CHAPTER 3

Risk and Rates of Return

Chapter Outline
Understanding Risk and Return
Types of risk and return
-Stand-alone risk
- Portfolio risk
Measurement of Risk & Return:
-CAPM Model
Problems for practice

5-1
 Introduction

This chapter, will help us to understand

what is risk and return how they are
measured, and what actions can be
taken to minimize risk, or at least to
ensure that you are adequately
compensated for bearing it.

5-2
 4.1 :Definition of Risk:
Generally, the term risk use to refer the chance that
some unfavorable event will occur. Risk may be define in
term of the variability of possible out come from a given
investment.

Risk is define in Websters college dictionary as

possibility of loss or injury: peril. Most people view
risk just a chance of loss.
In reality, risk occurs when we cannot be certain about
the out come of a particular activity or event, so we are
not sure what will occur in the future.

5-3
 Contd.
In everyday usage / practice, "risk" is often used
synonymously with "probability" and restricted to
negative risk or is often defined as the
unexpected variability or volatility of returns.
Risk is defined as the combination of
the frequency, or probability, of occurrence and
the consequence of a specified hazardous event.

Finally the risk is the chance that an out come

other than expected will occur.

5-4
 Defining Risk
Therefore , investment risk can be
measured by the variability of the
investments returns.

Investment risk, then, is related to

the possibility of actually earning a return
other than expected.
--- Greater the variability of the
possible outcomes, the riskier the
investment.
5-5
5
 4.2 : Investment Return and Risk
Investment return and risk are fundamental to
understanding market behavior. Return on
investment is essentially profit earnings made by
an investor. Investment risk, then, is related to the
possibility of actually earning a return other than
expected.
Investment Risk refers to the probability of
depreciation as well as its potential magnitude /
degree, which can exceed original invested
amount.
5-6
Understanding Risk and Return
Greater the variability of the possible
outcomes, the riskier the investment.
Return:
Simply stated, return means outcome of an
investment. If an investor invests money in
real assets or financial assets; then he may
get return from real assets or from financial
assets.
Again return may be actual or expected.
Return is the reward from undertaking the
investment. Return on a typical investment
consists of two components viz., yield and
capital gain. 5-7
 Understanding Risk and Return
Yield is the income component of a securitys
returns. Capital gain is the change in price on a
security over some period of time
The expected return may differ from
realized returns and this variation is a risk
factor.
All nancial assets are expected to
produce cash ows, and the riskiness of an
asset is judged in terms of the riskiness of
its cash ows.
5-8
 4.3 : Base of Risk.
Investment risk is related to the probability
of earning a low or negative actual return.
The greater the chance of lower than
expected or negative returns, the riskier
the investment.
The riskiness of an asset can be
considered in two ways:
A. Stand alone risk.
B. Portfolio risk.
5-9
 4.3 : Base of Risk.
Stand alone risk:
The risk associated with an investment
when it is held by itself, or in isolation, not in
combination.
It means assets cash flows are analyzed by
themselves. Therefore, stand alone risk is
measured by standard deviation or coefficient of
variation.
Portfolio risk:
The risk associated with an investment
when it is held in combination with other assets, not
by itself.
5-10
 Risk components
In a portfolio context, an assets risk can be
divided into two components: (a) diversiable
risk, which can be diversied away and thus is of
little concern to diversied investors, and (b)
market risk, which reects the risk of a general
stock market decline and which cannot be
eliminated by diversication, hence does concern
investors.

5-11
 Elements of Risk
The elements of risk may be broadly
classified into two groups. Such as:
a. Systematic Risk b. Unsystematic Risk

Systematic Risk:
i. Comprise factors that are external to a
company
ii. Affect a large number of securities in the
market simultaneously.
iii. Uncontrollable in nature.
iv) Interest rate risk, inflation risk etc.
5-12
 Elements of Risk
Unsystematic Risk:
i. Comprise factors that are internal to a
companies.
ii. Affect only those particular companies.
iii. These are controllable to a great extent.
iv. Supply of Raw material, production
problem, labor unrest etc.
Total Risk = Systematic Risk + Unsystematic
Risk

5-13
 Classification of Risk
Systematic risk is further subdivided into three
groups.
a. Interest Rate Risk
b. Market Risk
c. Purchasing Power Risk.
A. Interest Rate Risk:
Interest rate risk is a type of systematic risk that
particularly affects debt securities like bonds and
debenture.

