A B C D E F

1 Tool Kit Chapter 6 12/8/2012

2
3 Risk and Return
4
5 6-1 Investment Returns and Risk
6
7 Amount invested $1,000
8 Amount received in one year $1,100
9 Dollar return (Profit) $100
10 Rate of return = Profit/Investment = 10%
11
12 6-2 Measuring Risk for Discrete Distributions
13
14
15 The relationship between risk and return is a fundamental axiom in finance. Generally speaking, it
16 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
17 in finance arises from interpreting the exact nature of this relationship (accepting that risk aversion
18 differs from investor to investor). Risk and return interact to determine security prices, hence it is
19 of paramount importance in finance.
20
21
22 A listing of possible outcomes and their probabilities is called a probability distribution, as shown
23 below.
24
25
Rate of
26 Scenario Probability of Return in
Scenario Scenario
27 Best Case 0.30 37%
28 Most Likely 0.40 11%
29 Worst Case 0.30 −15%

30 1.00

31
32
33 Figure 6-1
34 Discrete Probability Distribution for Three Scenarios
35
36 Probability of Scenario
37 Most
38 0.5 Likely
39
40 0.4 Worst Best
0.4 Case Case
41
42 0.3
43 0.3
44
45 0.2
46 0.2
47 0.1
48 0.1
49
0.0
−15% 11% 37%
Outcomes: Market Return for 3 Scenarios
 0.3
0.3
0.2
0.2
0.1
0.1
A B C D E F
50 0.0
51 −15% 11% 37%
52 Outcomes: Market Return for 3 Scenarios
53
54
55
56 Given the probabilities and the outcomes for possible returns, it is possible to calculate the expected
57 return and standard deviation.
 A B C D E F
58
59 Figure 6-2
60 Calculating Expected Returns and Standard Deviations: Discrete Probabilities
61 INPUTS: Expected Return Standard Deviation

Product of Squared
62 Probability of Market Rate Probability and Deviation from Deviation
Scenario of Return Return Expected Return (5) = (4)2
Scenario (1) (2) (3) = (1) x (2) (4) = (2) − D66
63 Best Case 0.30 37% 11.1% 26% 6.8%
64 Most Likely 0.40 11% 4.4% 0% 0.0%
65 Worst Case 0.30 −15% −4.5% −26% 6.8%

66 1.00 Exp. ret. = Sum = 11.0% Sum = Variance =

Std. Dev. = Square

67 root of variance =

68
69
70
71 6-3 Risk in a Continuous Distribution
72
73 It is possible to add more scenarios.
74

75 Scenario Market Rate

Probability of of Return in
Scenario Scenario
76 1 0.0002 -66%
77 2 0.0011 -55%
78 3 0.0054 -44%
79 4 0.0205 -33%
80 5 0.0575 -22%
81 6 0.1201 -11%
82 7 0.1870 0%
83 8 0.2167 11%
84 9 0.1870 22%
85 10 0.1201 33%
86 11 0.0575 44%
87 12 0.0205 55%
88 13 0.0054 66%
89 14 0.0011 77%
90 15 0.0002 88%
91 1.0000
92
93 Expected return = 11.0%
94 Standard deviation = 20.2%
95
96
97 Figure 6-3
98 Discrete Probability Distribution for 15 Scenarios
99
100 Probability of Scenario
101
102
0.25

0.20

0.15

0.10

0.05

0.00
-66% -55% -44% -33% -22% -11% 0% 11% 22% 33% 44% 55% 66% 77% 88%
 Probability of Scenario

