Risk and Rates of Return

Risk The chance that some unfavorable event will occur; investment risk can be measured by
the variability of the investments return.

Stand-Alone Risk

Probability Distributions

Subjective (estimated)
Objective (historical)
Continuous
Discrete

Expected Rate of Return

weighted average of all possible outcomes
the rate of return expected to be realized from an investment
the mean value of the probability distribution of possible results

Variance (2)

Standard Deviation ()
measures total risk

Coefficient of Variation (CV = /k)

measures risk per unit of return
can be used to rank stocks based upon their risk/return characteristics
the CV is most useful when analyzing investments that have different expected
rates of return and different levels of risk

Risk Aversion
the greater a securitys risk, the greater the return investors will demand and thus the
less they are willing to pay for the investment

Risk Premium
the portion of a securitys expected return that is attributed to the additional risk of an
investment over and above the risk-free rate of return

Portfolio Risk

Portfolio a collection or grouping of investment securities or assets

Prepared by Jim Keys -1-
 Efficient Portfolio
1) Maximize return for a given level of risk
2) Minimize risk for a given level of return

Portfolio Return
the expected return on a portfolio, kp, is the weighted average of the expected returns
on the individual stocks in the portfolio
the portfolio weights must sum to 1.0
the realized rate of return is the return that is actually earned on a stock or portfolio of
stocks

Portfolio Risk
the riskiness of a portfolio of securities, p, in general is not a weighted average of the
standard deviations of the individual securities in the portfolio
the correlation coefficient, r, is a measure of the degree of co-movement between two
variables; in this case, the variable is the rate of return on two stocks over some past
period
-1.0 r +1.0
the riskiness of a portfolio will be reduced as the number of stocks in the portfolio
increases; the lower the correlation between stocks that are added to the portfolio the
greater the benefits of continued diversification

Firm-Specific, Diversifiable, or Unsystematic Risk

that part of a securitys risk associated with random outcomes generated by events or
behaviors specific to the firm; firm-specific risk can be eliminated by proper
diversification

Market, Nondiversifiable, or Systematic Risk

that part of a securitys risk that cannot be eliminated by diversification because it is
associated with economic or market factors that will affect most firms

Capital Asset Pricing Model (CAPM)

the relevant riskiness of an individual stock is its contribution to the riskiness of a
well-diversified portfolio, since all investors can be well-diversified if they wish; the
market offers no compensation for undertaking diversifiable risk
the risk that remains after diversifying is market risk, or the risk that is inherent in the
market, and it can be measured as the degree to which a given stock tends to move with
the market
a stocks beta coefficient, , is a measure of the extent to which the returns on a given
stock move with the stock market as a whole (in most cases, a proxy for the market is
used, such as the S & P 500 stock index)
by definition, the beta of the market, M = +1.0

Prepared by Jim Keys -2-

 Portfolio Beta
the beta of a portfolio of securities, p, is a weighted average of the individual
securities betas

Relationship Between Risk and Rates of Return

Security Market Line (SML) or the CAPM Equation:

kj = kRF + (kM kRF) j

the SML shows the relationship between risk as measured by beta and the
required return for individual securities
kj is the required rate of return on stock j; kRF is the risk-free rate of return (U.S.
Treasury securities); kM is the required rate of return on the market portfolio and j is the
beta coefficient of stock j

Problems

1) Given the following probability distribution of returns for a stock, what is the expected rate
of return, standard deviation of the returns, and coefficient of variation on the investment?

Probability Rate of Return

.10 -10%
.20 5%
.30 10%
.40 25%

Prepared by Jim Keys -3-

2) Using the CAPM, determine the appropriate required rate of return for each of the three
stocks listed below, given that the risk-free rate is 5% and the expected rate of return for the
market is 17%.

STOCK BETA ()

A .75
B .90
C 1.40

3) Determine the expected return and beta for the following three-stock portfolio:

EXPECTED
STOCK INVESTMENT BETA RETURN

A $ 60,000 1.00 12.0%

B 37,500 0.75 11.0%
C 52,500 1.30 15.0%

4) A stock has an expected return of 14.25%. The beta of the stock is 1.25 and the risk-free rate
is 6.0%. What is the market risk premium, RPM?

Prepared by Jim Keys -4-

 Answers
1) Expected Rate of Return = 13%
Standard Deviation = 11.22%
Coefficient of Variation = .863

2) k A = 14.0%
k B = 15.8%
k C = 21.8%

3) k p = 12.8%
p = 1.04

4) RPM = 6.60%

INTEGRATIVE PROBLEM

ASSUMETHATYOURECENTLYGRADUATEDWITHAMAJORINFINANCE,ANDYOU
JUSTLANDEDAJOBINTHETRUSTDEPARTMENTOFALARGEREGIONALBANK.
YOURFIRSTASSIGNMENTISTOINVEST$100,000FROMANESTATEFORWHICH
THEBANKISTRUSTEE.BECAUSETHEESTATEISEXPECTEDTOBEDISTRIBUTED
TOTHEHEIRSINABOUTONEYEAR,YOUHAVEBEENINSTRUCTEDTOPLANFORA
ONEYEARHOLDINGPERIOD.FURTHER,YOURBOSSHASRESTRICTEDYOUTOTHE
FOLLOWINGINVESTMENTALTERNATIVES,SHOWNWITHTHEIRPROBABILITIESAND
ASSOCIATEDOUTCOMES.(DISREGARDFORNOWTHEITEMSATTHEBOTTOMOF
THEDATA;YOUWILLFILLINTHEBLANKSLATER.)