A bond is normally issued with a coupon rate which

is equal to the interest rate prevailing in the market
at the time of issue.
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 Contd.
Subsequent to the issue, the market interest
rate may change but the coupon rate remains
constant till the maturity of the instrument.
The change in market interest rate relative to the
coupon rate of a bond causes changes in its
market price.
This variation in bond prices caused due to the
variations in interest rates in known as interest
risk.

5-15
 Contd.
B. Market Risk:
The stock market is seen to be volatile. This volatility
leads to variation in the returns of investors in
shares. The variation in returns caused by the
volatility of the stock market is referred to as market
risk.
C. Purchasing Power Risk:
Another type of systematic risk is the purchasing
power risk. It refers to the variation in investor
returns caused by inflation.
Inflation results in lowering of the purchasing power
of money.
5-16
 Elements of Risk
Unsystematic risk has two types of risk:
a. The operating environment of the company.
b. The financing pattern adopted by the company.
These two types of unsystematic risk are
referred to as
I. Business risk
II. Financial Risk.
I. Business Risk:
Every company operates within a particular
operating environment.
This operating environment comprises both
internal and external environment.

5-17
17
 Elements/Classification of
Risk
The impact of these operating conditions is
reflected in the operating costs of the
company.

Business risk is thus a function of the operating

conditions faced by a company and is the
variability in operating income caused by the
operating conditions of the company.

5-18
18
 Elements of Risk
II. Financial Risk.
Financial risk is a function of financial leverage
which is the use of debt in the capital structure.
The presence of debt in the capital structure
creates fixed payments in the forms of interest
which is a compulsory payment to be made
whether the company makes profit or loss.
The variability in the earnings per share due to
the presence of debt in the capital structure of a
company is referred to as financial risk.

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19
 4.4 : Methods of Measuring
Returns

How to measure returns generated by an

investment manager?

Two ways to measure returns:

1. Dollar Weighted Rate of Return
2. Time Weighted Rate of Return

5-20
 1. Dollar-Weighted
The dollar-weighted rate of return is
analogous / similar to the internal rate of return
in corporate finance
It is the rate of return that makes the present
value of a series of cash flows equal to the
cost of the investment:
C1 C2 C3 Cn
cost
(1 R) (1 R) (1 R) (i R) n
2 3

5-21
 Time-Weighted Rates of Return
The time-weighted rate of return measures the
compound growth rate of an investment
It eliminates the effect of cash inflows and outflows by
computing a return for each period and linking them
(like the geometric mean return):

time - weighted return (1 R1 )(1 R2 )(1 R3 )(1 R4 ) 1

5-22
 Understanding Risk and Return

Or Rate of Return =

Where, rt = actual, expected, or required rate of return

during period t ,
Ct=cash (flow) received from the asset investment in the
time period t-1 to t,
Pt = price (value) of asset at time t,
Pt-1 = price (value) of asset at time t - 1
5-23
 Measuring Returns
Dollar weighted rate of return is the internal rate of
return (IRR) of an investment.
The dollar return is simply the total dollars received from the
investment less the amount invested:
Dollar return = Amount received - Amount invested
$1,100 - $1,000
= $100.
Although expressing returns in dollars is easy, but two
problems arise:
(1) To make a meaningful judgment about the return, you
need to know the scale (size) of the investment;
(2) You also need to know the timing of the return; a $100
return on a $100 investment is a very good return if it
occurs after one year, but the same dollar return after 20
years would not be very good or expected.
5-24
 Contd.
In investment management industry, time
weighted rate of return is preferred:
The solution to the scale and timing problems is
to express investment results as rates of return,
or percentage returns. For example, the rate of
return on the1-year stock investment, when
$1,100 is received after one year, is 10 percent:
Rate of return = Amount received - Amount invested
Amount invested
($1,100 - $1,000) / $1,000 = 10%.

