A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35

F 4/11/2010

Chapter 6. Tool Kit for Risk and Return RETURNS ON INVESTMENTS (Section 6.1)
Amount invested Amount received in one year Dollar return (Profit) Rate of return = Profit/Investment = $1,000 $1,100 $100 10%

STAND-ALONE RISK (Section 6.2)

The relationship between risk and return is a fundamental axiom in finance. Generally speaking, it is totally logical to assume that investors are only willing to assume additional risk if they are adequately compensated with additional return. This idea is rather fundamental, but the difficulty in finance arises from interpreting the exact nature of this relationship (accepting that risk aversion differs from investor to investor). Risk and return interact to determine security prices, hence it is of paramount importance in finance.

PROBABILITY DISTRIBUTION A probability distribution is a listing of all possible outcomes and their corresponding probabilities. Figure 6-1. Probability Distributions for Sale.Com and Basic Foods Inc. Demand for the Probability of this Company's Products Demand Occurring Strong Normal Weak 0.30 0.40 0.30 Rate of Return on Stock if this Demand Occurs Sale.com Basic Foods 90% 45% 15% 15% 60% 15%

Figure 6-1. Probability Distrib Demand for the Company's Products Weak BA A AA S

1.00

A 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80

F Calculate the stock

EXPECTED RATE OF RETURN The expected rate of return is the rate of return that is expected to be realized from an investment. It is found as the weighted average of the probability distribution of returns.

Figure 6-2. Calculation of Expected Rates of Return: Payoff Matrix

Demand for the Probability of this Sale.com Rate of Return (3) 90% 15% 60% Product (2) x (3) = (4) 27.0% 6.0% 18.0% 15.0% Basic Foods Rate of Return (5) 45% 15% 15% Product (2) x (5) = (6) 13.5% 6.0% 4.5% 15.0% Company's Products Demand Occurring (1) (2) Strong Normal Weak 0.3 0.4 0.3 1.0 Expected Rate of Return = Sum of Products =

r =

r =

MEASURING STAND-ALONE RISK: THE STANDARD DEVIATION The standard deviation is a measure of a distribution's dispersion. Figure 4. Probability Distributions of Sale.com's and Basic Foods' Rates of Return Panel a. Sale.com

Panel b. Basic Foods

0.40

0.40

0.30

0.30

0.20 Probability of Occurrence

0.20 Probability of Occurrence

0.10

0.10

0.00 -75

-60

-45

-30

-15

15

30

45

60

75

90

0.00 -75

-60

-45

-30

-15

15

30

45

Rate of Return (%) Rate Expected of Return

Rate of Return (%) Rate Expected of Return

A 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119

Calculating Standard Deviation Here are the steps used to calculate the standard deviation. First, find the differences of all the possible returns from the expected return. Second, square those differences. Third, multiply the squared numbers by the probability of their occurrence. Fourth, find the sum of all the weighted squares. Finally, take the square root of that number. Here are the calculations for Sale.com and Basic Foods.

Figure 6-5. Calculating Sale.com's and Basic Foods' Standard Deviations Panel a.
(1) 0.3 0.4 0.3 1.0 (2) 90% 15% 60% (3) 15% 15% 15%

Sale.com

(2) (3) = (4) 75.0% 0.0% 75.0%

(4)2 = (5) 56.25% 0.00% 56.25%

(5) x (1) = (6) 16.88% 0.00% 16.88% 33.75% 58.09%

Sum = Variance = Std. Dev. = Square root of variance =

Panel b.

