Econ 136: Financial Economics

Problem Set #9
Due Date: November 20, 2014
1. XYZ Corporation paid dividends of $2.27 during the past year, and the current stock
price is $28.60. Analysts consensus estimate of the earnings growth rate is 5.15% per
year. What is the expected rate of return for XYZ stock?
The Gordon Growth Model for XYZ Corporation
D0 (1 + g)
(1)
rXYZ g
can be rearranged to given the required rate of return in terms of the other variables:
V0 =

D0 (1 + g)
+g
V0
$2.27 (1 + 0.0515)
+ 0.0515
$28.60
$2.3869
=
+ 0.0515 = 0.1349 = 13.49% or 13.5%
$28.60

rXYZ =

(2)
(3)
(4)

2. Given the following table of returns for Berkshire Hathaway (BRK-A) and Google
(GOOG):
Annual Return (%)
Year Berkshire Hathaway Google
1989
80.95
58.26
1990
47.37
33.79
1991
31.00
29.88
1992
132.44
30.35
1993
32.02
2.94
1994
25.37
4.29
1995
28.57
28.86
1996
0.00
6.36
1997
11.67
48.64
1998
36.19
23.55
(a) Calculate the covariance and correlation of returns between the two companies.
The sample covariance X,Y and the correlation X, Y for two random variates X
and Y is
N
X
(xi x) (yi y)
(5)
X,Y =
N 1
i=1
X,Y
X,Y =
(6)
X Y
where x and y are the calculated means. For this problem we have
1

 rBRK-A = 0.2737, rGOOG = 0.1780 and BRK-A,GOOG = 0.0774.

2
2
= 0.0778 and BRK-A,GOOG = 0.5407
= 0.2638, GOOG
BRK-A
(b) Calculate the variance of a portfolio composed of one-quarter Berkshire Hathaway
and three-quarters Google.
Since variance of a general portfolio is
2
port

N
N X
X

wi wj i,j ,

(7)

i=1 j=1

the variance of a portfolio of one-quarter Berkshire Hathaway and three-quarters

Google is
11
33
13
2
port
=
0.2638 +
0.0778 + 2 0.0774 = 0.0893
(8)
44
44
44
3. Reproduce the graph on Slide 18 from Lecture 19 using the expected return and standard deviation data given on the slide. In this graph the risk of the portfolio is the
standard deviation of the portfolio.
The graph on slide 18 of Lecture 19,

RISK and EXPECTED RETURN

0.5

0.4

return
risk, l = +1
risk, l = 0
risk, l = -1

0.3

0.2

0.1

0.0
0.0

0.2

0.4
0.6
0.8
Fraction of Portfolio in Unilever

1.0

can be reproduced through application of our equations for expected portfolio return and
risk
N
N X
N
X
X
2
E(rport ) =
=
wi E(ri ) and port
wi wj i j i,j
(9)
i=1

i=1 j=1

where
E(rport ) = wULA E(rULA ) + (1 wULA ) E(rTM )
and
q
port =

(10)

2
2
2
+ 2wULA (1 wULA ) ULA TM ULA,TM (11)
+ (1 wULA )2 TM
ULA
wULA

with wi given on the x-axis, identified with each curve, and the data
E(r)

TM
0.14
0.25

ULA
0.18
0.40

4. You have been asked to analyze the risk of a portfolio composed of the following three
assets:
Expected
Standard
Company
Return (%) Deviation (%)
Sony Corporation (SNE)
13
23
Tesoro Petroleum (TSO)
7
35
Storage Technology (STK)
17
44
You have also been given the following table of correlations:
SNE
SNE
1.00
TSO 0.15
STK
0.25

TSO
0.15
1.00
0.27

STK
0.25
0.27
1.00

Calculate the variance of a portfolio, equally weighted across these three investments.
The portfolio variance is
2
port

N X
N
X
i=1 j=1

wi wj i j i,j

1 XX
=
i j i,j
9 i=1 j=1

1 2
2
2
+ STK
+ 2SNE TSO SNE,TSO
SNE + TSO
9
+ 2SNE STK SNE,STK + 2TSO STK TSO,STK ]
1
= [0.0529 + 0.1225 + 0.1936 0.0242 + 0.0506 0.0832]
9
= 0.0347

(12)

(13)
(14)
(15)

5. Assume you currently have all your wealth ($1MM) invested in the Vanguard 500 index
fund, and that you expect to earn an annual return of 7%, with a standard deviation of
returns of 25%. Since you have become more risk averse, you decide to shift $850,000
from the Vanguard 500 index fund to Treasury bills. The T-bill rate is 1%. Estimate
the expected return and standard deviation of your new portfolio.
Your reallocation of assets has resulted in a new portfolio consisting of two assets:
(a) T-bills with E(rT-bill ) = 0.01, T-bill = 0 and wT-bill = 0.85 (= $850K/$1MM).
(b) the Vanguard 500 index fund with E(rV500 ) = 0.07, V500 = 0.25 and
wV500 = 0.15 (= $150K/$1MM).
The expected return of the portfolio is
E(rport ) =