5-25
 Example -1
T-bill, 1 month holding period buy for
$9488, sell for $9528. So, 1 month R :

9528 - 9488
R= = .0042 = .42%
9488
Annualized R: = (1.0042)12 - 1 = .052 = 5.2%

5-26
 example 2
100 IBM shares for 9 months buy for $62, sell for
$101.50 and earn $.80 dividends. 9 months R:

101.50 - 62 + .80
= .65 =65%
62

annualized R: (1.65)12/9 - 1 = .95 = 95%

5-27
 Expected Rate of Return
measuring likely future return
based on probability distribution
random variable
So, the Expected Rate of Return, k is the
rate of return expected to be realized from an
investment; the weighted average of the
probability distribution of possible results.
E(R) = SUM (Ri x Prob(Ri)

5-28
 example 1
R Probability (R)
10% .2
5% .4
-5% .4

E(R) = (.2)10% + (.4)5% + (.4)(-5%)

= 2%

5-29
 RISK ASSESSMENT
Scenario Analysis
Range
Probability Distributions
Scenario analysis: An approach for assessing
risk that uses several possible alternative
outcomes (scenarios) to obtain a sense of the
variability among returns.
Range : A measure of an assets risk, which is
found by subtracting the return associated with
the pessimistic (worst) outcome from the return
associated with the optimistic (best) outcome.
5-30
 RISK ASSESSMENT
Probability Distributions: probability is The
chance that a given outcome will occur.
probability distribution is A model that relates
probabilities to the associated outcomes.
bar chart: The simplest type of probability
distribution; shows only a limited number of
outcomes and associated probabilities for a given
event.
continuous probability distribution : A
probability distribution showing all the possible
outcomes and associated probabilities for a given
event. 5-31
 Probability Distribution
A listing of all possible outcomes, or
events, with a probability ( chance of occurrence)
assigned to each outcome.
Example:
If you buy a bond, you expect to receive
interest on the bond.
The possible out come from the
investment are.
A. The issuer will make the interest
payments or.
B. The issuer will fail to make the interest
payment.
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32
 Probability Distribution

Distribution Table.
Out come Probability
Make the Payment 0.40
Fail to make the payment 0.60
Total Probability 1.00

The higher the possibility of default

on the interest payment , the riskier the bond.

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33
 Probability distribution

Stock
X

Stock Y

Rate of
-20 0 15 50
return (%)

Which stock is riskier? Why?

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34
 The tighter the probability distribution, the less
variability there is and more likely it is that the
actual outcome will be close to the expected
Value.

The les likely it is that the actual return will be

much different from the expected return.

Thus, the tighter the probability distribution, the

lower the risk assigned to a stock.

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35
 RISK MEASUREMENT
measure likely fluctuation in return
how much will R vary from E(R)
how likely is actual R to vary from E(R)
measured by
variance (s2)
standard deviation (s)
Coefficient of Variation (CV)
Standard Deviation : A statistical measure of the
variability of a set of observations.
It is the most common statistical indicator of an
assets risk; it measures the dispersion around the
expected value. 5-36
 RISK MEASUREMENT
Process of standard deviation (s)
1. Calculate the expected rate of return:
Expected rate of return =

5-37
 EXPECTRED RATE OF RETURN
Expected rate of return.
The rate of return expected to
realized from an investment.
-- The mean value of the probability
distribution of possible results.

Calculation of expected rate of return:

n
k Priki
i 1

5-38
38
Where:
^
k = Expected rate of return.
Pr = probability of the ith outcome
will occur.
Ki = is the ith possible outcome.
N = is the number of possible
outcome.

5-39
39
 Example:
The probability distribution showing
the possible outcomes for investment in
martin products and U.S. Electric are given
below:
State of Prb. of (Pr) Martin Products U.S. Electric
Economy occurring Ki Pr Ki Ki Pr Ki
Boom 0.20 110% 22 20 4
Normal 0.50 22% 11 16 8
Recession 0.30 -60% -18 10 3
Total 1.00 of Pr Ki 15% of Pr Ki 15%
5-40
 Using the data for martin products,
we obtain its expected rate of return as
follows: ^
k= Pr1(k1) + pr(k2) + pr3(k3)

= 0.2(110%) + 0.5 ( 22%)

+ 0.3 (-60%)
= 15%

5-41
41
 RISK MEASUREMENT

2. Subtract the expected rate of return (k )

from each possible outcome (k ) i

to obtain a set of deviations about k or

Deviation = k- k .
i

5-42
 RISK MEASUREMENT
3. Square each deviation, then multiply the
result by the probability of occurrence for
its related outcome, and then sum these
products to obtain the variance of the
probability distribution.

4. Finally, find the square root of the

variance to obtain the standard deviation:

5-43
 RISK MEASUREMENT
Coefficient of Variation (CV) : Standardized
measure of the risk per unit of return;
calculated as the standard deviation divided
by the expected return.

