8% + |
D
(20% - 8%), |
D
= 0.5

OR: | = Rise/Run
|
A
= (32%-2%)/(20%-5%) = 2.0

Solutions - 10
|
D
= (14%-6.5%)/(20%-5%) = 0.5

(b) What is the equation of the SML if there is an equal chance of the market returning
either 5% or 20%? (2 marks)

E(r
M
) = 0.5(5%) + 0.5(20%) = 12.5%

SML: r
J
= 8% + |
J
(12.5% - 8%)
= 8% + |
J
(4.5%)

(c) What is the expected return on each stock if there is an equal chance of the market
returning either 5% or 20%? (4 marks)

E(r
A
) = 8% + 2.0(4.5%) = 17.00%
E(r
D
) = 8% + 0.5(4.5%) = 10.25%


Kayser Investment Services is evaluating AMG stock. The stock does not pay dividends
and is expected to appreciate to $22.00 one year from now from its current $20.00.

Using a standard spreadsheet to estimate beta using 4 years of monthly excess return data,
the analyst obtained the following:

Constant (Intercept) 0.01688
Slope Coefficient 1.803607
Std Err of Slope Coef. 0.213563

Required:

(a) What is the beta estimate? (1 mark)

1.80

(b) If the treasury bill rate is 4% and the expected return on the market is 12%, what is
the analysts estimate of the required return on the stock over the next year? (2
marks)

4% + 1.80(12%-4%) = 18.4%

(c) Given the analysts prediction of a $22.00 share price in one year, the current price
of $20.00 and the estimate of the required return what would the analyst predict
should happen to the share price? (2 marks)

Fair price = 22/(1.184) = 18.58

Solutions - 11

(d) What is the equation of the security market line? (1 marks)

E(r) = 4% + |(8%)

(e) What would cause the security market line to become steeper? Give a specific
example. (2 marks)

The market risk premium increasing, say from 8% to 10%.


Mei Yee Chan has $50,000 that she wants to invest in the stock market. She has obtained
the following information from a reliable stock broker:

Stock A: Variance, (
2
A
o ) 0.0400

Correlation with the market (
AM
) 0.3750
Stock B: Variance, (
2
B
o ) 0.2025
Correlation with the market (
BM
) 0.4000
Market: Variance, (
2
B
o ) 0.2025
Yield on Treasury Bills 5.0%
Market Risk Premium 8.0%
Correlation between Stocks A&B (
AB
) 0.5000

Required:

(a) If Mei Yee invests the $50,000 in only one of Stocks A or B, which stock is the
riskier and why? (2 marks)

Stock B has the higher Variance/Std Dev, which is relevant since Mei Yee
will not benefit from diversification.

(b) Which stock is the riskier in the context of the CAPM and why? (3 marks)

Stock B has the higher beta (see part (d), below) and therefore is riskier in a
CAPM context.

(c) What proportion of the risk of each stock is systematic? (2 marks)

1600 . 0 400 . 0
1406 . 0 375 . 0
2 2
B
2 2
A
= =
= =


Solutions - 12
(d) Calculate the beta and expected return for each stock. (4 marks)

( )
( ) ( )
( )
( ) ( ) % 20 . 8 % 8 4000 . 0 % 0 . 5 R E
4000 . 0
45 . 0
45 . 0
4000 .. 0
% 33 . 6 % 8 1667 . 0 % 0 . 5 R E
1667 . 0
45 . 0
20 . 0
3750 . 0
B
M
B
BM B
A
M
A
AM A
= + =
=
|
.
|
\
|
=
o
o
= |
= + =
=
|
.
|
\
|
=
o
o
= |

(e) Calculate the expected return and the standard deviation of a portfolio consisting
of $40,000 of stock A and the rest in stock B? (5 marks)