RETURNSONALTERNATIVEINVESTMENTS
ESTIMATEDRATEOFRETURN
STATEOFTHETHIGHCOLLECU.S.MARKET2STOCK
ECONOMYPROB.BILLSTECHTIONSRUBBERPORTFOLIOPORTFOLIO

RECESSION0.18.0%22.0%28.0%10.0%13.0%
BELOWAVG0.28.02.014.710.01.0
AVERAGE0.48.020.00.07.015.0
ABOVEAVG0.28.035.010.045.029.0
BOOM0.18.050.020.030.043.0

k^
STDDEV()
COEFOFVAR(CV)
BETA()

THEBANK'SECONOMICFORECASTINGSTAFFHASDEVELOPEDPROBABILITY
ESTIMATESFORTHESTATEOFTHEECONOMY,ANDTHETRUSTDEPARTMENTHASA

Prepared by Jim Keys -5-

 SOPHISTICATEDCOMPUTERPROGRAMTHATWASUSEDTOESTIMATETHERATEOF
RETURNONEACHALTERNATIVEUNDEREACHSTATEOFTHEECONOMY.HIGHTECH
INC.ISANELECTRONICSFIRM;COLLECTIONSINC.COLLECTSPASTDUEDEBTS;
ANDU.S.RUBBERMANUFACTURESTIRESANDVARIOUSOTHERRUBBERAND
PLASTICSPRODUCTS.THEBANKALSOMAINTAINSAN"INDEXFUND"THATOWNS
AMARKETWEIGHTEDFRACTIONOFALLPUBLICLYTRADEDSTOCKS;YOUCAN
INVESTINTHATFUNDANDTHUSOBTAINAVERAGESTOCKMARKETRESULTS.
GIVENTHESITUATIONASDESCRIBED,ANSWERTHEFOLLOWINGQUESTIONS:

A. (1)WHYISTHETBILL'SRETURNINDEPENDENTOFTHESTATEOFTHE
ECONOMY?DOTBILLSPROMISEACOMPLETELYRISKFREERETURN?(2)WHY
AREHIGHTECH'SRETURNSEXPECTEDTOMOVEWITHTHEECONOMYWHEREAS
COLLECTIONS'AREEXPECTEDTOMOVECOUNTERTOTHEECONOMY?

ANSWER:(1)THE8PERCENTTBILLRETURNDOESNOTDEPENDONTHESTATEOFTHE
ECONOMYBECAUSETHETREASURYMUST(ANDWILL)REDEEMTHEBILLSATPAR
REGARDLESSOFTHESTATEOFTHEECONOMY.
THETBILLSARERISKFREEINTHEDEFAULTRISKSENSEBECAUSETHE8
PERCENTRETURNWILLBEREALIZEDINALLPOSSIBLEECONOMICSTATES.HOWEVER,
REMEMBERTHATTHISRETURNISCOMPOSEDOFTHEREALRISKFREERATE,SAY,3
PERCENT,PLUSANINFLATIONPREMIUM,SAY5PERCENT.BECAUSETHEREIS
UNCERTAINTYABOUTINFLATION,ITISUNLIKELYTHATTHEREALIZEDREALRATEOF
RETURNWOULDEQUALTHEEXPECTED3PERCENT.FOREXAMPLE,IFINFLATIONAVERAGED
6PERCENTOVERTHEYEAR,THENTHEREALIZEDREALRETURNWOULDBEONLY8%)6%=
2%,NOTTHEEXPECTED3%.THUS,INTERMSOFPURCHASINGPOWER,TBILLSARENOT
RISKLESS.
ALSO,IFYOUINVESTEDINAPORTFOLIOOFTBILLS,ANDRATESTHEN
DECLINED,YOURNOMINALINCOMEWOULDFALL;THATIS,TBILLSAREEXPOSEDTO
REINVESTMENTRATERISK.SO,WECONCLUDETHATTHEREARENOTRULYRISKFREE
SECURITIESINTHEUNITEDSTATES.IFTHETREASURYSOLDINFLATIONINDEXED,TAX
EXEMPTBONDS,THEYWOULDBETRULYRISKLESS,BUTALLACTUALSECURITIESARE
EXPOSEDTOSOMETYPEOFRISK.
(2)HIGHTECH'SRETURNSMOVEWITH,HENCEAREPOSITIVELYCORRELATED
WITH,THEECONOMY,BECAUSETHEFIRM'SSALES,ANDHENCEPROFITS,GENERALLYWILL
EXPERIENCETHESAMETYPEOFUPSANDDOWNSASTHEECONOMY.IFTHEECONOMYIS
BOOMING,SOWILLHIGHTECH.ONTHEOTHERHAND,COLLECTIONSISCONSIDEREDBY
MANYINVESTORSTOBEAHEDGEAGAINSTBOTHBADTIMESANDHIGHINFLATION,SOIF
THESTOCKMARKETCRASHES,INVESTORSINTHISSTOCKSHOULDDORELATIVELYWELL.
STOCKSSUCHASCOLLECTIONSARETHUSNEGATIVELYCORRELATEDWITH(MOVECOUNTER
TO)THEECONOMY.(NOTE:INACTUALITY,ITISALMOSTIMPOSSIBLETOFINDSTOCKS
THATAREEXPECTEDTOMOVECOUNTERTOTHEECONOMY.EVENCOLLECTIONSSHARES
HAVEPOSITIVE(BUTLOW)CORRELATIONWITHTHEMARKET.)

Prepared by Jim Keys -6-

 B. CALCULATETHEEXPECTEDRATEOFRETURNONEACHALTERNATIVEANDFILLIN
THEROWFORk^INTHEPRECEDINGTABLE.

ANSWER:THEEXPECTEDRATEOFRETURN,^k,ISEXPRESSEDASFOLLOWS:
PriISTHEPROBABILITYOFOCCURRENCEOFTHEiTHSTATE,kiISTHEESTIMATED
RATEOFRETURNFORTHATSTATE,ANDnISTHENUMBEROFSTATES.HEREISTHE
CALCULATIONFORHIGHTECH:

^kHIGHTECH=0.1(22.0%)+0.2(2.0%)+0.4(20.0%)+0.2(35.0%)+0.1(50.0%)
=17.4%.