The coefficient of variation shows the risk per

unit of return, and it provides a more
meaningful basis for comparison when the
expected returns on two alternatives are not
the same.
5-44
 II. Managing risk
Diversification
holding a group of assets
lower risk lowering E(R)

5-45
 Why?
individual assets do not have same return
pattern
combining assets reduces overall return
variation

5-46
 measuring relative risk
if some risk is diversifiable,
then s is not the best measure of risk
is an absolute measure of risk
CV is the best measure of risk
need a measure just for the systematic
component
- Beta factor is a relative measure of risk.

5-47
 4.5 : What is investment risk?
Two types of investment risk
Stand-alone risk
Portfolio risk
Investment risk is related to the probability of
earning a low or negative actual return.
The greater the chance of lower than expected
or negative returns, the riskier the investment.

5-48
 Standalone Risk
Standalone risk measures the dangers
associated with a single facet of a company's
operations or by holding a specific asset. In
portfolio management, standalone risk
measures the undiversified risk of an
individual asset. For a company, standalone
risk allows portfolio manager to determine a
project's risk as if it were operating as an
independent entity.

5-49
 Portfolio Risk

Portfolio risk or market risk, which reects

the risk of a general stock market decline and
which cannot be eliminated by diversication,
hence does concern investors.

5-50
 Example of Stand alone Risk: Investment
alternatives
Assume that you recently graduated with a major in
finance, and you just landed a job in the trust
department of a large regional bank. Your first
assignment is to invest $1,00,000 from an estate
for which the bank is trustee. Because the estate is
expected to be distributed to the heirs in about one
year, you have been instructed to plan for a one-
year holding period. Further, your boss has
required you to the following investment
alternatives, shown with their probabilities and
associated outcomes. (Disregard for now the items
at the bottom of the data; you will fill in the blanks
later.) 5-51
 Example of Stand alone Risk:
Investment alternatives
Economy Prob. T-Bill HT Coll USR MP

Recession 0.1 8.0% -22.0% 28.0% 10.0% -13.0%

Below avg 0.2 8.0% -2.0% 14.7% -10.0% 1.0%

Average 0.4 8.0% 20.0% 0.0% 7.0% 15.0%

Above avg 0.2 8.0% 35.0% -10.0% 45.0% 29.0%

Boom 0.1 8.0% 50.0% -20.0% 30.0% 43.0%

5-52
 Example of Stand alone Risk:
Investment alternatives
The banks economic forecasting staff has
developed probability estimates for the state of
the economy, and the trust department has a
sophisticated computer program that was
used to estimate the rate of return on each
alternative under each state of economy. High
Tech Inc. is an electronics firm; Collections
Inc. collects past due debts; and U.S. Rubber
manufactures tries and various other rubber
and plastic products.
5-53
 Example of Stand alone Risk:
Investment alternatives
The bank also maintains and index fund,
what owns a market weighted fraction of all
publicity traded stocks; you can invest in that
fund and thus obtain average stock market
results. Given the situation as described,
answer the following questions :
1. Calculate the expected rate of return on
each alternative, and fill in the row for in
the preceding table.
5-54
 Example of Stand alone Risk: Investment
alternatives
2. What type of risk is measured by the standard
deviation ?
3. Suppose you created a two-stock portfolio by
investing $50,000 in High Tech and $50,000 in
Collections.
(i) calculate the expected return (kp), the standard
deviation (p) and the coefficient of variation (CVp)
for this portfolio and fill in the appropriate rows in the
preceding table.
(ii)How does the riskiness of this two-stock portfolio
compare to the riskiness of the individual stocks if
they were held in isolation. 5-55
 Why is the T-bill return independent of
the economy? Do T-bills promise a
completely risk-free return?
T-bills will return the promised 8%, regardless of the
economy.
No, T-bills do not provide a risk-free return, as they
are still exposed to inflation. Although, very little
unexpected inflation is likely to occur over such a
short period of time.
T-bills are also risky in terms of reinvestment rate
risk.
T-bills are risk-free in the default sense of the word.

5-56
 How do the returns of HT and Coll.
behave in relation to the market?
HT Moves with the economy, and has a
positive correlation. This is typical.
Coll. Is countercyclical with the
economy, and has a negative correlation.
This is unusual.