A B C D E F
0.25
103
104
105 0.20
106
107 0.15
108
109
110 0.10
111
112 0.05
113
114 0.00
115 -66% -55% -44% -33% -22% -11% 0% 11% 22% 33% 44% 55% 66% 77% 88%
116
117 Outcomes: Market Return for 15 Scenarios
118
119
120
121 At some point, it becomes impractical to keep adding scenarios. Many analysts use the normal
122 distribution to estimate stock returns.
123
124 Here is an example of a normal distribution with a similar mean and standard deviation as the
125 discrete distribution shown above.
126
127
128
129 Normal Distribution
130 Probability
131 0.2500
132
133
134 0.2000
135
136 0.1500
137
138
139 0.1000
140
141 0.0500
142
143
144 0.0000
145 -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%
146 Return
147
148
149
150 6-4 Using Historical Data to Estimate Risk
151
152 Investors often use historical data to estimate risk. This is quite easy in Excel by using the AVERAGE
153 and STDEV functions.
154
155
 A B C D E F
156
157 Standard Deviation Based On a Sample of Historical Data
158 Inputs: Realized
159 Year return
160 2011 15.0%
161 2012 −5.0%
162 2013 20.0%
163 Calculations:
164 Average =AVERAGE(E160:E162) = 10.0%
165 Standard deviation =STDEV(E160:E162) = 13.2%
166
167
168
169
170 Measuring the Standard Deviation of MicroDrive
171
172 The monthly stock returns for MicroDrive and one of its competitors, SnailDrive, during the past 48
173 months are shown in the figure below. The actual data are below the figure.
174
175
176 Figure 6-5
177 Historical Monthly Stock Returns for MicroDrive and SnailDrive
178
179 Monthly Rate of Return
180
50%
181 MicroDrive
182 40%
183
184 30%
185 SnailDrive
186 20%
187
188 10%
189
190 0%
191
192 -10%
193
194 -20%
195
196 -30%
197 0 6 12 18 24 30 36 42 48
198 Month of Return
199
200 MicroDrive SnailDrive
201 Average Return (annualized) 14.6% 8.6%
202 Standard Deviation (annualized) 49.2% 25.8%
203
204
205 Portfolio weights
206 SnailDrive:
207 MicroDrive:
208 Period Market MicroDrive SnailDrive
 A B C D E F
209 1 2.37% 1.66% -7.41%
210 2 12.68% 23.52% 2.15%
211 3 -1.13% -4.76% -0.16%
212 4 10.93% 38.58% -5.34%
213 5 -0.02% -3.46% 10.13%
214 6 -3.31% -5.37% 1.82%
215 7 12.68% 22.52% 0.67%
216 8 -3.96% -8.58% -4.07%
217 9 -4.90% -13.02% -3.25%
218 10 7.10% 0.17% 17.04%
219 11 2.94% 24.40% 4.28%
220 12 -6.52% -18.05% 0.41%
221 13 3.72% 6.18% -6.90%
222 14 4.74% 12.24% 2.98%
223 15 -8.21% -18.22% 0.29%
224 16 -5.15% 7.15% -12.43%
225 17 3.92% 9.69% -0.48%
226 18 1.08% 12.21% -6.26%
227 19 -2.48% -6.74% 4.44%
228 20 3.92% -16.00% 13.02%
229 21 3.13% -11.96% 9.67%
230 22 0.17% -19.00% -2.26%
231 23 5.17% 13.91% 2.90%
232 24 2.56% 17.84% 4.74%
233 25 -5.41% 14.67% -10.96%
234 26 -2.09% -16.88% 4.34%
235 27 1.08% 3.28% 4.32%
236 28 10.47% 28.86% 9.32%
237 29 -3.74% 2.33% -3.34%
238 30 2.94% 12.48% -3.53%
239 31 -9.50% -7.21% -1.01%
240 32 5.17% -9.79% 10.33%
241 33 -0.75% 0.60% -7.79%
242 34 -9.04% 0.88% -10.85%
243 35 -9.50% -8.94% -9.91%
244 36 4.74% 2.49% 9.61%
245 37 -0.38% -11.24% -0.01%
246 38 4.32% -9.47% 1.40%
247 39 -1.89% -20.12% 4.37%
248 40 -3.96% -0.15% -8.09%
249 41 6.58% 3.42% 16.51%
250 42 -1.32% 4.07% 9.28%
251 43 4.74% -13.45% 1.72%
252 44 -3.10% -13.05% -5.96%
253 45 7.95% -1.61% 12.41%
254 46 10.93% 29.01% -1.59%
255 47 -1.70% 6.08% -12.09%
256 48 -3.96% -2.82% -0.08%
257 Full 48 Months Market MicroDrive SnailDrive
258 Average monthly return: 0.9% 1.22% 0.72%
259 Standard deviation of monthly returns: 5.8% 14.19% 7.45%
260 Average return (annual): 11.0% 14.6% 8.6%
261 Standard deviation (annual): 20.0% 49.2% 25.8%
262
263
 A B C D E F
264 Past 12 Months Month Market MicroDrive SnailDrive
265 37 -0.4% -11.2% 0.0%
266 38 4.3% -9.5% 1.4%
267 39 -1.9% -20.1% 4.4%
268 40 -4.0% -0.2% -8.1%
269 41 6.6% 3.4% 16.5%
270 42 -1.3% 4.1% 9.3%
271 43 4.7% -13.5% 1.7%
272 44 -3.1% -13.0% -6.0%
273 45 7.9% -1.6% 12.4%
274 46 10.9% 29.0% -1.6%