WECANNOWADDTHE17.4%TOTHEBOTTOMOFTHETABLE,ANDUSETHESAMEFORMULA
TOCALCULATEk'SFORTHEOTHERALTERNATIVES.HERETHEYARE:

^kTBILLS= 8.0%
k^COLLECTIONS = 1.7%
k^U.S.RUBBER = 13.8%
k^M = 15.0%

C. YOUSHOULDRECOGNIZETHATBASINGADECISIONSOLELYONEXPECTEDRETURNS
ISONLYAPPROPRIATEFORRISKNEUTRALINDIVIDUALS.BECAUSETHE
BENEFICIARIESOFTHETRUST,LIKEVIRTUALLYEVERYONE,ARERISKAVERSE,
THERISKINESSOFEACHALTERNATIVEISANIMPORTANTASPECTOFTHE
DECISION.ONEPOSSIBLEMEASUREOFRISKISTHESTANDARDDEVIATIONOF
RETURNS.(1)CALCULATETHISVALUEFOREACHALTERNATIVE,ANDFILLIN
THEROWFORINTHETABLEABOVE.(2)WHATTYPEOFRISKISMEASURED
BYTHESTANDARDDEVIATION?(3)DRAWAGRAPHTHATSHOWSROUGHLYTHE
SHAPEOFTHEPROBABILITYDISTRIBUTIONSFORHIGHTECH,U.S.RUBBER,AND
TBILLS.

ANSWER:(1)THESTANDARDDEVIATIONISCALCULATEDASFOLLOWS:

HIGHTECH=[(22.017.4)2(0.1)+(2.017.4)2(0.2)+(20.017.4)2(0.4)
+(35.017.4)2(0.2)+(50.017.4)2(0.1)]

=(401.4)1/2

=20.0%

HEREARETHESTANDARDDEVIATIONSFORTHEOTHERALTERNATIVES:

TBILLS = 0.0%.

Prepared by Jim Keys -7-

 COLLECTIONS= 13.4%.
U.S.RUBBER= 18.8%.
M = 15.3%.

(2)THESTANDARDDEVIATIONISAMEASUREOFASECURITY'S(ORAPORTFOLIO'S)
TOTAL,ORSTANDALONE,RISK.THELARGERTHESTANDARDDEVIATION,THEHIGHER
THEPROBABILITYTHATACTUALREALIZEDRETURNSWILLFALLFARBELOWTHEEXPECTED
RETURN,ANDTHATLOSSESRATHERTHANPROFITSWILLBEINCURRED.

(3)PROBABILITYDISTRIBUTIONCURVESFORHIGHTECH,U.S.RUBBER,ANDTBILLS
ARESHOWNHERE:

PROBABILITY
OF OCCURENCE

T-BILLS

U.S. HIGH TECH

RUBBER

-45 -30 -15 15 30 45 RATE OF

13.8 17.4 RETURN
(%)

Prepared by Jim Keys -8-

 D. SUPPOSEYOUSUDDENLYREMEMBEREDTHATTHECOEFFICIENTOFVARIATION(CV)
ISGENERALLYREGARDEDASBEINGABETTERMEASUREOFTOTALRISKTHANTHE
STANDARDDEVIATIONWHENTHEALTERNATIVESBEINGCONSIDEREDHAVEWIDELY
DIFFERINGEXPECTEDRETURNS.CALCULATETHECVsFORTHEDIFFERENT
SECURITIES,ANDFILLINTHEROWFORCVINTHEPRECEDINGTABLE.DOES
THECVPRODUCETHESAMERISKRANKINGSASTHESTANDARDDEVIATION?

ANSWER:THECOEFFICIENTOFVARIATION(CV)ISASTANDARDIZEDMEASUREOF
DISPERSIONABOUTTHEEXPECTEDVALUE;ITSHOWSTHEAMOUNTOFRISKPERUNITOF
RETURN.

CV =___
k^

CVTBILLS =0.0%/8.0%=0.0.

CVHIGHTECH =20.0%/17.4%=1.1.

CVCOLLECTIONS =13.4%/1.7%=7.9.

CVU.S.RUBBER =18.8%/13.8%=1.4.

CVM =15.3%/15.0%=1.0.

WHENWEMEASURERISKPERUNITOFRETURN,COLLECTIONS,WITHITSLOW
EXPECTEDRETURN,BECOMESTHERISKIESTSTOCK.THECVISABETTERMEASUREOFAN
ASSET'STOTAL,ORSTANDALONE,RISKTHANBECAUSECVCONSIDERSBOTHTHE
EXPECTEDVALUEANDTHEDISPERSIONOFADISTRIBUTIONASECURITYWITHALOW
EXPECTEDRETURNANDALOWSTANDARDDEVIATIONCOULDHAVEAHIGHERCHANCEOFA
LOSSTHANONEWITHAHIGHBUTAHIGH^k.

E. SUPPOSEYOUCREATEDATWOSTOCKPORTFOLIOBYINVESTING$50,000INHIGH
TECHAND$50,000INCOLLECTIONS.(1)CALCULATETHEEXPECTEDRETURN
(k^p),THESTANDARDDEVIATION(p),ANDTHECOEFFICIENTOFVARIATION
(CVp)FORTHISPORTFOLIOANDFILLINTHEAPPROPRIATEROWSINTHETABLE
PRECEDING.(2)HOWDOESTHERISKINESSOFTHISTWOSTOCKPORTFOLIO
COMPARETOTHERISKINESSOFTHEINDIVIDUALSTOCKSIFTHEYWEREHELDIN
ISOLATION?