5-57
 4.6 : Risk Measurement Tools

SD- Standard Deviation A total

measure of risk.
beta -coefficient- a measure of market
risk or systematic risk
CV - Coefficient of Variation- A relative
measure of risk, or standardized measure of
dispersion about the expected value, that shows
the risk per unit of return

5-58
Risk: Calculating the standard
deviation for each alternative
s Standard deviation

s Variance s2
n
s (k
i1
i
k ) Pi
2

5-59
 Standard deviation calculation
n ^
s
i1
(k i k ) 2 Pi

1
(8.0 - 8.0) (0.1) (8.0 - 8.0) (0.2)
2 2
2

s T bills (8.0 - 8.0)2 (0.4) (8.0 - 8.0)2 (0.2)

2
(8.0 - 8.0) (0.1)

s T bills 0.0% s C oll 13.4%

s HT 20.0% s U SR 18.8%
s M 15.3%
5-60
Calculating the expected return for
each alternative
^
k expected rate of return
^ n
k
i1
k i Pi

^
k HT (-22.%) (0.1) (-2%) (0.2)
(20%) (0.4) (35%) (0.2)
(50%) (0.1) 17.4%

5-61
 Summary of expected returns for
all alternatives
Alternatives Exp return
HT 17.4%
Market 15.0%
USR 13.8%
T-bill 8.0%
Coll. 1.7%
HT has the highest expected return, and appears
to be the best investment alternative, but is it
really? Have we failed to account for risk?

5-62
Comparing standard deviations
Prob.
T - bill

USR

HT

0 8 13.8 17.4 Rate of Return (%)

5-63
 Comments on standard deviation
as a measure of risk
Standard deviation (i) measures total, or stand-
alone risk.
The larger i is, the lower the probability that
actual returns will be closer to expected returns.
Larger i is associated with a wider probability
distribution of returns.
Difficult to compare standard deviations,
because return has not been accounted for.
5-64
Comparing risk and return
Security Expected return Risk,

T-bills 8.0% 0.0%

HT 17.4% 20.0%
Coll* 1.7% 13.4%
USR* 13.8% 18.8%
Market 15.0% 15.3%
* Seem out of place.

5-65
 Coefficient of Variation (CV)
A standardized measure of dispersion about the
expected value, that shows the risk per unit of
return.

Std dev s
CV ^
Mean k

5-66
 Risk rankings,
by coefficient of variation
CV
T-bill 0.000
HT 1.149
Coll. 7.882
USR 1.362
Market 1.020
Collections has the highest degree of risk per unit
of return.
HT, despite having the highest standard deviation
of returns, has a relatively average CV.
5-67
Illustrating the CV as a measure
of relative risk

Prob.

A B

0 Rate of Return (%)

A = B , but A is riskier because of a larger

probability of losses. In other words, the same
amount of risk (as measured by ) for less returns.
5-68
 Investor attitude towards risk
Risk aversion assumes investors dislike
risk and require higher rates of return to
encourage them to hold riskier securities.
Risk premium the difference between the
return on a risky asset and less risky asset,
which serves as compensation for investors to
hold riskier securities.

5-69
 Examples:
Problem 1
The Delta corporation is considering an
investment in one of the two mutually exclusive
proposals, Project A involving an initial outlay of
Tk. 1,70,000 and Project B involving Tk.
1,50,000. The certainty equivalent approach is
used in evaluating risky investments. The
current yield on treasury bills is 5% and the
company uses this as the risk less arte. The
relevant information are as follows:

5-70
 Year Project A Project B

Cash flow (Tk.) Certainty- Cash flow (Tk.) Certainty-

equivalent equivalent

1 90,000 0.8 90,000 0.9

2 1,00,000 0.7 90,000 0.8
3 1,10,000 0.5 1,00,000 0.6

Which project should be acceptable to the

company?
Which project is riskier? How do you know?
If the company was to use the risk adjusted
discount rate method, which project would be
analyzed with higher rate?
5-71
 Examples:
Problem 2
A company is considering two mutually exclusive
projects S and T. Project S costs Tk. 30,000 and
project T Tk. 36,000. The following particulars
relate to these projects:
Year Project S Project T
CFAT (Tk.) Probability CFAT (Tk.) Probability

1 3,000 0.1 3,000 0.2

2 6,000 0.4 6,000 0.3

3 12,000 0.4 12,000 0.3

4 15,000 0.1 15,000 0.2

5-72
 Examples:
Problem 2 (Contd.)
Required:
Compute the expected cash flows of the projects.
Compute the risk attached to each project.
Which project do you consider more risky and
why?