275 47 -1.7% 6.1% -12.1%
276 48 -4.0% -2.8% -0.1%
277 Past 12 Months Market MicroDrive SnailDrive
278 Average return (annual): 18.2% -29.3% 17.9%
279 Standard deviation (annual): 17.8% 44.5% 28.8%
280 Total compound return: 18.2% -32.1% 15.1%
281
282
283
284 6-5 Risk in a Portfolio Context
285
286 Now we are going to analyze the risk of a portfolio instead of the stand-alone risk of individual
287 assets.
288
289 Creating a Portfolio
290
291
Look at the data for MicroDrive and SnailDrive shown above. The last column shows a portfolio with
292 the weights shown below. Here are the results for the two companies and for the portfolio. Notice
293 that the portfolio has a higher return than SnailDrive and less risk than either of the two stocks.
294
295
296
297 Portfolio weights
298 SnailDrive: 75%
299 MicroDrive: 25%
300
301 Full 48 Months Market MicroDrive SnailDrive
302 Average monthly return: 0.9% 1.2% 0.7%
303 Standard deviation of monthly returns: 5.8% 14.2% 7.4%
304 Average return (annual): 11.0% 14.6% 8.6%
305 Standard deviation (annual): 20.0% 49.2% 25.8%
306
307
308 Correlation
309
310 Loosely speaking, correlation measures the tendency of two variables to move together.
311
312 Correlation between MicroDrive and SnailDrive:
313 r= -0.104 =CORREL(E209:E256,F209:F256)
314
315
316 6-6 The Relevant Risk of a Stock: The Capital Asset Pricing Model (CAPM)
 A B C D E F
317
318 The Capital Asset Pricing Model (CAPM) provides a measure of risk.
319
320 Contribution to Market Risk: Beta
321
322 The relevant risk of an individual stock as defined by its beta. Beta measures how much risk a stock
323 contributes to a well-diversified portfolio.
324
325 Beta for Stock i = bi = riM(si/sM)
326
327 A portfolio's beta is the weighted average of the stock's individual betas. Consider the following
328 example.
329
330 Contribution of
331 Weight in Stock to Portfolio
332 Stock Beta: Portfolio: Beta:
333 bi wi bi x wi x sM
334 Stock 1 0.6 25.0% 0.150
335 Stock 2 1.2 25.0% 0.300
336 Stock 3 1.2 25.0% 0.300
337 Stock 4 1.4 25.0% 0.350
338 Portfolio beta = 1.100
339
340 The standard deviation of a well-diversified portfolio is:
341
342 Std. Dev. of portfolio = sp = bp (sM)
343
344 If the example portfolio had more than 4 stocks and was well-diversified, then its standard deviation
345 would be:
346
347 Beta of portfolio = bp = 1.1
348 Std. Dev. of market = sM = 20%
349 Std. Dev. of portfolio = sp = 22%
350
351
352 Figure 6-7
353 The Contribution of Individual Stocks to Portfolio Risk: The Effect of Beta
354
355 Portfolio standard deviation = 22%
b1w
356 b4w 1s
357 4s M=
358 M= 3.0
359 7.0 %
360 % b2w
361 2s
362 M=
363 6.0
b3w %
3s
M=
6.0
%
 M= 3.0
7.0 %
% b2w
2s
M=
A B C 6.0
D E F
364 b3w %
365 3s
366 M=
367 6.0
368 %
369
370
371 Market standard deviation = sM = 20.0%
372
373 Contribution of Contribution of
374 Weight in Stock to Portfolio Stock to Portfolio
375 Stock Beta: Portfolio: Beta: Risk:
376 bi wi bi x wi bi x wi x sM Category Labels for chart.
377 Stock 1 0.6 25.0% 0.150 3.0%b1w1sM
378 Stock 2 1.2 25.0% 0.300 6.0%b2w2sM
379 Stock 3 1.2 25.0% 0.300 6.0%b3w3sM
380 Stock 4 1.4 25.0% 0.350 7.0%b4w4sM
381 1.100 22.0%b5w5sM
382
383
384 Estimating Beta
385
386 We can use the data shown previously for MicroDrive and SnailDrive to estimate their betas.
387
388
389 Calculating Beta Market MicroDrive SnailDrive
390 Standard deviation (annual): 20.0% 49.17% 25.80%
391 Correlation with the market: 0.582 0.465
392 bi = riM(si/sM) 1.430 0.600
393
394 Beta can also be calculated as the slope of a regression of the stock (on the y-axis) and the market
395 (on the x-axis). This can be done using the SLOPE function or by plotting the returns and specifying
that the chart show the TRENDLINE.
396
397
398 Calculating Beta as the Slope of a Regression Using Excel Functions (See Excel explanations to right)