ANSWER:(1)TOFINDTHEEXPECTEDRATEOFRETURNONTHETWOSTOCKPORTFOLIO,WE
FIRSTCALCULATETHERATEOFRETURNONTHEPORTFOLIOINEACHSTATEOFTHE

Prepared by Jim Keys -9-

ECONOMY.BECAUSEWEHAVEHALFOFOURMONEYINEACHSTOCK,THEPORTFOLIO'S
RETURNWILLBEAWEIGHTEDAVERAGEINEACHTYPEOFECONOMY.FORARECESSION,
WEHAVE:kp=0.5(22%)+0.5(28%)=3%.WEWOULDDOSIMILARCALCULATIONS
FORTHEOTHERSTATESOFTHEECONOMY,ANDGETTHESERESULTS:

STATEPORTFOLIO
RECESSION3.0%
BELOWAVERAGE6.4
AVERAGE10.0
ABOVEAVERAGE12.5
BOOM15.0

ADDTHESETOTHETABLETOCOMPLETETHELASTCOLUMN.
NOWWECANMULTIPLYPROBABILITIESTIMESOUTCOMESINEACHSTATETOGET
THEEXPECTEDRETURNONTHISTWOSTOCKPORTFOLIO,9.6%.
ALTERNATIVELY,WECOULDAPPLYTHISFORMULA,
k=wjkj=0.5(17.4%)+0.5(1.7%)=9.6%,
WHICHFINDSkASTHEWEIGHTEDAVERAGEOFTHEEXPECTEDRETURNSOFTHE
INDIVIDUALSECURITIESINTHEPORTFOLIO.

ITISTEMPTINGTOFINDTHESTANDARDDEVIATIONOFTHEPORTFOLIOASTHEWEIGHTED
AVERAGEOFTHESTANDARDDEVIATIONSOFTHEINDIVIDUALSECURITIES,ASFOLLOWS:
pwHT(C)+wHT(C)=0.5(20%)+0.5(13.4%)=16.7%.
HOWEVER,THISISNOTCORRECTITISNECESSARYTOUSEADIFFERENTFORMULA,THE
ONEFORTHATWEUSEDEARLIER,APPLIEDTOTHETWOSTOCKPORTFOLIO'SRETURNS.
THEPORTFOLIO'SDEPENDSJOINTLYON(1)EACHSECURITY'SAND(2)THE
CORRELATIONBETWEENTHESECURITIES'RETURNS.THEBESTWAYTOAPPROACHTHE
PROBLEMISTOESTIMATETHEPORTFOLIO'SRISKANDRETURNINEACHSTATEOFTHE
ECONOMYANDTHENTOESTIMATEpWITHTHEFORMULA.GIVENTHEDISTRIBUTIONOF
RETURNSFORTHEPORTFOLIO,WECANCALCULATETHEPORTFOLIO'SANDCVASSHOWN
BELOW:

p=[(3.09.6)2(0.1)+(6.49.6)2(0.2)+(10.09.6)2(0.4)
+(12.59.6)2(0.2)+(15.09.6)2(0.1)]1/2
=3.3%.

CVp=3.3%/9.6%=0.3.

(2)USINGEITHERORCVASOURTOTALRISKMEASURE,THETOTALRISKOF
THEPORTFOLIOISSIGNIFICANTLYLESSTHANTHETOTALRISKOFTHEINDIVIDUAL
STOCKS.THISISBECAUSETHETWOSTOCKSARENEGATIVELYCORRELATEDWHENHIGH
TECHISDOINGPOORLY,COLLECTIONSISDOINGWELL,ANDVICEVERSA.COMBINING
THETWOSTOCKSDIVERSIFIESAWAYSOMEOFTHERISKINHERENTINEACHSTOCKIFIT
WEREHELDINISOLATION,I.E.,INASINGLESTOCKPORTFOLIO.

Prepared by Jim Keys - 10 -

OPTIONALQUESTION:USEONLYIFYOUHAVELOTSOFTIME.DOESTHEEXPECTEDRATE
OFRETURNONTHEPORTFOLIODEPENDONTHEPERCENTAGEOFTHEPORTFOLIOINVESTED
INEACHSTOCK?WHATABOUTTHERISKINESSOFTHEPORTFOLIO?
ANSWER:USINGASPREADSHEETMODEL,IT'SEASYTOVARYTHECOMPOSITION
OFTHEPORTFOLIOTOSHOWTHEEFFECTONTHEPORTFOLIO'SEXPECTEDRATEOFRETURN
ANDSTANDARDDEVIATION:

HIGHTECHPLUSCOLLECTIONS
^
%INHIGHTECHkpp
_______________________
0%1.7%13.4%
103.310.0
204.96.7
306.43.3
408.00.0
509.63.3
6011.16.7
7012.710.0
8014.313.4
9015.816.7
10017.420.0

NOTICETHATTHEEXPECTEDRATEOFRETURNONTHEPORTFOLIOISMERELYA
LINEARCOMBINATIONOFTHETWOSTOCK'SEXPECTEDRATESOFRETURN.HOWEVER,
PORTFOLIORISKISANOTHERMATTER.ASTHEVALUESSHOW,pBEGINSTOFALLAS
HIGHTECHANDCOLLECTIONSARECOMBINED;ITREACHESZEROAT40%HIGHTECH;AND
THENITBEGINSTORISE.HIGHTECHANDCOLLECTIONSCANBECOMBINEDTOFORMA
NEARZERORISKPORTFOLIOBECAUSETHEYAREVERYCLOSETOBEINGPERFECTLY
NEGATIVELYCORRELATED;THEIRCORRELATIONCOEFFICIENTIS)0.9998.(NOTE:
UNFORTUNATELY,WECANNOTFINDANYACTUALSTOCKSWITHr=)1.0.)