5-73
 Examples:
Problem 3
The probability distributions of two projects cash
flows are given below :
Project X Project Y

CF Probability CF Probability

5,000 0.2 2,500 0.1

7,500 0.4 7,000 0.2
10,000 0.3 12,000 0.5
15,000 0.1 16,000 0.2
Calculate the expected CF, the standard deviation
and coefficient of variation of each projects. Which
of these two mutually exclusive projects do you
prefer? And Why? 5-74
 Portfolio Return and Risk
Analysis:

5-75
 Portfolio Expected Return
Portfolio Expected Return is Weighted
average of the returns earned on the
investments in stocks, bonds, real estate, etc.,
made at different times and earning different
rates of return at these times. It has been argued
that this rate of return does not reflect the true
rate of return on investments being earned
today. This led to the development of the current
assumptions products.

5-76
 Portfolio Returns
A portfolio is a collection of investment
securities or assets. For example, If you owned
some stock of X, some stock of Y & some stock of
Z, you would hold a threestock portfolio

The expected return on a p , is simply the
weighted average of the expected returns on the
individuals stock in the portfolio, with the weights
being the fraction of the total portfolio investment
in each stock ie. n
kp = wj k j.
j=1

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77
 Portfolio Returns
Here:

are the expected returns on the
k j
individuals stocks
wj are
are the weights,
the stocks in the portfolio
N
Example: In January 2005, a security analyst estimated the
following returns could be expected on four large
companies:

AT & T 10%
General Electric 13%
Microsoft 30%
Citigroup 16%

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78
 Portfolio Returns & Risk
If we formed a $100,000 portfolio,
investing$25,000 in each stock, the expected
portfolio return would be :
= .25(.10) + .25(.13) + .25(.30) +.25(.16)
= 17.25
Portfolio Risk:
Riskiness of a portfolio, sp , generally is not
a weighted average of the standard deviations
of the individual secretaries in the portfolio; the
portfolio risk usually is smaller than the
weighted average of the stocks ss.

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79
Calculating Portfolio Expected
Return
^
k p is a weighted average :

^ n ^
kp w
i 1
i ki

^
k p 0.5 (17.4%) 0.5 (1.7%) 9.6%

P = weighted average portfolio return,

^
Wi = Portfolio weight
Ki = rate of individual security return
N= no. of securities in the portfolio

5-80
 Contd.
The contribution of each security to
portfolio expected return depends on:
1. the securitys expected return
2. the securitys weight

5-81
 Portfolio construction: Risk and return
Assume a two-stock portfolio is created with
$50,000 invested in both HT and Collections.

Expected return of a portfolio is a weighted

average of each of the component assets of the
portfolio.
Standard deviation is a little more tricky and
requires that a new probability distribution for the
portfolio returns be devised.
Beta () measures a stocks market risk, and
shows a stocks volatility relative to the market.
5-82
 Portfolio construction: Risk and return
PORTFOLIO RETURN:
The return on a portfolio is a weighted average of
the returns on the individual assets from which it is
formed. So, The expected return on a portfolio,
k p The weighted average of the expected returns
on the assets held in the portfolio. The portfolio
return, rp:

Where, wj = proportion of the portfolios total dollar

value represented by asset j
rj = return on asset j

5-83
 An alternative method for determining
portfolio expected return

Economy Prob. HT Coll Port.

Recession 0.1 -22.0% 28.0% 3.0%
Below avg 0.2 -2.0% 14.7% 6.4%
Average 0.4 20.0% 0.0% 10.0%
Above avg 0.2 35.0% -10.0% 12.5%
Boom 0.1 50.0% -20.0% 15.0%
^
k p 0.10 (3.0%) 0.20 (6.4%) 0.40 (10.0%)
0.20 (12.5%) 0.10 (15.0%) 9.6%

5-84
Portfolio Risk & Holding Combination of Assets

A portfolio is a collection of investment

securities or assets. For example, If you
owned some stock of X, some stock of Y &
some stock of Z, you would hold a three
stock portfolio

Portfolio risk means how the movement of a

particular security can interact with the movement
of all other securities in the portfolio.

5-85
Portfolio Risk & Holding Combination of Assets

The variance of the return of the portfolio

with its expected return is treated as portfolio
risk. The calculation of portfolio risk is bit
difficult than individual security.