(1) 0.3 0.4 0.3 1.0

(2) 45% 15% 15%

(3) 15% 15% 15%

(2) (3) = (4) (4)2 = (5) 30.0% 9.00% 0.0% 0.00% 30.0% 9.00% Sum = Variance = Std. Dev. = Square root of variance =

Basic Foods

(5) x (1) = (6) 2.70% 0.00% 2.70% 5.40% 23.24%

If Sales.com's and Basic Foods' stock return distributions are from normal distributions, then we can find confidence intervals 0.6826 Sale.com Basic Foods Expected Return 15% 15% Std. Deviation 58.09% 23.24% 1- range around expected return -43.09% to 73.09% -8.24% to 38.24%

USING HISTORICAL DATA TO MEASURE RISK

A 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161

Figure 6-7. Standard Deviation Based On a Sample of Historical Data

Year 2008 2009 2010 Average =AVERAGE(D122:D124) = Standard deviation =STDEV(D122:D124) = Realized return 15.0% 5.0% 20.0% 10.0% 13.2%

MEASURING STAND-ALONE RISK: THE COEFFICIENT OF VARIATION The coefficient of variation indicates the risk per unit of return, and it is calculated by dividing the standard deviation by the expected return. Std. Dev. 58.09% 23.24% Expected return 15% 15% CV 3.87 1.55

Sale.com Basic Foods

RISK IN A PORTFOLIO CONTEXT Portfolio Expected Return

(Section 6.3)

The expected return on a portfolio is simply a weighted average of the expected returns of the individual assets in the portfolio. The weights are the percentage of total portfolio funds invested in each asset. Consider the following portfolio and the hypothetical illustrative returns data.

Figure 6-8. Expected Returns on a Portfolio of Stocks

Stock Southwest Airlines Starbucks FedEx Dell Total investment = Amount of Investment $300,000 $100,000 $200,000 $400,000 $1,000,000 Portfolio Weight 0.3 0.1 0.2 0.4 1.0 Expected Return 15.0% 12.0% 10.0% 9.0% Weighted Expected Return 4.5% 1.2% 2.0% 3.6%

Portfolio's Expected Return =

11.3%

Portfolio Standard Deviation

A 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210

Portfolios of stocks are created to diversify investors from unnecessary risk. The diversifiable, or idiosyncratic, risk is eliminated as more stocks are added. Diversification effects are strongest when combining uncorrelated assets. The following figures illustrate how creating two-stock portfolios with different correlations between the stocks affects the expected return and risk of various fictional portfolios.

Figure 6-9. Portfolio Risk: Perfect Negative Correlation

Stock W
40% 30% 20%
Return

Stock M
40% 30% 20%
Return

Portfolio WM
40% 30% 20%
Return

10% 0% -10%

10% 0% -10%

10% 0% -10%

2010 Weights Year 2006 2007 2008 2009 2010 Average return = Standard deviation = Stock W 0.5 Stock W 40% -10% 35% -5% 15% 15.00% 22.64%

2010 Stock M 0.5 Stock M -10% 40% -5% 35% 15% 15.00% 22.64% Correlation coefficient =

2010

Portfolio WM

15% 15% 15% 15% 15% 15.00% 0.00% -1.00

CONCLUSION: When two stocks are perfectly negatively correlated, diversification is its strongest, and in this case the portfolio return is a certain (no risk) 15%. Of course, this situation is very rare.

Figure 6-10. Portfolio Risk: Perfect Positive Correlation

Stock W
40% 30% 20%
Return

Stock W'
40% 30% 20%
Return

Portfolio WW'
40% 30% 20%
Return

10%

10%

10%

Stock W
40% 40%

Stock W' B

Portfolio WW'
40%

C D E F 30% 30% 30% 211 212 20% 20% 20% 213 Return Return Return 214 10% 10% 10% 215 216 0% 0% 0% 217 218 -10% -10% -10% 219 2010 2010 2010 220 Stock W Stock W' 221 222 Weights 0.5 0.5 223 Portfolio WW' Year Stock W Stock W' 224 225 2006 40% 40% 40% 226 2007 -10% -10% -10% 2008 35% 35% 35% 227 2009 -5% -5% -5% 228 229 2010 15% 15% 15% 230 Average return = 15.00% 15.00% 15.00% 22.64% 22.64% 22.64% 231 Standard deviation = 232 233 Correlation coefficient = 1.00 234 235 236 CONCLUSION: When two stocks are perfectly positively correlated, diversification has no effect, and the portfolio's risk is 237 a weighted average of its individual stocks' risks. Note that in this graph only the portfolio returns are visible, but realize 238 that the stocks' returns follow an identical path. 239 240 241 Figure 6-11. Portfolio Risk: Imperfect (Partial) Correlation 242 243 Portfolio WY Stock W Stock Y 244 40.00% 40% 40% 245 246 30.00% 30% 30% 247 248 20.00% 20% 20% 249 Return Return 250 Return 10.00% 10% 10% 251 252 0.00% 0% 0% 253 254 -10.00% -10% -10% 255 2010 2010 2010 256 Stock W Stock Y 257 258 Weights 0.5 0.5 259