F. SUPPOSEANINVESTORSTARTSWITHAPORTFOLIOCONSISTINGOFONERANDOMLY
SELECTEDSTOCK.WHATWOULDHAPPEN(1)TOTHERISKINESSAND(2)TOTHE
EXPECTEDRETURNOFTHEPORTFOLIOASMOREANDMORERANDOMLYSELECTED
STOCKSWEREADDEDTOTHEPORTFOLIO?WHATISTHEIMPLICATIONFOR
INVESTORS?DRAWTWOGRAPHSTOILLUSTRATEYOURANSWER.

ANSWER:

Prepared by Jim Keys - 11 -

 PROBABILITY
OF OCCURENCE

PORT FOLIO OF
SIM ILAR STOCKS

SING LE-STOCK
PORT FOLIO

-45 -30 -15 15 30 45 RATE OF

RETURN
(%)

THISGRAPHSHOWSTHEPROBABILITYDISTRIBUTIONSFORAONESTOCKPORTFOLIOANDA
PORTFOLIOOFMANYSIMILARSTOCKS.THEGRAPHSHOWSTHATTHESTANDARDDEVIATION
GETSSMALLERASMORESTOCKSARECOMBINEDINTHEPORTFOLIO,WHILEkp(THE
PORTFOLIO'SRETURN)REMAINSCONSTANT.THUS,BYADDINGSTOCKSTOYOUR
PORTFOLIO,WHICHINITIALLYSTARTEDASASINGLESTOCKPORTFOLIO,RISKHASBEEN
REDUCED.
INTHEREALWORLD,STOCKSAREPOSITIVELYCORRELATEDWITHONEANOTHER
IFTHEECONOMYDOESWELL,SODOSTOCKSINGENERAL,ANDVICEVERSA.CORRELATION
COEFFICIENTSBETWEENSTOCKSGENERALLYRANGEFROM+0.5TO+0.7.THEGRAPHBELOW
SHOWSTHERELATIONSHIPBETWEENPORTFOLIOSIZEANDRISK.

Prepared by Jim Keys - 12 -

 PORTFOLIO
RISK, P (%)

DIVERSIFIABLE
(UNSYSTEMATIC) RISK

TOTAL
RISK NONDIVERSIFIABLE
(SYSTEMATIC) RISK

1 10 20 30 40 NUMBEROF
STOCKS

ASINGLESTOCKSELECTEDATRANDOMWOULDONAVERAGEHAVEASTANDARDDEVIATION
OFABOUT28PERCENT.ASADDITIONALSTOCKSAREADDEDTOTHEPORTFOLIO,THE
PORTFOLIO'SSTANDARDDEVIATIONDECREASESBECAUSETHEADDEDSTOCKSARENOT
PERFECTLYPOSITIVELYCORRELATED.HOWEVER,ASMOREANDMORESTOCKSAREADDED,
EACHNEWSTOCKHASLESSOFARISKREDUCINGIMPACT,ANDEVENTUALLYADDING
ADDITIONALSTOCKSHASVIRTUALLYNOEFFECTONTHEPORTFOLIO'SRISKASMEASURED
BY.INFACT,STABILIZESATABOUT15PERCENTWHEN40ORMORERANDOMLY
SELECTEDSTOCKSAREADDED.THUS,BYCOMBININGSTOCKSINTOWELLDIVERSIFIED
PORTFOLIOS,INVESTORSCANELIMINATEALMOSTONEHALFTHERISKINESSOFHOLDING
INDIVIDUALSTOCKS.(NOTE:ITISNOTCOMPLETELYCOSTLESSTODIVERSIFY,SO
EVENTHELARGESTINSTITUTIONALINVESTORSHOLDLESSTHANALLSTOCKS.EVEN

Prepared by Jim Keys - 13 -

INDEXFUNDSGENERALLYHOLDASMALLERPORTFOLIOTHATISHIGHLYCORRELATEDWITH
ANINDEXSUCHASTHES&P500RATHERTHANHOLDALLTHESTOCKSINTHEINDEX.)
THEIMPLICATIONISCLEAR:INVESTORSSHOULDHOLDWELLDIVERSIFIED
PORTFOLIOSOFSTOCKSRATHERTHANINDIVIDUALSTOCKS.(INFACT,INDIVIDUALSCAN
HOLDDIVERSIFIEDPORTFOLIOSTHROUGHMUTUALFUNDINVESTMENTS.)BYDOINGSO,
THEYCANELIMINATEABOUTHALFOFTHERISKINESSINHERENTININDIVIDUALSTOCKS.

G. (1)SHOULDPORTFOLIOEFFECTSIMPACTTHEWAYINVESTORSTHINKABOUTTHE
RISKINESSOFINDIVIDUALSTOCKS?(2)IFYOUCHOSETOHOLDAONESTOCK
PORTFOLIOANDCONSEQUENTLYWEREEXPOSEDTOMORERISKTHANDIVERSIFIED
INVESTORS,COULDYOUEXPECTTOBECOMPENSATEDFORALLOFYOURRISK;
THATIS,COULDYOUEARNARISKPREMIUMONTHATPARTOFYOURRISKTHAT
YOUCOULDHAVEELIMINATEDBYDIVERSIFYING?