399 MicroDrive SnailDrive

400 bi = riM(si/sM) 1.430 0.600
401 Intercept -0.001 0.002
402 R squared 0.338 0.216
403 Calculating Confidence Intervals using Excel Functions
404 Input desired probability for confidence interval 95% 95%
405 Lower boundary of confidence interval for beta 0.836 0.261
406 Upper boundary of confidence interval for beta 2.024 0.939
407 Lower boundary of confidence interval for intercept -0.035 -0.018
408 Upper boundary of confidence interval for intercept 0.033 0.021
409
410
 A B C D E F
411 Figure 6-8
412 Stock Returns of MicroDrive and the Market: Estimating Beta
413
414 y-axis: Historical
415 MicroDrive Returns
416
417
418 45.0%
419
420
421
422
423
424
425
f(x) = 1.43 x − 0.000958333333333
426 R² = 0.338285166007709
427
428
429
430 0.0%
431 -45% 0% 45%
432
433
x-axis: Historical
434
Market Returns
435
436
437
438
439
440
441
442
443 -45.0%
444
445
446
447
 A B C D E F
448
449 EXAMPLE: CALCULATING BETA COEFFICIENTS FOR AN ACTUAL COMPANY
450
451 Now we show how to calculate beta for an actual company, General Electric.
452
453 Step 1. Retrieve Data
454
455 We downloaded stock prices and dividends from http://finance.yahoo.com for General Electric,
456 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
457 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
458 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
459 reflect any dividends or stock splits. Scroll to the bottom of the page and click "Download to
Spreadsheet."
460
461
462
463
The downloaded data are in csv format. Convert to xls by opening a new Excel worksheet, copying
464 the date and adjusted index price data to it, and saving as an xls file. Then repeat the process to get
465 the S&P index data. At this point you have returns data for GE and the S&P Index, as we show below.
466
467
468 Step 2. Calculate Returns
469
470
Next, calculate the percentage change in adjusted prices (which already reflect dividends) for GE
471 and the S&P to obtain returns, with the spreadsheet set up as shown below.
472 Yahoo actually adjusts the stock prices to reflect any stock splits or dividend payments. For
473 example, suppose the stock price is $100 in July, the company has a 2-for-1 split, and the actual price
474 in August is $60. The reported adjusted price for August would be $60, but the reported price for
July would be $50, which reflects the stock split. This gives an accurate stock return of 20%: ($60-
475 $50)/$50 = 20%, the same as if there had not been a split, in which case the return would have been
476 ($120-$100)/$100 = 20%.
477 Or suppose the actual price in September is $50, the company pays a $10 dividend, and the actual
478 price in October is $60. Shareholders have had a return of ($60+$10-$50)/$50 = 40%. Yahoo
reports an adjusted price of $60 for October, and an adjusted price of $42.857 for September, which
479 gives a return of ($60-$42.857)/$42.857 = 40%.
480 In other words, the percent change in the adjusted price accurately reflects the actual return.
481
482
483
484 At this point, we are ready to calculate some statistics and to find GE's beta coefficient. This is shown
485 below the data.
486
487
488 Not in Textbook: Stock Return Data for GE and the S&P 500 Index