A 260 261 262 263 264 265 266 267 268 269 270 271 272 273 274 275 276 277 278 279 280 281 282 283 Year 2006 2007 2008 2009 2010 Average return = Standard deviation =

B Stock W 40% -10% 35% -5% 15% 15.00% 22.64%

D Stock Y 40% 15% -5% -10% 35% 15.00% 22.64% Correlation coefficient =

F
Portfolio WY

40.00% 2.50% 15.00% -7.50% 25.00% 15.00% 18.62% 0.35

CONCLUSION: In the case where two stocks are somewhat correlated, diversification is effective in lowering portfolio risk. Here, the portfolio return is an average of the stock returns and risk is reduced from 22.64% for the individual stocks to 18.62% for the portfolio. Notice that the portfolio's return is always between that of the two stocks. If more similarly-correlated stocks were added, risk would continue to fall, but as we shall see, there is a limit to how low risk (the portfolio's SD) can go.

Contribution to Market Risk: Beta

The beta coefficient measures the amount of risk that a stock contributes to a well-diversified portfolio. It also reflects the tendency of a stock to move up and down with the market. Shown below in the chart and in the table are the returns for three stocks and for the stock market.

A 284 285 286 287 288 289 290 291 292 293 294 295 296 297 298 299 300 301 302 303 304 305 306 307 308 309 310 311 312 313 314 315 316 317 318 319 320 321 322 323 324 325 326 327 328 329 330 331 332

Figure 6-13. Relative Returns of Stocks H, A, and L

40%

Stock H: b = 1.5 Stock A: b = 1.0 Stock L: b = 0.5

Returns on Stocks H, A, and L -40%

0%

0%

40%

-40% Return on the Market

Year 1 2 3 Average = Standard deviation = Beta =

Market 19.0% 25.0% -15.0% 9.7% 21.6%

Historical Returns Stock H 26.0% 35.0% -25.0% 12.0% 32.4% 1.5

Stock A 19.0% 25.0% -15.0% 9.7% 21.6% 1.0

Stock L 12.0% 15.0% -5.0% 7.3% 10.8% 0.5

Note: These three stocks plot exactly on their regression lines. This indicates that they are exposed only to market risk. Portfolios that concentrate on stocks with betas of 1.5, 1.0, and 0.5 have patterns similar to those shown in the graph. Standard deviation is calculated with the Excel STDEV function because the data come from an historical sample.

Probability Distributions for H, A, and L

Notice that Stock L has the lowest average return, but it also has the tightest distribution. On the other hand, Stock H has the highest average return, but the widest distribution.

Stock L

A B 333 334 335 336 337 338 339 340 341 342 343 344 345 346 347 348 -80.0% -60.0% -40.0% -20.0% 349 350 351 352 353 Calculating Beta for H, A, and L 354 355 First, calculate correlation and covariance. 356 Correlation of stock 357 with Market, i,M 358 359 360 361 362 363 364 365 366 367 368 369 Covariance of stock with Market, COVi,M Method 1: bi = i,M (i / M) Method 2: bi = COVi,M / (M)2 Method 3: Slope of regression Beta =

Stock L

Stock A

Stock H 0.0% 20.0% 40.0% 60.0% 80.0% 100.0%

1.00

1.00

1.00

6.98%

4.65%

2.33%

1.5

1.0

0.5

1.5

1.0

0.5

1.5

1.0

0.5

A 370 371 372 373 374 375 376 377 378 379 380 381 382 383 384 385 386 387 388 389 390 391 392 393 394 395 396 397 398 399 400 401 402 403 404 405 406 407 408 409 410 411 412 413 414 415 416 417 418