( ) ( ) ( ) ( ) ( ) ( )( ) ( )( )
( ) ( ) ( ) ( ) ( )( )( )( )( )
% 93 . 21 2193 . 0
0481 . 0.0144 0.0081 0.0256
45 . 0 20 . 0 5 . 0 2 . 0 8 . 0 2 2025 . 0 2 . 0 04 . 0 8 . 0
x x 2 x x
% 71 . 6 % 20 . 8 20 . 0 % 33 . 6 80 . 0 r E x r E x r E
20 . 0 8 . 0 1 x
80 . 0 000 40,000/50, x
P
2 2
B A AB B A
2
B
2
B
2
A
2
A
2
P
B B A A P
B
A
= = o
= + + =
+ + =
o o + o + o = o
= + = + =
= =
= =


(a) Fill in the blanks in Table 6-11-1. o
M
= 0.12 (3 marks)

Table 6-11-1

Stock o |
Correlation
with Market
A 0.18 1.20 0.80
B 0.24 1.50 0.75
C 0.15 0.60 0.48

(b) Calculate the expected return for the three stocks in Table 6-11-2. r
f
= 3% and
MRP = 10% (3 marks)

Solutions - 13
Table 6-11-2

Stock o | E(r) Rank (c) Rank (d)
D 0.30 1.00 13% 1 2
E 0.20 1.40 17% 2 1
F 0.18 0.80 11% 3 3

(c) Rank the stocks in Table 6-11-2 from highest to lowest risk in the context of being
the sole component of an investors portfolio. Indicate the ranking in Table 6-11-
2. (2 marks)

(d) Rank the stocks in Table 6-11-2 from highest to lowest risk in the context of a
well-diversified portfolio. Indicate the ranking in Table 6-11-2. (2 marks)

(e) You are provided with the following information about the stocks in a portfolio in
Table 6-11-3:
Table 6-11-3

Correlation with:
Stock o Weight
X Y Z
E(r)
X 0.20 0.20 1.0 0.8 0.6 12%
Y 0.30 0.50 0.8 1.0 0.4 14%
Z 0.25 0.30 0.6 0.4 1.0 13%

(f) Compute the expected return and standard deviation of the portfolio. (5 marks)

E(r
P
) = (0.2)(0.12) + (0.5)(0.14) + (0.3)(0.13) = 13.3%

( ) ( ) ( ) ( ) ( ) ( ) ( )( )( )( )( )
( )( )( )( )( ) ( )( )( )( )( )
2279 . 0 051925 . 0
051925 . 0
009 . 0 0036 . 0 0096 . 0 005625 . 0 0225 . 0 0016 . 0
25 . 0 3 . 0 4 . 0 3 . 0 5 . 0 2 25 . 0 2 . 0 6 . 0 3 . 0 2 . 0 2
3 . 0 2 . 0 8 . 0 5 . 0 2 . 0 2 25 . 0 3 . 0 3 . 0 5 . 0 2 . 0 2 . 0
P
2 2 2 2 2 2
2
P
= = o
=
+ + + + + =
+ +
+ + + = o


Bradley Bedrock is trying to decide how to invest his RRSP contribution this year. One
friend, Fred Flintstone is recommending the Domestic Dynofund, while another Barney
Rubble, is recommending the Granite International Fund.


Solutions - 14
Investment o E(r)
Correlation With
Bedrocks Portfolio
Bedrocks Portfolio 0.20 0.12 1.0
Domestic Dynofund 0.15 0.10 0.9
Granite Intl Fund 0.30 0.10 -0.5

While Bradley sat back and sipped his tea, Fred and Barney were arguing. Barney, why
would you suggest a Fund that has twice as much risk but the same level of return?
Gee, Fred, I thought it would be good for Bradley to get some international
diversification.

Required:

You decide whether Fred or Barney is right. The new investment will be 20% of
Bradleys portfolio. Support your answer with the appropriate calculations.