N
X

wi E(ri ) = wV500 E(rV500 ) + wT-bill E(rT-bill )

(16)

i=1

= 0.15 0.07 + 0.85 0.01 = 0.019 or 1.9%

(17)

The standard deviation of the portfolio is the square root of the portfolio variance
2
port
=

=
=

N X
N
X

wi wj i j i,j

i=1 j=1
2
2
wV500
V500
2
2
wV500
V500

(18)

2
2
+ wT-bill
T-bill
+ 2wV500 wT-bill V500 T-bill V500,T-bill

(19)
(20)

because T-bill = 0. So
port = wV500 V500 = 0.15 0.25 = 0.0375 or 3.75%

(21)

6. Show how equating the Sharpe ratio and the slope on the efficient frontier,
E(rm ) rf
m

and

m (E(ri ) E(rm ))
2
i,m m

respectively, results in the CAPM result for the expected return on asset i, E(ri ) of
E(ri ) = rf + [E(rm ) rf ]

where =

i,m
2
m

2
where E(rm ) is the expected return on the market portfolio, rf is the risk-free rate, m
is the variance of the return of the market portfolio, and i,m is the covariance of the
returns of asset i and the market portfolio.

Equating these items

m (E(ri ) E(rm ))
E(rm ) rf
=
2
m
i,m m

(22)

we can make an initial simplification by multiplying both sides by m which yields

E(rm ) rf =

2
(E(ri ) E(rm ))
m
.
2
i,m m

(23)

2
DIviding the numerator and denominator on the right-hand side by m
yields

E(rm ) rf =

E(ri ) E(rm )
,
1

(24)

2
. Multiplying through by 1 gives us
where we have used the fact that = i,m /m

[E(rm ) rf ] [ 1] = E(ri ) E(rm )

(25)

or
[E(rm ) rf ] E(rm ) + rf = E(ri ) E(rm ) .

(26)

Adding E(rm ) to each side and rearranging we obtain the desired result:
E(ri ) = rf + [E(rm ) rf ] .

(27)

7. Given the following table of annual percent returns for Scientific Atlanta and the market
portfolio:
Year Scientific Atlanta
1989
85.95
1990
40.37
1991
31.00
1992
125.44
1993
32.02
1994
15.37
1995
20.57
1996
11.00
1997
11.67
1998
4.00

Market Portfolio
31.49
3.17
35.57
7.58
11.36
2.55
37.57
22.68
33.10
28.32

(a) Calculate the covariance of returns between Scientific Atlanta and the market
portfolio.
The sample covariance is -0.0049.
(b) Calculate the variance of returns for both investments.
The sample variance of Scientific Atlanta returns is 0.2349.
The sample variance of the market portfolio returns is 0.0192.
(c) Calculate the beta for Scientific Atlanta
2
From our definition of beta, SA = SA, market /market
= 0.0049/0.0192 = 0.2552

8. Assume that the market has an expected return of 12% and volatility (risk or standard
deviation) of 18%. Suppose the CAPM accurately describes the data you are using. If
Hewlett-Packard (HP) has a 25.0% correlation with the market and a 38% volatility
when the risk-free rate is 1.2%:
(a) What is the covariance between HP and the market?
HP, m = HP m HP, m = 0.38 0.18 0.25 = 0.0171 .
(b) What is HPs beta?
2
HP = HP, m /m
= 0.0171/(0.18)2 = 0.528 .

(c) What is the expected return on HP?

Using CAPM the expected return is
E(rHP ) = rf + HP [E(rm ) rf ] = 1.2% + 0.528 [12% 1.2%] = 6.9% .

(28)

(d) What percentage of HPs total risk (variance) is specific (non-systematic)?

From Lecture 20 we have that
2 (rj ) = j2 2 (rm ) + 2 (j )
| {z }
| {z }
2 (j )
| {z }

idiosyncratic
systematic
risk
risk
2
2 2
(rj ) j (rm )

idiosyncratic
risk

{z

(29)

(30)

systematic
risk

or, on a percentage basis

2
2 (j )
2 (rm )
=
1

.
j
2 (rj )
2 (rj )
| {z }
| {z }

(31)

systematic
risk

idiosyncratic
risk

Substituting our results above we get

2
2 (HP )
2 (rm )
=
1

HP 2
2 (rHP )
(rHP )
| {z }
|
{z
}

(32)

systematic
risk

idiosyncratic
risk

=1

2
2 (0.18)
(0.528)
(0.38)2

{z

systematic
risk

= 0.9374 .

By this metric, 93.74% of HPs risk is specific and 6.26% is systematic.

(33)