C
(Section 6.4)

CALCULATING BETA COEFFICIENTS

Now we show how to calculate beta for an actual company, General Electric. Step 1. Retrive Data We downloaded stock prices and dividends from http://finance.yahoo.com for General Electric, using its ticker symbol GE, and for the S&P 500 Index ( symbol ^SPX), which contains 500 actively traded large stocks. For example, to download the GE data, enter its ticker symbol in the upper left section and click Go. Then select Historical Prices from the upper left side of the new page. After the daily prices come up, click monthly prices, enter a start and stop date, and click "Get Prices." When presenting monthly data, the date shown is for the first date in the month, but the data are actually for the last day of trading in the month , so be alert for this. Note that these prices are "adjusted" to reflect any dividends or stock splits. Scroll to the bottom of the page and click "Download to Spreadsheet." The downloaded data are in csv format. Convert to xls by opening a new Excel worksheet, copying the date and adjusted index price data to it, and saving as an xls file. Then repeat the process to get the S&P index data. At this point you have returns data for GE and the S&P Index, as we show below. Step 2. Calculate Returns Next, calculate the percentage change in adjusted prices (which already reflect dividends) for GE and the S&P to obtain returns, with the spreadsheet set up as shown below. At this point, we are ready to calculate some statistics and to find GE's beta coefficient. This is shown below the data.

Figure 6-14. Stock Return Data for GE and the S&P 500 Index
Month March 2009 February 2009 January 2009 December 2008 November 2008 October 2008 September 2008 August 2008 July 2008 June 2008 May 2008 April 2008 March 2008 February 2008 January 2008 December 2007 November 2007 October 2007 September 2007 August 2007 July 2007 Month End 797.87 735.09 825.88 903.25 896.24 968.75 1,164.74 1,282.83 1,267.38 1,280.00 1,400.38 1,385.59 1,322.70 1,330.63 1,378.55 1,468.36 1,481.14 1,549.38 1,526.75 1,473.99 1,455.27 Return 8.5% -11.0% -8.6% 0.8% -7.5% -16.8% -9.2% 1.2% -1.0% -8.6% 1.1% 4.8% -0.6% -3.5% -6.1% -0.9% -4.4% 1.5% 3.6% 1.3% -3.2%

Month End $10.11 $8.51 $11.78 $15.74 $16.37 $18.60 $24.30 $26.43 $26.61 $25.10 $28.57 $30.42 $34.43 $30.83 $32.59 $34.17 $35.00 $37.62 $37.84 $35.29 $35.19

Return 18.8% -27.8% -25.2% -3.8% -12.0% -23.5% -8.1% -0.7% 6.0% -12.1% -6.1% -11.6% 11.7% -5.4% -4.6% -2.4% -7.0% -0.6% 7.2% 0.3% 1.3%

419 420 421 422 423 424 425 426 427 428 429 430 431 432 433 434 435 436 437 438 439 440 441 442 443 444 445 446 447 448 449 450 451 452 453 454 455 456 457 458 459 460

A June 2007 May 2007 April 2007 March 2007 February 2007 January 2007 December 2006 November 2006 October 2006 September 2006 August 2006 July 2006 June 2006 May 2006 April 2006 March 2006 February 2006 January 2006 December 2005 November 2005 October 2005 September 2005 August 2005 July 2005 June 2005 May 2005 April 2005 March 2005

B 1,503.35 1,530.62 1,482.37 1,420.86 1,406.82 1,438.24 1,418.30 1,400.63 1,377.94 1,335.85 1,303.82 1,276.66 1,270.20 1,270.09 1,310.61 1,294.87 1,280.66 1,280.08 1,248.29 1,249.48 1,207.01 1,228.81 1,220.33 1,234.18 1,191.33 1,191.50 1,156.85 1,180.59

C -1.8% 3.3% 4.3% 1.0% -2.2% 1.4% 1.3% 1.6% 3.2% 2.5% 2.1% 0.5% 0.0% -3.1% 1.2% 1.1% 0.0% 2.5% -0.1% 3.5% -1.8% 0.7% -1.1% 3.6% 0.0% 3.0% -2.0% NA