489
Market Level GE Adjusted
(S&P 500 Index) Market's Stock Price at GE's
Month at Month End Return Month End Return
490 March 2012 1,408.47 3.1% $20.07 5.4%
491 February 2012 1,365.68 4.1% $19.05 2.7%
492 January 2012 1,312.41 4.4% $18.55 4.5%
493 December 2011 1,257.60 0.9% $17.75 13.6%
 A B C D E F
494 November 2011 1,246.96 -0.5% $15.62 -4.8%
495 October 2011 1,253.30 10.8% $16.40 9.8%
496 September 2011 1,131.42 -7.2% $14.94 -5.8%
497 August 2011 1,218.89 -5.7% $15.86 -9.0%
498 July 2011 1,292.28 -2.1% $17.42 -5.0%
499 June 2011 1,320.64 -1.8% $18.34 -3.2%
500 May 2011 1,345.20 -1.4% $18.94 -4.0%
501 April 2011 1,363.61 2.8% $19.72 2.0%
502 March 2011 1,325.83 -0.1% $19.34 -4.2%
503 February 2011 1,327.22 3.2% $20.18 4.6%
504 January 2011 1,286.12 2.3% $19.29 10.1%
505 December 2010 1,257.64 6.5% $17.52 16.5%
506 November 2010 1,180.55 -0.2% $15.04 -1.2%
507 October 2010 1,183.26 3.7% $15.22 -1.4%
508 September 2010 1,141.20 8.8% $15.44 13.0%
509 August 2010 1,049.33 -4.7% $13.66 -10.2%
510 July 2010 1,101.60 6.9% $15.21 11.8%
511 June 2010 1,030.71 -5.4% $13.60 -11.3%
512 May 2010 1,089.41 -8.2% $15.33 -13.3%
513 April 2010 1,186.69 1.5% $17.68 3.6%
514 March 2010 1,169.43 5.9% $17.06 13.4%
515 February 2010 1,104.49 2.9% $15.05 0.5%
516 January 2010 1,073.87 -3.7% $14.98 6.3%
517 December 2009 1,115.10 1.8% $14.09 -5.0%
518 November 2009 1,095.63 5.7% $14.83 12.3%
519 October 2009 1,036.19 -2.0% $13.20 -13.2%
520 September 2009 1,057.08 3.6% $15.20 18.8%
521 August 2009 1,020.62 3.4% $12.79 3.7%
522 July 2009 987.48 7.4% $12.33 14.4%
523 June 2009 919.32 0.0% $10.78 -12.4%
524 May 2009 919.14 5.3% $12.30 6.6%
525 April 2009 872.81 9.4% $11.54 25.0%
526 March 2009 797.87 8.5% $9.23 18.8%
527 February 2009 735.09 -11.0% $7.77 -27.7%
528 January 2009 825.88 -8.6% $10.75 -25.1%
529 December 2008 903.25 0.8% $14.36 -3.9%
530 November 2008 896.24 -7.5% $14.94 -12.0%
531 October 2008 968.75 -16.9% $16.97 -23.5%
532 September 2008 1,166.36 -9.1% $22.18 -8.0%
533 August 2008 1,282.83 1.2% $24.12 -0.7%
534 July 2008 1,267.38 -1.0% $24.28 6.0%
535 June 2008 1,280.00 -8.6% $22.91 -12.2%
536 May 2008 1,400.38 1.1% $26.08 -6.1%
537 April 2008 1,385.59 4.8% $27.76 -11.6%
538 March 2008 1,322.70 NA $31.42 NA
539
540 Description of Data
541 Average return (annual): 3.7% -2.7%
542 Standard deviation (annual): ### 40.8%
543 Minimum monthly return: ### -27.7%
544 Maximum monthly return: ### 25.0%
545 Correlation between GE and the market: 0.83
546 Beta: bGE = rGE,M (sGE / sM) 1.64
547
548 Beta (using the SLOPE function): 1.64
 A B C D E F
549 Intercept (using the INTERCEPT function): -0.01
550 R2 (using the RSQ function): 0.68
551
552
 A B C D E F
553 Step 3. Examine the Data and Calculate Beta
554
Using the AVERAGE function and the STDEV function, we found the average historical
555 return and standard deviation for GE and the market. (We converted these from
556 monthly figures to annual figures. Notice that you must multiply the monthly standard
557 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
558 correlation between GE and the market. We used the SLOPE, INTERCEPT, and RSQ
559 functions to estimate the regression for beta.
560
561
562
563 6-7 The Relationship between Risk and Return in the Capital Asset Pricing Model
564
565 The SML shows the relationship between the stock's beta and its required return, as predicted by the CAPM.
566
567 rRF 6% << Varies over time, but is constant for all firms at a given time.
568 rM 11% << Varies over time, but is constant for all firms at a given time.
569 bi 0.5 << Varies over time, and varies from firm to firm.
570
571 The SML predicts stock i's required return to be:
572
573 RPM = rM - rRF
574 ri = rRF + bi(RPM)
575
576 RPM = rM - rRF = 5%
577
578 ri = rRF + bi(RPM) 8.5%
579
580 With the above data, we can generate a Security Market Line that is flexible enough to allow for changes in
581 any of the input factors. We generate a table of values for beta and expected returns, and then plot the
582 graph as a scatter diagram.
583
584
Security
585 Market Line: Risk-Free Rate
Beta ri
586 0.00 6.0% 6%
587 0.50 8.5% 6%
588 1.00 11.0% 6%
589 1.50 13.5% 6%
590 2.00 16.0% 6%
591
 A B C D E F
592 Figure 6-9
593 The Security Market Line
594
595
596
597
598
599 Required Return
600 18%
601
602
603
604
605 12%
606
607
608
609
610
611 6%
612
613
614
615
616 0%
617
0.00 0.50 1.00 1.50 2.00 2.50
618
619 Beta
620
621
622 The Security Market Line shows the projected changes in expected return, due to changes in the beta
623 coefficient. However, we can also look at the potential changes in the required return due to
624 variations in other factors, for example the market return and risk-free rate. In other words, we can
625 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 (r M – rRF), which is also the slope of
626
the SML. Hence, an increase in the market return results in an increase in the maturity risk
627 premium, other things held constant.
628
629
630
631 Portfolio Returns
632
633 The same relationship holds for required returns: The required return on a portfolio is simply a
634 weighted average of the required returns of the individual assets in the portfolio. The weights are
635 the percentage of total portfolio funds invested in each asset. The required return on a portfolio is
also equal to:
636
637
638 rp = rRF + bp(RPM)
639
640
641 The expected return on a portfolio is simply a weighted average of the expected returns of the
642 individual assets in the portfolio. The weights are the percentage of total portfolio funds invested in
643 each asset. Consider the following portfolio and the hypothetical illustrative returns data.
644
645
 A B C D E F
646
Weighted
Amount of Portfolio Expected
647 Stock Investment Weight Return Expected
Return
648 Southwest Airlines $300,000 0.3 15.0% 4.5%
649 Starbucks $100,000 0.1 12.0% 1.2%
650 FedEx $200,000 0.2 10.0% 2.0%
651 Dell $400,000 0.4 9.0% 3.6%
652 Total investment = $1,000,000 1.0
653
654 Portfolio's Expected Return = 11.3%