ANSWER:(1)PORTFOLIODIVERSIFICATIONDOESAFFECTINVESTORS'VIEWSOFRISK.
ASTOCK'STOTAL,ORSTANDALONE,RISKASMEASUREDBYITSORCV,MIGHTBE
IMPORTANTTOANUNDIVERSIFIEDINVESTOR,BUTITISNOTRELEVANTTOAWELL
DIVERSIFIEDINVESTOR.ARATIONAL,RISKAVERSEINVESTORISMOREINTERESTEDIN
THEIMPACTTHATTHESTOCKHASONTHERISKINESSOFHISORHERPORTFOLIOTHANON
THESTOCK'SSTANDALONE,ORTOTAL,RISK.STANDALONERISKISCOMPOSEDOF
DIVERSIFIABLE,ORCOMPANYSPECIFIC,RISK,WHICHCANBEELIMINATEDBYHOLDING
THESTOCKINAWELLDIVERSIFIEDPORTFOLIO,ANDTHERISKTHATREMAINS,WHICHIS
CALLEDMARKETRISKBECAUSEITISPRESENTEVENWHENTHEENTIREMARKETPORTFOLIO
ISHELD.
(2)IFYOUHOLDAONESTOCKPORTFOLIO,YOUWILLBEEXPOSEDTOAHIGH
DEGREEOFRISK,BUTYOUWON'TBECOMPENSATEDFORIT.IFTHERETURNWEREHIGH
ENOUGHTOCOMPENSATEYOUFORYOURHIGHRISK,ITWOULDBEABARGAINFORMORE
RATIONAL,DIVERSIFIEDINVESTORS.THEYWOULDSTARTBUYINGIT,ANDTHESEBUY
ORDERSWOULDDRIVETHEPRICEUPANDTHERETURNDOWN.THUS,YOUSIMPLYCOULD
NOTFINDSTOCKSINTHEMARKETWITHRETURNSHIGHENOUGHTOCOMPENSATEYOUFOR
THESTOCK'SDIVERSIFIABLERISK.

H. THEEXPECTEDRATESOFRETURNANDTHEBETACOEFFICIENTSOFTHE
ALTERNATIVESASSUPPLIEDBYTHEBANK'SCOMPUTERPROGRAMAREAS
FOLLOWS:

SECURITYRETURN(k^)RISK(BETA)
________________________________
HIGHTECH17.4%1.29
MARKET15.01.00
U.S.RUBBER13.80.68
TBILLS8.00.00
COLLECTIONS1.70.86

Prepared by Jim Keys - 14 -

 (1) WHATISABETACOEFFICIENT,ANDHOWAREBETASUSEDINRISK
ANALYSIS?(2)DOTHEEXPECTEDRETURNSAPPEARTOBERELATEDTO
EACHALTERNATIVE'SMARKETRISK?(3)ISITPOSSIBLETOCHOOSE
AMONGTHEALTERNATIVESONTHEBASISOFTHEINFORMATIONDEVELOPED
THUSFAR?USETHEDATAGIVENATTHESTARTOFTHEPROBLEMTO
CONSTRUCTAGRAPHTHATSHOWSHOWTHETBILL'S,HIGHTECH'S,AND
COLLECTIONS'BETACOEFFICIENTSARECALCULATED.THENDISCUSSWHAT
BETASMEASUREANDHOWTHEYAREUSEDINRISKANALYSIS.

ANSWER:DRAWTHEFRAMEWORKOFTHEGRAPH,PUTUPTHEDATA,THENPLOTTHEPOINTS
FORTHEMARKET(45LINE)ANDCONNECTTHEM,ANDTHENGETTHESLOPEASY/X=
1.0.)STATETHATANAVERAGESTOCK,BYDEFINITION,MOVESWITHTHEMARKET.
THENDOTHESAMEWITHHIGHTECHANDU.S.RUBBER.BETACOEFFICIENTSMEASURE
THERELATIVEVOLATILITYOFAGIVENSTOCKVISAVISANAVERAGESTOCK.THE
AVERAGESTOCK'SBETAIS1.0.MOSTSTOCKSHAVEBETASINTHERANGEOF0.5TO
1.5.THEORETICALLY,BETASCANBENEGATIVE,BUTINTHEREALWORLDTHEY
GENERALLYAREPOSITIVE.

BETASARECALCULATEDASTHESLOPEOFTHE"CHARACTERISTIC"LINE,WHICHISTHE
REGRESSIONLINESHOWINGTHERELATIONSHIPBETWEENAGIVENSTOCKANDTHEGENERAL
STOCKMARKET.THECHARACTERISTICLINEFOREACHINVESTMENTISGIVEN
HERE:

ST OCK
CHARACTERISTIC LINES
RE TU RN
(%)

50

H I G H T E CH
40
M ARK E T
30
U .S. RU B BE R

20

10
= 0.00
T-BIL L S

M ARK E T
-10 RE TU RN
10 20 30 40
(%)
-10
= -0.86
CO L LE CTI O N S
-20

Prepared by Jim Keys - 15 -

THEEXPECTEDRETURNSARERELATEDTOEACHALTERNATIVE'SMARKETRISKTHATIS,
THEHIGHERTHEALTERNATIVE'SRATEOFRETURNTHEHIGHERITSBETA.ALSO,NOTE
THATTBILLSHAVE0RISK.
WEDONOTYETHAVEENOUGHINFORMATIONTOCHOOSEAMONGTHEVARIOUS
ALTERNATIVES.WENEEDTOKNOWTHEREQUIREDRATESOFRETURNONTHESE
ALTERNATIVESANDCOMPARETHEMWITHTHEIREXPECTEDRETURNS.

OPTIONALQUESTION:IFWEHADDATAONTBILLSANDPLOTTEDTHEMONTHEGRAPH,
WHATDOYOUTHINKTHEREGRESSIONLINEWOULDLOOKLIKE,ANDWHATWOULDIT
INDICATEABOUTTHEMARKETRISKOFTBILLS?
ANSWER:SEETHEGRAPH.THEREGRESSIONLINEPROBABLYWOULD(EXCEPTBY
CHANCE)BEAHORIZONTALLINEWITHAVERTICALAXISINTERCEPTOFABOUT8
PERCENT,INDICATINGTHATTBILLSPROVIDEAGUARANTEEDRETURNREGARDLESSOF
WHATTHEMARKETDOES.(WITHTBILLS,THETHEORETICALCHARACTERISTICLINE
(HORIZONTAL)WOULDBEBETTERTHANANEMPIRICALONE.)