D $34.75 $33.87 $33.22 $31.87 $31.47 $32.24 $33.28 $31.32 $31.17 $31.34 $30.02 $28.81 $29.05 $29.97 $30.26 $30.43 $28.76 $28.44 $30.44 $30.80 $29.24 $29.03 $28.79 $29.55 $29.68 $31.05 $30.82 $30.70

E 2.6% 2.0% 4.2% 1.3% -2.4% -3.1% 6.3% 0.5% -0.5% 4.4% 4.2% -0.8% -3.1% -1.0% -0.6% 5.8% 1.1% -6.6% -1.2% 5.3% 0.7% 0.8% -2.6% -0.4% -4.4% 0.7% 0.4% NA

Description of Data Average return (annual): Standard deviation (annual): Minimum monthly return: Maximum monthly return: Correlation between GE and the market: Beta: bGE = GE,M (GE / M) Beta (using the SLOPE function): Intercept (using the INTERCEPT function): R2 (using the RSQ function):

-8.5% 15.9% -16.8% 8.5%

-22.9% 28.9% -27.8% 18.8% 0.76 1.37 1.37 -0.01 0.57

461 462 463 464 465 466 467 468 469 470 471 472 473 474 475 476 477 478 479 480 481 482 483 484 485 486 487 488 489 490 491 492 493 494 495 496 497 498 499 500 501 502 503 504 505

A B C D E Step 3. Examine the Data Using the AVERAGE function and the STDEV function, we found the average historical return and standard deviation for GE and the market. (We converted these from monthly figures to annual figures. Notice that you must multiply the monthly standard deviation by the square root of 12, and not 12, to convert it to an annual basis.) These are shown in the rows above. We also used the CORREL function to find the correlation between GE and the market. We used the SLOPE, INTERCEPT, and RSQ functions to estimate the regression for beta. Step 4. Plot the Data and Calculate Beta Using the Chart Wizard, we plotted the GE returns on the y-axis and the market returns on the x-axis. We also used the menu Chart > Options to add a trend line, and to display the regression equation and R2 on the chart. The chart is shown below.

30.0%

y-axis: Historical GE Returns -30%

0.0% 0% 30%

x-axis: Historical -30.0% Market Returns

506 507 508 509 510 511 512 513 514 515 516 517 518 519 520 521 522 523 524 525 526 527 528 529 530 531 532 533 534 535 536 537 538 539 540 541 542 543 544 545 546 547 548 549 550 551 552 553 554

B C D E F Interesting note: We did the above analysis in July of 2008 and then updated it in March of 2009, after the market crash. Here are some resulting differences: As of March 2009 Market GE -8.45% -22.94% 15.92% 28.93% 1.3744 0.7562 0.5719 As of July 2008 Market GE 3.83% -0.14% 9.60% 15.66% 0.5987 0.3673 0.1349

Average return (annual) Standard deviation (annual) Beta (using the SLOPE function) Correlation between GE and the market. R2 (using the Excel function)

Average returns for GE and the market both fell. SDs rose, indicating higher stand-alone risk. GE's beta rose, indicating greater sensitivity to changes in the market. GE's correlation with the market rose, indicating that much of GE's decline was due to the market drop. R2 rose, indicating that GE's returns were more closely related to market changes than in the earlier period. These changes are all logical, but perhaps the most interesting one, for our purposes is the change in beta.
We will use beta when we estimate a firm's cost of capital, and the change in beta indicates a significant

change in the cost of equity. Based on its low beta (well below 1.0) in July, GE appeared to have a low cost of equity. It's sharper-than-average price drop indicated that it was, ex post, really more risky than average. That indicates that its "true risk" in July was risker than the average investor thought. People have tried to forecast beta, and if they can do so, they can earn abnormal returns in the market. At any rate, forecasting betas by adjusting historical betas for changes in leverage and other factors is widely practiced.

