Chpt.

10
2.  EXCEL: The table below shows the one-year teturn distribution of Startup Inc. 
Calculate
a.  The expected return
b.  The standard deviation of the return.
                               Return                               Probability
                               -100%                                     40%
                                -75%                                      20%
                                -50%                                      20%
                                -25%                                      10%
                                1000%                                   10%

a.   E [ R] =- 1( 0.4) - 0.75 ( 0.2) - 0.5 ( 0.2) - 0.25 ( 0.1) +10 ( 0.1) =32.5%

Variance [ R ] =( - 1 - 0.325) 0.4 +( - 0.75 - 0.325) 0.2 +( - 0.5 - 0.325) 0.2

2 2 2

b. +( - 0.25 - 0.325) 0.1 +( 10 - 0.325) 0.1

2 2

=10.46

Standard Deviation  10.46  3.235  323.5%

13.  Consider an economy with two types of firms, S and I.  S firms all move together.  I
firms move independently.  For both types of firms, there is a 60% probability that the
firm will have a 15% return and a 40% probability that the firms will have a -10% return. 
What is the volatility (standard deviation) of a portfolio that consists of an equal
investment in 20
a.        Types S firms?
b.      Types I firms?

a. E [ R ] =0.15 ( 0.6 ) - 0.1 ( 0.4 ) =0.05

Standard Deviation = ( 0.15 - 0.05) 0.6 +( - 0.1 - 0.05) 0.4 =0.12247

2 2

Because all S firms in the portfolio move together there is no diversification benefit. So the
standard deviation of the portfolio is the same as the standard deviation of the stocks—12.25%

b. E [ R] =0.15 ( 0.6) - 0.1 ( 0.4) =0.05

Standard Deviation = ( 0.15 - 0.05) 0.6 +( - 0.1 - 0.05) 0.4 =0.12247

2 2

Type I stocks move independently. Hence the standard deviation of the portfolio is
0.12247
SD Portfolio of 20 Type I stocks   2.74%
20
19.  Suppose the market portfolio is equally likely to increase b 30% or decrease by 10%.
a.  Calculate the beta of a firm that goes up on average by 43% when the market goes up
and goes down by 17% when the market goes down.
b.  Calculate the beta of a firm that goes up on average by 18% when the market goes
down and goes down by 22% when the market goes up.
c.  Calculate the beta of a firm that is expected to go up by 4% independently of the
market.

D Stock 43 - ( - 17) 60
a. Beta = = = =1.5
D Market 30 - ( - 10) 40

D Stock - 18 - 22 - 40
b. Beta = = = =- 1
D Market 30 - ( - 10) 40

c. A firm that moves independently has no systemic risk so Beta = 0

 
22. Suppose the market risk premium is 6.5% and the risk-free interest rare is 5%. 
Calculate the cost of capital of investing in a project with a beta of 1.2

( )
Cost of Capital =rf +b E [ R m ] - rf =5 +1.2 ( 6.5) =12.8%
 
(12).  You are a risk-averse investor who is considering investing in one of two
economies.  The expected return and volatility of all stocks in both economies is the
same.  In the first economy, all stocks move together-in good times all prices rise
together and in bad times they all fall together.  In the second economy, stock returns are
independent-one stock increasing in price has no effect on the prices of other stocks. 
Which economy would you choose to invest in ? EXPLAIN

A risk-averse investor would choose the economy in which stock returns are
independent because this risk can be diversified away in a large portfolio.

Chapter 11
4.  EXCEL:  Using the data in the following table, estimate (a) the average return and
volatility for each stock, (b) the covariance between the stocks, and (c) the correlation
between these two stock.
                                                                       
                                Realized Returns
               Year                                                 StockA                                            Stock B
              1998                                    -10%                                                21%
              1999                                    20%                                                 30%
              2000                                    5%                                                    7%
              2001                                  -5%                                                    -3%
              2002                                   2%                                                   -8%
             2003                                     9%                                                  25%
 
a.
10  20  5  5  2  9
RA   3.5%
6
21  30  7  3  8  25
RB 
6
 12%
 0.1  0.035   0.21  0.4   
 0.2  0.035   0.3  0.12   
 
1  0.05  0.035   0.07  0.12   
Covariance   
5  0.05  0.035   0.03  0.12   
 0.02  0.035   0.08  0.12   
 
 0.09  0.035   0.25  0.12  
 0.00794

b.
 0.1  0.035  2  
 
1  0.2  0.08    0.05  0.035   
2 2

Variance of A   
5  0.05  0.035  2   0.02  0.035  2 
 
   0.09  0.035  2 
 0.01123
 0.21  0.12  2   0.3  0.12  2  
1 
Variance of B   0.07  0.12    0.03  0.12  
2 2

5 
 0.08  0.12  2   0.25  0.12  2 
 
 0.02448

Covariance
Correlation 
c. Variance of A Variance of B
 0.479

20. Kaui Surf Boards is seeking to raise capital from a large group of investors to
expand its operations.  Suppose these investors currently hold the S&P 500
Portfolio, which has a volatility of 15% and an expected return of 10%.  The
investment is expected to have a volatility of 30% and a 15% correlation with the
S&P 500.  If the risk-free investment is 4%, what is the appropriate cost of
capital for Kaui Surf Board’s expansion?
 sp 30%
 K  0.15   0.3
15%

Required Return  4%  0.3  6%   5.8%