OPTIONALQUESTION:IFYOUPLOTTEDCOLLECTIONS'CHARACTERISTICLINE,WHAT
WOULDITSSLOPEBE,ANDWHATWOULDTHISINDICATEABOUTITSRISK?
ANSWER:SEETHEGRAPH.COLLECTIONSHASANEGATIVESLOPEOF0.86,
HENCEITSBETAIS0.86.THUS,COLLECTIONSSTOCKISLIKEANINSURANCEPOLICY
AGAINSTMARKETDECLINESWHENTHEMARKETCRASHESANDYOUROTHERSTOCKSAREALL
PLUMMETING,YOURCOLLECTIONSSTOCKWILLBEGOINGUPANDTHUSREDUCINGYOUR
TOTALPORTFOLIO'SLOSSES.

I. (1)WRITEOUTTHESECURITYMARKETLINE(SML)EQUATION,USEITTO
CALCULATETHEREQUIREDRATEOFRETURNONEACHALTERNATIVE,ANDTHEN
GRAPHTHERELATIONSHIPBETWEENTHEEXPECTEDANDREQUIREDRATESOF
RETURN.(2)HOWDOTHEEXPECTEDRATESOFRETURNCOMPAREWITHTHE
REQUIREDRATESOFRETURN?(3)DOESTHEFACTTHATCOLLECTIONSHASA
NEGATIVEBETAMAKEANYSENSE?WHATISTHEIMPLICATIONOFTHENEGATIVE
BETA?(4)WHATWOULDBETHEMARKETRISKANDTHEREQUIREDRETURNOFA
5050PORTFOLIOOFHIGHTECHANDCOLLECTIONS?OFHIGHTECHANDU.S.
RUBBER?

ANSWER:(1)HEREISTHESMLEQUATION:
kj=kRF+(kM)kRF)j.

IFWEUSETHETBILLYIELDASAPROXYTHERISKFREERATE,THENkRF=8%.
FURTHER,OURESTIMATEOFkM=^kMIS15%.THUS,THESMLISDRAWNASFOLLOWS:

Prepared by Jim Keys - 16 -

 k
(%)
24
SML

20

16
kM = 15

12

kT-B IL LS = 8

0 1 2 BETA ( )

(2)USINGTHESMLEQUATION,WEHAVETHEFOLLOWINGRELATIONSHIPS:

EXPECTEDREQUIRED

RETURNRETURN

SECURITY(k
^
)(k)CONDITION

HIGHTECH17.4%17.0%UNDERVALUED: ^k>k
Prepared by Jim Keys - 17 -
MARKET15.015.0FAIRLYVALUED(MARKETEQUILIBRIUM)
U.S.RUBBER13.812.8UNDERVALUED: ^k>k
TBILLS8.08.0FAIRLYVALUED
COLLECTIONS1.72.0OVERVALUED: k>^k

THESERETURNSAREPLOTTEDONTHESMLGRAPHNEXT.

k
(%)
24
SML
20
HIGH TECH
16
kM = 15
U.S.
RUBBER
12

kT-BILLS = 8

COLLECTIONS
BETA ( )
-1 0 1 2

THETBILLSANDMARKETPORTFOLIOPLOTONTHESML,HIGHTECHANDU.S.RUBBER
PLOTABOVEIT,ANDCOLLECTIONSPLOTSBELOWIT.THUS,THETBILLSANDTHE
MARKETPORTFOLIOPROMISEAFAIRRETURN,HIGHTECHANDU.S.RUBBERAREGOOD
DEALSBECAUSETHEYHAVEEXPECTEDRETURNSABOVETHEIRREQUIREDRETURNS,AND
COLLECTIONSHASANEXPECTEDRETURNBELOWITSREQUIREDRETURN.

(3)COLLECTIONSISANINTERESTINGSTOCK.ITSNEGATIVEBETAINDICATES
NEGATIVEMARKETRISKINCLUDINGITINAPORTFOLIOOF"NORMAL"STOCKSWILL

Prepared by Jim Keys - 18 -

LOWERTHEPORTFOLIO'SRISK.THEREFORE,ITSREQUIREDRATEOFRETURNISBELOW
THERISKFREERATE.BASICALLY,THISMEANSTHATCOLLECTIONSISAVALUABLE
SECURITYTORATIONAL,WELLDIVERSIFIEDINVESTORS.TOSEEWHY,CONSIDERTHIS
QUESTION:WOULDANYRATIONALINVESTOREVERMAKEANINVESTMENTWHICHHASA
NEGATIVEEXPECTEDRETURN?THEANSWERIS"YES"JUSTTHINKOFTHEPURCHASEOF
ALIFEORFIREINSURANCEPOLICY.THEFIREINSURANCEPOLICYHASANEGATIVE
EXPECTEDRETURNBECAUSEOFCOMMISSIONSANDINSURANCECOMPANYPROFITS,BUT
BUSINESSESBUYFIREINSURANCEBECAUSETHEYPAYOFFATATIMEWHENNORMAL
OPERATIONSAREINBADSHAPE.LIFEINSURANCEISSIMILARITHASAHIGHRETURN
WHENWORKINCOMECEASES.ANEGATIVEBETASTOCKISCONCEPTUALLYSIMILARTOAN
INSURANCEPOLICY.

(4) NOTETHATTHEBETAOFAPORTFOLIOISSIMPLYTHEWEIGHTEDAVERAGE
OFTHEBETASOFTHESTOCKSINTHEPORTFOLIO.THUS,THEBETAOFA
PORTFOLIOWITH50PERCENTHIGHTECHAND50PERCENTCOLLECTIONSIS:

p=wjj
j=1

p=0.5(HIGHTECH)+0.5(COLLECTIONS)=0.5(1.29)+0.5()0.86)

=0.215,

ANDTHEPORTFOLIO'SREQUIREDRETURNIS9.5%:

kp=kRF+(kM)kRF)p
=8.0%+(15.0%)8.0%)(0.215)
=8.0%+7%(0.215)=9.51%9.5%.

