Strictly for course AB1201 internal circulation only.

Nanyang Business School

AB1201 Financial Management
Tutorial 5: Risk and Rates of Return
(Common Questions)

Questions 1 to 3 will be presented by students while Question 4 will be presented by

instructors.

1) Evaluate the following statements to determine whether they are TRUE or FALSE.
Explain your answers.

a) When diversifiable risk has been diversified away, the inherent risk that remains is market
risk, which is constant for all stocks in the market.

b) Portfolio diversification reduces the variability of returns on an individual stock.

c) If all the investors in the market are risk averse and hold only one stock, we can conclude
that the required rate of return on a stock whose standard deviation is 0.21 will be greater
than the required return on a stock whose standard deviation is 0.10. However, if stocks are
held in portfolios, it is possible that the required return could be higher on the stock with the
lower standard deviation.

d) An investor who holds just one stock will generally be exposed to more risk than an
investor who holds a diversified portfolio of stocks, assuming the stocks are all equally risky.
Since the holder of the 1-stock portfolio is exposed to more risk, he or she can expect to earn
a higher rate of return to compensate for the greater risk.

e) Market risk refers to the tendency of a stock to move with the general stock market. A
stock with above-average market risk will tend to be more volatile than an average stock, and
its beta will be greater than 1.0.

2) Required rate of return. Suppose rRF = 9%, rM = 14%, and bi = 1.3.

a) What is ri, the required rate of return on Stock i?
b) Now suppose rRF increases to 10 percent and the slope of the SML remains constant. How
would this affect rM and ri?
c) Now assume rRF remains at 9 percent but rM falls to 13 percent. The slope of the SML does
not remain constant. How would these changes affect ri?

3) Security Market Line. You plan to invest in the Kish Hedge Fund, which has total capital
of $500 million invested in five stocks:

Stock Investment Stocks Beta Coefficient

A $160 million 0.5
B 120 million 2.0
C 80 million 4.0
D 80 million 1.0
E 60 million 3.0

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Kishs beta coefficient can be found as a weighted average of its stocks betas. The risk-free
rate is 6 percent, and you believe the following probability distribution for future market
returns is realistic:

Probability Market Return

0.1 7%
0.2 9
0.4 11
0.2 13
0.1 15

a) What is the equation for the Security Market Line (SML)? (Hint: First determine the
expected market return.)
b) Calculate the Kishs required rate of return.
c) Suppose Rick Kish, the president, receives a proposal from a company seeking new capital.
The amount needed to take a position in the stock is $50 million, it has an expected return of
15 percent, and its estimated beta is 2.0. Should Kish invest in the new company? At what
expected rate of return should Kish be indifferent to purchasing the stock?

4) Evaluating risk and return. Stock X has an expected return of 10 percent, a beta
coefficient of 0.9, and a 35 percent standard deviation of expected returns. Stock Y has a
12.5 percent expected return, a beta coefficient of 1.2, and a 25 percent standard deviation.
The risk-free rate is 6 percent, and the market risk premium is 5 percent.
a) Calculate the coefficient of variation of each stock.
b) Which stock is riskier for diversified investors? Which stock is riskier for undiversified
investors?
c) Use the CAPM model to calculate each stocks required rate of return.
d) On the basis of the two stocks expected and required returns, which stock would be more
attractive to a diversified investor?
e) Calculate the required return of a portfolio that has $7,500 invested in Stock X and $2,500
invested in Stock Y.
f) If the market risk premium increased to 6 percent, which of the two stocks would have the
larger increase in its required return? Why would the market risk premium increase?

Self-practice questions

Question 1
You want your portfolio beta to be 0.95. Currently, your portfolio consists of $4,000 invested
in Stock A with a beta of 1.47 and $3,000 in Stock B with a beta of 0.54. You have another
$9,000 to invest and want to divide it between an asset with a beta of 1.74 and a risk-free
asset. How much should you invest in the risk-free asset?

Question 2
You are managing a portfolio of 5 stocks, stocks M, N, O, P, and Q, which are held in equal
amounts. The current beta of the portfolio is 1.8, and the beta of stock M is 2.2. If stock M is
sold, what would the beta of the replacement stock have to be to produce a new portfolio beta
of 1.6?

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Answers to self-practice questions

Question 1
Total investment = 4000+3000+9000 = 16,000
Let investment in asset with beta of 1.74 be $X

The trick to answering the question is to recognize that risk-free asset has beta of zero.

Solve the following equation for X.

4000 3000 9000
1.47 + 0.54 + 1.74 + 0 = 0.95
16000 16000 16000 16000

X = $4425.3
Therefore, investment in risk-free asset = 9000-4425.3 = $4574.7

Question 2
Step1: Find beta of portfolio of N, O, P, and Q. Let beta of this portfolio be X.

4/5X+1/5(2.2) = 1.8 X = 1.7

Step 2: Find beta of replacement stock. Let it be Y.

4/5(1.7) + 1/5Y = 1.6 Y = 1.2

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