The most popular measure of portfolio risk

is the variance or standard deviation ( p ) of
the probability distribution of possible returns.

5-86
 Contd.
Standard Deviation ( p )- Calculating Martin
Products Standard Deviation

5-87
 Variance ( 2)

Square each deviation, then multiply the result

by the probability of occurrence for its related
outcome, and then sum these products to
obtain the variance of the probability
distribution.

5-88
Calculating portfolio standard
deviation and CV
1
0.10 (3.0 - 9.6) 2
2

0.20 (6.4 - 9.6)2

s p 0.40 (10.0 - 9.6)2 3.3%
0.20 (12.5 - 9.6)2
2

0.10 (15.0 - 9.6)

3.3%
CVp 0.34
9.6%
5-89
 Comments on portfolio risk
measures

p = 3.3% is much lower than the i of

either stock (HT = 20.0%; Coll. =
13.4%).
p = 3.3% is lower than the weighted
average of HT and Coll.s (16.7%).
\ Portfolio provides average return of
component stocks, but lower than
average risk.
.
5-90
 General comments about risk
Most stocks are positively correlated
with the market (k,m 0.65).
35% for an average stock.
Combining stocks in a portfolio
generally lowers risk.

5-91
 Creating a portfolio:
Beginning with one stock and adding
randomly selected stocks to portfolio
p decreases as stocks added, because they
would not be perfectly correlated with the
existing portfolio.
Expected return of the portfolio would remain
relatively constant.
Eventually the diversification benefits of adding
more stocks dissipates (after about 10 stocks),
and for large stock portfolios, p tends to
converge to 20%.

5-92
Illustrating diversification effects of a
stock portfolio

sp (%)
Company-Specific Risk
35
Stand-Alone Risk, sp

20
Market Risk

0 10 20 30 40 2,000+
# Stocks in Portfolio
5-93
Breaking down sources of risk
Stand-alone risk = Market risk + Firm-
specific risk
Market risk portion of a securitys stand-
alone risk that cannot be eliminated
through diversification. Measured by
beta.
Firm-specific risk portion of a securitys
stand-alone risk that can be eliminated
through proper diversification.
5-94
 Examples:
Problem 1
Consider a three stock portfolio consisting of
stocks X, Y, and Z with expected returns of 12%,
20% and 17% respectively. Assume that 50% of
investible funds is invested in stock X, 30% in Y
and 20% in Z.
Calculate portfolio expected return.
Problem 2
Four securities have the following expected
returns :
A = 15%, B = 12%, C = 30% and D = 22%
5-95
 Examples:
Calculate the expected returns for a portfolio
consisting of all four securities under the
following conditions:
i. The portfolio weights are 25% each;
ii. The portfolio weights are 10% in A with
remainder equally divided among the other three
securities and
i. The portfolio weights are 25% in A, 28% in B,
22% in C and 25% in D.

5-96
 Examples:
Problem - 3
Stocks X and Y have the following historical
returns :

Year Stock Xs Returns Stock Ys Returns

1996 -19% -14.50%
1996 33% 21.80%
1998 15% 30.50%
1999 0.50% -7.60%
2000 27% 26.30%

Calculate the portfolio risk of the securities of

50% weights are placed in each stock X and Y.
5-97
 Examples:
Problem - 4
A portfolio consists of three securities P, Q and R with
the following information :
Particulars P Q R Correlation Co-
efficient
Expected Return (%) 27 23 21

Standard Deviation (%) 31 27 25

Correlation Co-
efficient
PQ -0.5
QR +0.6
PR 0.7

If the securities are equally weighted, how much is the

risk and return of the portfolio of these three securities.
5-98
 Correlation
Correlation: A statistical measure of the
relationship between any two series of numbers.
positively correlated: Describes two series that
move in the same direction.
negatively correlated: Describes two series that
move in opposite directions.
correlation coefficient : A measure of the
degree of correlation between two series.
perfectly positively correlated: Describes two
positively correlated series that have a correlation
coefficient of +1.
perfectly negatively 5-99
 Correlation
perfectly negatively correlated :
Describes two negatively correlated series
that have a correlation coefficient of -1.

Uncorrelated : Describes two series that

lack any interaction and therefore have a
correlation coefficient close to zero.