THE RELATIONSHIP BETWEEN RISK AND RATES OF RETURN

(Section 6.5)

The SML shows the relationship between the stock's beta and its required return, as predicted by the CAPM.

rRF rM bi

6% 11% 0.5

<< Varies over time, but is constant for all firms at a given time. << Varies over time, but is constant for all firms at a given time. << Varies over time, and varies from firm to firm.

The SML predicts stock i's required return to be: ri = rRF + bi(RPM) ri = rRF + bi(rM rRF) ri = 6% + 0.5(11% - 6%) ri =

8.5%

=B536+B538*(B537-B536)

With the above data, we can generate a Security Market Line that is flexible enough to allow for changes in any of the input factors. We generate a table of values for beta and expected returns, and then plot the graph as a scatter diagram.

Beta

Required Return

A 555 556 557 558 559 560

B 0.00 0.50 1.00 1.50 2.00

C 6.0% 8.5% 11.0% 13.5% 16.0%

A 561 562 563 564 565 566 567 568 569 570 571 572 573 574 575 576 577 578 579 580 581 582 583 584 585 586 587 588 589 590 591 592 593 594 595 596 597 598 599 600 601 602 603 604 605 606 607 608 609

Figure 6-11. Security Market Line

18%

12% Required Return 6%

0% 0.00

0.50

1.00 Beta

1.50

2.00

2.50

The Security Market Line shows the projected changes in expected return, due to changes in the beta coefficient. However, we can also look at the potential changes in the required return due to variations in other factors, for example the market return and risk-free rate. In other words, we can see how required returns can be influenced by changing inflation and risk aversion. The level of investor risk aversion is measured by the market risk premium (rM rRF), which is also the slope of the SML. Hence, an increase in the market return results in an increase in the maturity risk premium, other things held constant. We will look at two potential conditions as shown in the following columns: OR Scenario 1. Interest rates increase: Risk-free rate
Beta Old market return
Change in interest rates

New market return

6% 0.50 11% 2% 13% 10.5%

Scenario 2. Investors become more risk averse: Risk-free rate 6% Beta 0.50 Old market return 11% Increase in MRP 2.5% New market return 13.5% Required return 9.75%

Required return

Now we can see how these two factors can affect a Security Market Line, using a data table for the required return with different beta coefficients. Required Return Interest Rate Risk Aversion Beta Original Situation Increases Increases 8.5% 10.5% 9.75% 0.00 6.00% 8.00% 6.00% 0.50 8.50% 10.50% 9.75% 1.00 11.00% 13.00% 13.50% 1.50 13.50% 15.50% 17.25% 2.00 16.00% 18.00% 21.00%

A 610 611 612 613 614 615 616 617 618 619 620 621 622 623 624 625 626 627 628 629 630 631 632 633 634 635 636 637 638 639 640 641 642 643

The SML Under Inflation and Risk Aversion Increases

9% 8% 7% 6% 5% Required 4% Returns 3% 2% 1% 0% 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 2.00 Risk, bi
Column B Column C Column D

1. As beta, which measures risk, increases, the required return on securities increases, given the existence of risk aversion. 2. If iinterest rates increase, the required return on all securities, regardless of risk increases by the increase in the risk-free rate. 3. If risk aversion increases, the return on all securities except the riskless asset (beta = 0) increase. However, the higher the beta, the greater the increase in the required return.

SECTION 6.1
SOLUTIONS TO SELF-TEST Suppose you pay $500 for an investment that returns $600 in one year. What is the annual rate of return?

Amount invested $500 Amount received in one year $600 Dollar return Rate of return $100 20%

SECTION 6.2
SOLUTIONS TO SELF-TEST An investment has a 20% chance of producing a 25% return, a 60% chance of producing a 10% return, and a 20% chance of producing a -15% return. What is its expected return? What is its standard deviation?
Probability

20% 60% 20%

Return 25% 10% -15% Expected return = Return 25% 10% -15%

Prob x Ret. 5.0% 6.0% -3.0% 8.0% expected return Deviation2 Prob x Dev.2 17.0% 2.890% 0.578% 2.0% 0.040% 0.024% -23.0% 5.290% 1.058% Variance = 1.660% Standard deviation = 12.9%