655
656
657 6-8 The Efficient Markets Hypothesis
658
659 The Efficient Markets Hypothesis (EMH) asserts that (1) stocks are always in equilibrium and (2) it
660 is impossible for an investor to “beat the market” and consistently earn a higher rate of return than
is justified by the stock’s risk.
661
662
663
664 6-9 The Fama-French Three-Factor Model
665
666 The Fama-French 3-Factor model shows the actual stock return given the risk-free rate, the return
667 on the market, the return on the SMB portfolio, and the return on the HML portfolio:
668
669
670
671
672
673 Suppose a company announces that it is going to include more outsiders on its board of directors
674 and that the company’s stock falls by 2% on the day of the announcement. Does that mean that
investors don’t want outsiders on the board?
675
676
677 Actual return on announcement day = -2%
678
679 Suppose you estimate the following coefficients of the Fama-French model using historical actual
680 data prior to the announcement date:
681
682 ai = 0.0
683 bi = 0.9
684 ci = 0.2
685 di = 0.3
686
687 These are the returns on the announcement day:
688
689 rRF ≈ 0.0%
690 rM = -3.0%
691 rSMB = -1.0%
692 rHML = -2.0%
693
694 The predicted return on the announcement day:
695
 A B C D E F
696 Predicted return = rRF,t + ai + bi(rM,t - rRF,t) + ci(rSMB,t) + di(rHML,t)
697 Predicted return = -3.5%
698
699 Unexplained return = Actual return - predicted return
700 Unexplained return = 1.5%
701
702
703
704
705
706
707
708
709
710
711
712
713
714
715
716
717
718
719
720
721
722
723
724
725
726
727
728
729
730
731
732
733
734
735
736
737
738
739
 G
58
59
60
61
Standard Deviation