( ) ( ) ( ) ( ) ( )( )( )( )( )
( ) ( ) ( ) ( ) ( )( )( )( )( )
14 . 0 0196 . 0 0196 . 0
0096 . 0 0036 . 0 0256 . 0
3 . 0 2 . 0 5 . 0 2 . 0 8 . 0 2 3 . 0 2 . 0 2 . 0 8 . 0
1875 . 0 03514 . 0 03514 . 0
00864 . 0 009 . 0 0256 . 0
15 . 0 2 . 0 9 . 0 2 . 0 8 . 0 2 15 . 0 2 . 0 2 . 0 8 . 0
BG
2 2 2 2
2
BG
BD
2 2 2 2
2
BD
= = o =
+ =
+ + = o
= = o =
+ + =
+ + = o

The benefits of the negative correlation far outweigh the lower standard
deviation. The portfolio has lower risk using the GIF fund. As long as the
proportion invested in the new fund is less than 62.8%, Barney is right:
the portfolio risk is lower


Assume that you currently have 50% of your wealth in a risk-free asset and 50% in the
two mutual funds below, which you may assume are efficiently and correctly priced:

Fund
Expected Return
on Stock (%)
Beta of Stock
% of Wealth
Invested in Stock
A 12.6 0.90 20
B 17.1 1.40 30

Required:

(a) Using the CAPM, calculate the risk-free rate and the expected return on the
market portfolio. (4 marks)

Solutions - 15

You have two equations in two unknowns, enough to solve for the two
missing values. The SML relationships imply:

17.1 = r
f
+ 1.40[MRP]
12.6 = r
f
+ 0.90[MRP]
Subtr: 4.5 = 0.5[MRP], MRP = 4.5/0.5 = 9.0
MRP = 9.0%, therefore r
f
= 4.5% and r
M
= 13.5%

(b) Calculate the expected return on your portfolio. (3 marks)

(c) What is the beta of your portfolio? (3 marks)

Investment E(r) (%) Wt (%) (Wt)E(r) | E(|)
A 12.6 20 2.52 0.9 0.18
B 17.1 30 5.13 1.4 0.42
r
f
4.5 50 2.25 0.0 0.00
Total (b) 9.90 (c) 0.60

(d) You want to invest in only the risk-free asset and the market portfolio. You want
an expected rate of return of 9.90%%. How would you allocate your wealth
between the risk-free asset and the market portfolio? (3 marks)

9.90% = (w
f
)(4.5%) + (w
M
)(13.5%)
But w
f
= 1 - w
M

w
M
= 60%, w
f
= 40%,


Why does the stock market fluctuate so much? Lets look at a typical firm that could
represent the entire market, as its values represent those close to the market average.
TypiCal Corp. is expected to pay a dividend next year of $1.50 per share. The firms beta
is 1.00 and growth prospects are quite strong, with the consensus estimate of future
growth being 8% in the foreseeable future.

Required:

(a) If the risk free rate is 5% and the market risk premium is 7.0%, what should be the
price of TypiCals common shares?

E(r
T
) = 5% + 1.00(7%) = 12%, P=$1.50/(0.12-0.08) = $37.50

(b) Suppose that investors have a great deal of confidence in the market, and bid the
market risk premium down to 4.0%. However, this investor optimism has pushed

Solutions - 16
the risk-free rate up to 6%. What would be the price of TypiCals common
shares?

E(r
T
) = 6% + 1.00(4%) = 10%, P=$1.50/(0.10-0.08) = $75.00

(c) Suppose the market has peaked and corrects, falling 15%, shaking investor
confidence. The market risk premium is now 10%, and the central bank has
reduced the T-bill (risk free) rate to 4%. What would be the price of TypiCals
common shares now?