FORAPORTFOLIOCONSISTINGOF50%HIGHTECHPLUS50%U.S.RUBBER,THEREQUIRED
RETURNWOULDBE14.9%:

p=0.5(1.29)+0.5(0.68)=0.985.
kp=8.0%+7%(0.985)=14.9%.

J. (1)SUPPOSEINVESTORSRAISEDTHEIRINFLATIONEXPECTATIONSBY3
PERCENTAGEPOINTSOVERCURRENTESTIMATESASREFLECTEDINTHE8PERCENT
TBILLRATE.WHATEFFECTWOULDHIGHERINFLATIONHAVEONTHESMLAND
ONTHERETURNSREQUIREDONHIGHANDLOWRISKSECURITIES?(2)SUPPOSE
INSTEADTHATINVESTORS'RISKAVERSIONINCREASEDENOUGHTOCAUSETHE
MARKETRISKPREMIUMTOINCREASEBY3PERCENTAGEPOINTS.(INFLATION

Prepared by Jim Keys - 19 -

 REMAINSCONSTANT.)WHATEFFECTWOULDTHISHAVEONTHESMLANDON
RETURNSOFHIGHANDLOWRISKSECURITIES?

ANSWER:(1)THISEFFECTISGRAPHEDBELOW.

CHANGES IN THE SML

k INCREASED
(%) RISK AVERSION
24 INCREASED
INFLATION

20

ORIGINAL
16 SITUATION

12

BETA ( )
-1 0 1 2

Prepared by Jim Keys - 20 -

HEREWEHAVEPLOTTEDTHESMLFORBETASRANGINGFROM0TO2.0.THEBASECASE
SMLISBASEDONkRF=8%ANDkM=15%.IFINFLATIONEXPECTATIONSINCREASEBY
3%,WITHNOCHANGEINRISKAVERSION,THENTHEENTIRESMLISSHIFTEDUPWARD
(PARALLELTOTHEBASECASESML)BY3PERCENTAGEPOINTS.NOW,kRF=11%,kM=
18%,ANDALLSECURITIES'REQUIREDRETURNSRISEBY3PERCENTAGEPOINTS.NOTE
THATTHEMARKETRISKPREMIUM,kMkRF,REMAINSAT7PERCENTAGEPOINTS.

(2)WHENINVESTORS'RISKAVERSIONINCREASES,THESMLISROTATEDUPWARD
ABOUTTHEYINTERCEPT(kRF).kRFREMAINSAT8PERCENT,BUTNOWkMINCREASESTO
18PERCENT,SOTHEMARKETRISKPREMIUMINCREASESTO10PERCENT.THEREQUIRED
RATEOFRETURNWILLRISESHARPLYONHIGHRISK(HIGHBETA)STOCKS,BUTNOTMUCH
ONLOWBETASECURITIES.

OPTIONALQUESTION:COVERIFTIMEISAVAILABLE.FINANCIALMANAGERSAREMORE
CONCERNEDWITHINVESTMENTDECISIONSRELATINGTOREALASSETSSUCHASPLANTAND
EQUIPMENTTHANWITHINVESTMENTSINFINANCIALASSETSSUCHASSECURITIES.HOW
DOESTHEANALYSISTHATWEHAVEGONETHROUGHRELATETOREALASSETINVESTMENT
DECISIONS,ESPECIALLYCORPORATECAPITALBUDGETINGDECISIONS?
ANSWER:THEREISAGREATDEALOFSIMILARITYBETWEENYOURFINANCIAL
ASSETDECISIONSANDAFIRM'SCAPITALBUDGETINGDECISIONS.HEREISTHE
LINKAGE:
(1) ACOMPANYMIGHTBETHOUGHTOFASAPORTFOLIOOFASSETS.IFTHECOMPANY
DIVERSIFIESITSASSETS,ANDESPECIALLYIFITINVESTSINSOMEPROJECTS
THATTENDTODOWELLWHENOTHERSAREDOINGBADLY,ITCANLOWERTHE
VARIABILITYOFITSRETURNS.
(2) COMPANIESOBTAINTHEIRINVESTMENTFUNDSFROMINVESTORS,WHOBUYTHE
FIRM'SSTOCKSANDBONDS.WHENINVESTORSBUYTHESESECURITIES,THEY
REQUIREARISKPREMIUMWHICHISBASEDONTHECOMPANY'SRISKASTHEY
(INVESTORS)SEEIT.FURTHER,BECAUSEINVESTORSINGENERALHOLDWELL
DIVERSIFIEDPORTFOLIOSOFSTOCKSANDBONDS,THERISKTHATISRELEVANT
TOTHEMISTHESECURITY'SMARKETRISK,NOTITSTOTAL,ORSTANDALONE,
RISK.THUS,INVESTORSVIEWTHERISKOFTHEFIRMFROMAMARKETRISK
PERSPECTIVE.
(3) THEREFORE,WHENAMANAGERMAKESADECISIONTOBUILDANEWPLANT,THE
RISKINESSOFTHEINVESTMENTINTHEPLANTTHATISRELEVANTTOTHEFIRM'S
INVESTORS(ITSOWNERS)ISITSMARKETRISK,NOTITSTOTALRISK.
ACCORDINGLY,MANAGERSNEEDTOKNOWHOWPHYSICALASSETINVESTMENT
DECISIONSAFFECTTHEIRFIRM'SBETACOEFFICIENT.APARTICULARASSET
MIGHTLOOKQUITERISKYWHENVIEWEDINISOLATION,BUTIFITSRETURNSARE
NEGATIVELYCORRELATEDWITHRETURNSONMOSTOTHERSTOCKS,THEASSET
Prepared by Jim Keys - 21 -
 MIGHTREALLYHAVELOWRISK.WEWILLDISCUSSALLTHISINMOREDETAILIN
OURCAPITALBUDGETINGDISCUSSIONS.

Prepared by Jim Keys - 22 -