62
Sq. Dev. × Prob.
(6) = (1) x (5)
63 2.0%
64 0.0%
65 2.0%

66 4.1%

67 20.1%

68
69
70
71
72
73
74

75

76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99
100
101
102
 G
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
bution 129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
% 60% 80% 145
100%
146
147
148
149
150
151
152
153
154
155
 G
156
157
158
159
160
161
162
163
164
165
166
167
168
169
170
171
172
173
174
175
176
177
178
179
180
181
182
183
184
lDrive 185
186
187
188
189
190
191
192
193
194
195
196
6 42 48 197
198
199
200
201
202
203
204
205
Portfolio weights
206 75%
207 25%
208 Portfolio
 G
209 -5.15%
210 7.49%
211 -1.31%
212 5.64%
213 6.73%
214 0.02%
215 6.13%
216 -5.19%
217 -5.69%
218 12.82%
219 9.31%
220 -4.20%
221 -3.63%
222 5.30%
223 -4.34%
224 -7.54%
225 2.06%
226 -1.64%
227 1.64%
228 5.76%
229 4.26%
230 -6.45%
231 5.65%
232 8.01%
233 -4.55%
234 -0.97%
235 4.06%
236 14.21%
237 -1.92%
238 0.47%
239 -2.56%
240 5.30%
241 -5.69%
242 -7.92%
243 -9.67%
244 7.83%
245 -2.82%
246 -1.31%
247 -1.75%
248 -6.10%
249 13.24%
250 7.98%
251 -2.07%
252 -7.73%
253 8.91%
254 6.06%
255 -7.55%
256 -0.76%
257 Portfolio
258 0.8%
259 6.3%
260 10.1%
261 21.8%
262
263
 G
264 Portfolio
265 -2.8%
266 -1.3%
267 -1.8%
268 -6.1%
269 13.2%
270 8.0%
271 -2.1%
272 -7.7%
273 8.9%
274 6.1%
275 -7.5%
276 -0.8%
277 Portfolio
278 6.1%
279 23.9%
280 3.6%
281
282
283
284
285
286
287
288
289
290
291
292
293
294
295
296
297
298
299
300
301 Portfolio
302 0.8%
303 6.3%
304 10.1%
305 21.8%
306
307
308
309
310
311
312
313
314
315
316
 G
364
365
366
367
368
369
370
371
372
373
374
375
376
Category Labels for chart.
377
378
379
380
381
382
383
384
385
386
387
388
389
390
391
392
393
394
395
396
397
398
399
400 =SLOPE(F209:F256,$D$209:$D$256)
401 =INTERCEPT(F209:F256,$D$209:$D$256)
402 =RSQ(F209:F256,$D$209:$D$256)
403
404
405 See explanation to right.
406 See explanation to right.
407 See explanation to right.
408 See explanation to right.
409
410
 G
448
449
450
451
452
453
454
455
456
457
458
459
460
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
 G
494
495
496
497
498
499
500
501
502
503
504
505
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
 G
549
550
551
552
 G
553
554
555
556
557
558
559
560
561
562
563
564
565
return, as predicted by the CAPM.
566
567
568
569
570
571
572
573
574
575
576
577
578
579
le enough to allow for580
changes in
581the
ed returns, and then plot
582
583
584