E(r
T
) = 4% + 1.00(10%) = 14%, P=$1.50/(0.14-0.08) = $25.00


Assume that you currently have 40% of your wealth in a risk-free asset and 60% in the
two mutual funds below, which you may assume are efficiently and correctly priced:

Fund
Expected Return
on Stock (%)
Beta of Stock
% of Wealth
Invested in Stock
X 20.0 2.00 35
Y 10.0 0.75 25

Required:

(a) Using the CAPM, calculate the risk-free rate and the expected return on the
market portfolio. (4 marks)

You have two equations in two unknowns, enough to solve for the two
missing values. The SML relationships imply:

20.0 = r
f
+ 2.00[MRP]
10.0 = r
f
+ 0.75[MRP]
Subtr: 10.0 = 1.25[MRP], MRP = 10.0/1.25 = 8.0
MRP = 8.0%, therefore r
f
= 4.0% and r
M
= 12.0%

(b) Calculate the expected return on your portfolio. (3 marks)

(c) What is the beta of your portfolio? (3 marks)

Investment E(r) (%) Wt (%) (Wt)E(r) | E(|)
X 20.0 35 7.00 2.00 0.70
Y 10.0 25 2.50 0.75 0.1875
r
f
4.0 40 1.60 0.00 0.00
Total (b) 11.10 (c) 0.8875


Solutions - 17

(d) You want to invest in only the risk-free asset and the market portfolio. You want
an expected rate of return of 9.0%. How would you allocate your wealth between
the risk-free asset and the market portfolio? (2 marks)

9.0% = (w
f
)(4.0%) + (w
M
)(12.0%)
But w
f
= 1 - w
M

9.0% = (1-w
M
)(4.0%) + (w
M
)(12.0%)
9.0% = 4.0% - (w
M
)(4.0%) + (w
M
)(12.0%)
5.0% = (8.0%)(w
M
)

w
M
= 5.0%/8.0% = 62.5%

w
M
= 62.5%, w
f
= 37.5%,

Solutions - 18

Security Beta Security Return, r
1 1.60 10.0%
2 0.80 6.0%
3 1.20 11.0%

The risk-free rate averaged 3% and the average return on the market portfolio was 8%.

Required:

(a) Draw the ex-post security market line (SML) on a properly labeled graph and
show where the securities plot on the graph. (5 marks)

r
|
SML
r
M
= 8%
1
3
r
1
= 10%
r
3
= 11%
1.2 1.6
9%
r
f
= 3%
2 r
2
= 6%
0.8 1.0
7%

Solutions - 19
(b) Using the graph, comment on the performance of these three stocks. (3 marks)

From the graph, we can see that Security 3 out-performed the SML by 2%
and Securities 1 and 2 each underperformed the SML by 1%.

Concept Questions


You recognize that making a decision based solely on expected returns is only appropriate
for risk-neutral individuals. If you are risk averse, the riskiness of each investment
alternative is an important aspect of the decision. Measures of risk include the standard
deviation of returns and beta. What type of risk is measured by the standard deviation? By
beta? What type of risk can be reduced or eliminated? How?

Standard Deviation, and variance, is used to measure total risk, while beta
measures systematic risk. Systematic risk is the portion of total risk that
cannot be diversified away. The risk that can be eliminated though
diversification is known by a number of synonymous names including
Unique Risk, Company Risk, Unsystematic Risk and Diversifiable Risk.


Under what circumstances should risk be measured by standard deviation and under what
circumstances should it be measured by beta?

Standard Deviation is used to measure total risk, such as the risk of a
portfolio. Beta is used to measure the security's contribution to the risk of a
portfolio and is the only risk that investors can expect to be compensated for
assuming. It is quite possible that an investor's portfolio may have more
total risk than that indicated by beta if it is not well-diversified.


What would cause the security market line to become steeper? (2 marks)

An increase in risk aversion across the economy would cause the SML to
become steeper, as it would take more expected return to get investors to
accept the additional risks of investing in the market rather than the risk free
security.


What would cause the security market line to shift upwards? (2 marks)

An increase in interest rates would cause a parallel upward shift in the SML.

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