Week 3 Tutorial Questions and Solution 06/08/2018

Chapter 11: QP

a. What is the expected return on an equally weighted portfolio of these three stocks?
Ans: To find the expected return of the portfolio, we need to find the return of the portfolio in
each state of the economy. This portfolio is a special case since all three assets have the
same weight. To find the expected return in an equally weighted portfolio, we can sum the
returns of each asset and divide by the number of assets, so the expected return of the
portfolio in each state of the economy is:

Boom: Rp = (.06 + .16 + .33) / 3

Rp = .1833, or 18.33%

Bust: Rp = (.14 + .02 .06) / 3

Rp = .0333, or 3.33%

To find the expected return of the portfolio, we multiply the return in each state of the
economy by the probability of that state occurring, and then sum. Doing this, we find:

E(Rp) = .65(.1833) + .35(.0333)

E(Rp) = .1308, or 13.08%

b. What is the variance of a portfolio invested 20 percent each in A and B, and 60 percent in C?
Ans:
This portfolio does not have an equal weight in each asset. We still need to find the return of the
portfolio in each state of the economy. To do this, we will multiply the return of each asset by its
portfolio weight and then sum the products to get the portfolio return in each state of the economy.
Doing so, we get:

Boom: Rp=.20(.06) +.20(.16) + .60(.33)

Rp =.2420, or 24.20%

Bust: Rp =.20(.13) +.20(.03) + .60(.06)

Rp = –.0040, or –.40%

And the expected return of the portfolio is:

E(Rp) = .65(.2420) + .35(.004)

E(Rp) = .1559, or 15.59%

To find the variance, we find the squared deviations from the expected return. We then
multiply each possible squared deviation by its probability, and then add all of these up.
The result is the variance. So, the variance of the portfolio is:

p2 = .65(.2420 – .1559)2 + .35(.0040 – .1559)2

p2 = .013767
Week 3 Tutorial Questions and Solution 06/08/2018

24. Analyzing a Portfolio

You have $100,000 to invest in a portfolio containing Stock X and Stock Y. Your goal is to create
a portfolio that has an expected return of 12.9 percent. If Stock X has an expected return of 11.2
percent and a beta of 1.30 and Stock Y has an expected return of 7.7 percent and a beta of .80,
how much money will you invest in Stock Y? How do you interpret your answer? What is the
beta of your portfolio?
Ans:
We are given the expected return of the assets in the portfolio. We also know the sum of the
weights of each asset must be equal to one. Using this relationship, we can express the expected
return of the portfolio as:

E(Rp) = .129 = XX(.112) + XY(.077)

.129 = XX(.112) + (1 – XX)(.077)
.129 = .112XX + .077 – .077XX
.052 = .035XX
XX = 1.48571

And the weight of Stock Y is:

XY = 1 – 1.48571
XY = –.48571

The amount to invest in Stock Y is:

Investment in Stock Y = –.48571($100,000)
Investment in Stock Y = –$48,571.43

A negative portfolio weight means that you short sell the stock. If you are not familiar with short
selling, it means you borrow a stock today and sell it. You must then purchase the stock at a later
date to repay the borrowed stock. If you short sell a stock, you make a profit if the stock
decreases in value.

32. Beta and CAPM

Suppose the risk-free rate is 4.7 percent and the market portfolio has an expected return of 11.2
percent. The market portfolio has a variance of .0382. Portfolio Z has a correlation coefficient with
the market of .28 and a variance of .3285. According to the capital asset pricing model, what is the
expected return on Portfolio Z?

Ans: First, we need to find the standard deviation of the market and the portfolio, which are:
M = (.0382)1/2 M = .1954, or 19.54%
Z = (.3285)1/2 Z = .5731, or 57.31%

Now we can use the equation for beta to find the beta of the portfolio, which is:
Z = (Z,M)(Z) / M
Z = (.28)(.5731) / .1954
Z = .82

Now, we can use the CAPM to find the expected return of the portfolio, which is:

E(RZ) = Rf + Z[E(RM) – Rf]

E(RZ) = .047 + .82(.112 – .047)
E(RZ) = .1004, or 10.04%
Week 3 Tutorial Questions and Solution 06/08/2018

Ans: The amount of systematic risk is measured by the  of an asset. Since we know the market risk
premium and the risk-free rate, if we know the expected return of the asset we can use the CAPM
to solve for the  of the asset. The expected return of Stock I is:

E(RI) = .15(.11) + .55(.18) + .30(.08) = .1395, or 13.95%

Using the CAPM to find the  of Stock I, we find:

.1395 = .04 + .075I

I = 1.33

The total risk of an asset is measured by its standard deviation, so we need to calculate the
standard deviation of Stock I. Beginning with the calculation of the stock’s variance, we find:

I2 = .15(.11 – .1395)2 + .55(.18 – .1395)2 + .30(.08 – .1395)2

I2 = .00209

I = (.00209)1/2 = .0458, or 4.58%

Using the same procedure for Stock II, we find the expected return to be:

E(RII) = .15(–.25) + .55(.11) + .30(.31) = .1160

Using the CAPM to find the  of Stock II, we find:

.1160 = .04 + .075II

II = 1.01

And the standard deviation of Stock II is:

II2 = .15(–.25 – .1160)2 + .55(.11 – .1160)2 + .30(.31 – .1160)2
II2 = .03140
II = (.03140)1/2 = .1772, or 17.72%

Although Stock II has more total risk than I, it has much less systematic risk, since its beta is
much smaller than I’s. Thus, I has more systematic risk, and II has more unsystematic (Note:
total risk = systematic risk + unsystematic risk. Stock II has higher total risk and lower
systematic risk; therefore, Stock II has higher unsystematic risk) and more total risk. Since
Week 3 Tutorial Questions and Solution 06/08/2018

unsystematic risk can be diversified away, I is actually the “riskier” stock despite the lack of
volatility in its returns. Stock I will have a higher risk premium and a greater expected return.

Chapter 12 QP

a. What is the systematic risk of the stock return?

Ans: If m is the systematic risk portion of return, then:

m = GDPΔGDP + InflationΔInflation + rΔInterest rates

m = .0000734($17,863 – 17,034) – .90(2.60% – 2.80%) – .32(3.50% – 3.70%)
m = 6.33%

b. Suppose unexpected bad news about the firm was announced that causes the stock price to
drop by 1.1 percent. If the expected return on the stock is 11.7 percent, what is the
total return on this stock?

Ans. The unsystematic return is the return that occurs because of a firm specific factor such as the bad
news about the company. So, the unsystematic return of the stock is –1.1 percent. The total return is
the expected return, plus the two components of unexpected return: the systematic risk portion of
return and the unsystematic portion. So, the total return of the stock is:

R= R +m+
R = 11.70% + 6.33% – 1.1%
R = 11.79%
Week 3 Tutorial Questions and Solution 06/08/2018

Ans:
The beta for a particular risk factor in a portfolio is the weighted average of the betas of the
assets. This is true whether the betas are from a single factor model or a multi-factor model. So,
the betas of the portfolio are:

F1 = .20(1.55) + .20(.81) + .60(.73)

F1 = .91

F2 = .20(.80) + .20(1.25) + .60(–.14)

F2 = .33

F3 = .20(.05) + .20(–.20) + .60(1.24)

F3 = .71

So, the expression for the return of the portfolio is:

Ri = 3.2% + .91F1 + .33F2 – .71F3

Which means the return of the portfolio is:

Ri = 3.2% + .91(4.90%) + .33(3.80%) – .71(5.30%)

Ri = 5.11%