585

586
587
588
589
590
591
 G
592
593
594
595
596
597
598
599
600
601
602
603
604
605
606
607
608
609
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
644
645
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 $600

Dollar return $100

Rate of return 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?

ProbabilityReturn Prob x Ret.

20% 25% 5.0%
60% 10% 6.0%
20% -15% -3.0%
Expected return = 8.0%

Deviatio
n from
expecte
Probability Return d return Deviation2 Prob x Dev.2
20% 25% 17.0% 2.890% 0.578%
60% 10% 2.0% 0.040% 0.024%
20% -15% -23.0% 5.290% 1.058%
Variance = 1.660%
Standard deviation = 12.9%
SECTION 6-4
SOLUTIONS TO SELF-TEST

A stock’s 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
Year return
1 10%
2 -15%
3 35%

Average = 10.0%
Standard deviation = 25.0%
SECTION 6-6
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. Dell’s beta is estimated to
be 1.20, Ford’s beta is estimated to be 0.80, and Wal-Mart's beta is estimated to
be 1.0. What is the estimated beta of the investor’s portfolio?

Stock Investment Beta Weight Beta x Weight

Dell $25,000 1.2 0.25 0.30
Ford $50,000 0.8 0.50 0.40
Wal-Mart $25,000 1.0 0.25 0.25
Total $100,000
Portfolio beta = 0.95
SECTION 6-7
SOLUTIONS TO SELF-TEST

A stock has a beta of 0.8. Assume that the risk-free rate is 5.5% and that the
market risk premium is 6%. What is the stock’s required rate of return?

Beta 0.8
Risk-free rate 5.5%
Market risk premium 6.0%

Required rate of return 10.30%

SECTION 6-9
SOLUTIONS TO SELF-TEST

An analyst has modeled the stock of a company using a Fama-French three-factor model and has estimate
that ai = 0, bi = 0.7, ci = 1.2, and di = 0.7. Suppose the daily risk-free rate is approximately equal to zero, the
market return is 11%, the return on the SMB portfolio is 3.2%, and the return on the HML portfolio is 4.8% on
a particular day. The stock had an actual return of 16.9% on that day. What is the stock's predicted return for
that day? What is the stock’s unexplained return for the day?

ai 0.0%
bi 0.70
ci 1.20
di 0.70

Actual stock return 16.9%

Risk-free rate 0.0%
Market return 11.0%
SMB return 3.2%
HML return 4.8%

Predicted return 14.90%

Unexplained return 2.00%

and has estimate
qual to zero, the
ortfolio is 4.8% on
redicted return for