Probability

20% 60% 20%

A stocks returns for the past three years are 10%, -15%, and 35%. What is the historical average return? What is the historical sample standard deviation? Realized return 10% -15% 35% 10.0% 25.0%

Year 1 2 3 Average = Standard deviation =

An investment has an expected return of 15% and a standard deviation of 30%. What is its coefficient of variation? Expected return Standard deviation Coefficient of variation 15.0% 30.0% 2.0

ing a 10% return, its standard

is its coefficient of

SECTION 6.3
SOLUTIONS TO SELF-TEST An investor has a 3-stock portfolio with $25,000 invested in Dell, $50,000 invested in Ford, and $25,000 invested in Wal-Mart. Dells beta is estimated to be 1.20, Fords beta is estimated to be 0.80, and Wal-Marts beta is estimated to be 1.0. What is the estimated beta of the investors portfolio?
Stock

Dell Ford Wal-Mart Total

Investment $25,000 $50,000 $25,000 $100,000

Beta 1.2 0.8 1.0

Weight Beta x Weight 0.25 0.30 0.50 0.40 0.25 0.25 0.95

Portfolio beta =

An individual has $35,000 invested in a stock with a beta of 0.8 and another $40,000 invested in a stock with a beta of 1.4. If these are the only two investments in her portfolio, what is her portfolios beta?

Stock

Dell Ford Total

Investment $35,000 $40,000 $75,000

Beta 0.8 1.4

Weight Beta x Weight 0.466667 0.37 0.53 0.75 1.12

Portfolio beta =

SECTION 6.5
SOLUTIONS TO SELF-TEST A stock has a beta of 1.4. Assume that the risk-free rate is 5.5% and the market risk premium is 5%. What is the stocks required rate of return? Beta Risk-free rate Market risk premium Required rate of return 1.4 5.5% 5.0% 12.50%

Assume that the risk-free rate is 6% and that the expected return on the market is 13%. What is the required rate of return on a stock that has a beta of 0.7?

Beta Risk-free rate Market risk premium Required rate of return

0.7 6.0% 13.0% 15.10%

Assume that the risk-free rate is 5% and that the market risk premium is 6%. What is the required return on the market, on a stock with a beta of 1.0, and on a stock with a beta of 1.2?

Beta Risk-free rate Market risk premium Required rate of return Beta Risk-free rate Market risk premium Required rate of return

1 5.0% 6.0% 11.00% 1.2 5.0% 6.0% 12.20%

A stock has a beta of 1.4. Assume that the risk-free rate is 5.5% and the market risk premium is 5%. What is the stocks required rate of return? Beta Risk-free rate Market risk premium 2.8 5.5% 5.0%

Required rate of return19.50% A stock has a beta of 1.4. Assume that the risk-free rate is 5.5% and the market risk premium is 5%. What is the stocks required rate of return?

Sheet6 THE RELATIONSHIP BETWEEN RISK AND RATES OF RETURN

(Section 6.5)

The SML shows the relationship between the stock's beta and its required return, as predicted by the CAPM.

rRF rM bi

6% 11% 0.5

<< Varies over time, but is constant for all firms at a given time. << Varies over time, but is constant for all firms at a given time. << Varies over time, and varies from firm to firm.

The SML predicts stock i's required return to be: ri = rRF + bi(RPM) ri = rRF + bi(rM rRF) ri = 6% + 0.5(11% - 6%) ri = 8.5%

=B536+B538*(B537-B536)

THE RELATIONSHIP BETWEEN RISK AND RATES OF RETURN

(Section 6.5)

The SML shows the relationship between the stock's beta and its required return, as predicted by the CAPM.

rRF rM bi

6% 11% 1

<< Varies over time, but is constant for all firms at a given time. << Varies over time, but is constant for all firms at a given time. << Varies over time, and varies from firm to firm.

The SML predicts stock i's required return to be: ri = rRF + bi(RPM) ri = rRF + bi(rM rRF) ri = 6% + 0.5(11% - 6%) ri = 11.0%

=B536+B538*(B537-B536)

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Where Ri is the return of the investment and Rm is the return of the market.

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