5-100
 Capital Asset Pricing Model (CAPM)

5-101
 Lecture # 10
Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model or CAPM is really an
extension of the portfolio theory of Harry
Markowitz. It is developed in mid 1960s specially
by three researchers William Sharpe, John Linter
and Jan Mossin independently. Thats why the
model is often referred to as Sharpe, Linter and
Mossin Capital Asset Pricing Model.
5-102
 Contd.

The portfolio theory is a description of how

rational investors should build efficient portfolios
and select the optimal portfolios the way the
portfolio theory suggested.
Capital Asset Pricing Model (CAPM) based
upon the concept that a stocks required rate of
return is equal to the risk-free rate of return plus a
risk premium that reflects the riskiness of the stock
after diversification.
Primary conclusion: The relevant riskiness of a
stock is its contribution to the riskiness of a well-
diversified portfolio.
5-103
Pricing of securities / assets with
CAPM
The Capital Asset Pricing Model
(CAPM) can be used for evaluating the
pricing of securities. CAPM provides a
framework for assessing whether a
security is under priced, overpriced or
correctly priced. According to CAPM,
each security is expected to provide a
return proportionate with its level of
risk. 5-104
 If the investor are primarily concerned with
portfolio risk rather than the risk of the individual
securities in the portfolio, how should the riskiness
of an individual stock be measured?
CAPM:
A model used to determine the required return
on an assets, which is based on the proposition that
any assets return should be equal to the risk free
rate of return plus a risk premium that reflect the
asset's non-diversifiable risk.
CAPM = KRF + ( KM - KRF )

5-105
105
Market Risk Premium (RPM):
The additional return over the risk-free rate
needed to compensate investors for assuming an
average amount of return.
The market risk premium , RPM, depends on the
degree of aversion that investors on average have to
risk.
Security Market Line:
The line that shows the relationship between risk as
measured by beta and the required rate of return for
individual securities.

5-106
106
 Conclusions

As more stocks are added, each new stock

has a smaller risk-reducing impact on the
portfolio.
sp falls very slowly after about 40 stocks are
included. The lower limit for sp is about 20%
= sM .
By forming well-diversified portfolios,
investors can eliminate about half the
riskiness of owning a single stock.

5-107
107
Components of CAPM-SML & CML
Security Market Line (SML)- The line on a graph
that shows the relationship between risk as
measured by beta and the required rate of return
for individual securities.
The securities market line is a graphical
representation of the CAPM model. It is similar
to the CML, only for specific securities. The
security market line (SML) is the relationship
between expected return and risk of the
investment. For measuring the relationship, Beta
is shown on the x axis, and the required rate
of return is on the y axis.

5-108
When the expected return on the security as per
CAPM formulation is lower than the actual/
estimated return offered by that security, the
security will be considered to be under priced.

On the contrary, a security will be considered to

be over-priced when the expected return on the
security as per CAPM formulation is higher than
the actual return offered by the security.
See the following graph for evaluating securities
with CAPM
5-109
 CAPM and Security Market Line
E(r)
Under-priced
SML
a
M
E(rM)

Over-priced
rf

M = 1.0
5-110
 Decision rule for Evaluation of
Stock pricing

1. When Estimated /Actual rate of return > Exp

rate of return then security is under valued.

2. When Estimated /Actual rate of return < Exp

rate of return the security is said to be
overvalued.

3. When Estimated /Actual rate of return is more

or less equal or same to Exp rate of return then
security is said to be fairly valued.
5-111
 Calculation of securities / assets return by
using CAPM Model:

Ri= RF + (Rm-Rf) i

Or, Ri= RFR + i*RP { = COV (Ri, Rm) / 2m}

Ri = Expected return
RFR = Risk free Rate
Rm = Market Rate of return
= Beta factor
There is a linear relationship between Beta
factor and security / portfolio return.
5-112
 Determining the Expected
Return for a Risky Asset (CAPM)
Stock Beta Assume: RFR = 5% (0.05)
A 0.70 RM = 9% (0.09)
B 1.00 Implied market risk premium = 4%
C 1.15 (0.04)
D 1.40
E(R i ) RFR i (R M - RFR)
E -0.30
E(RA) = 0.05 + 0.70 (0.09-0.05) = 0.078 = 7.8%
E(RB) = 0.05 + 1.00 (0.09-0.05) = 0.090 = 09.0%
E(RC) = 0.05 + 1.15 (0.09-0.05) = 0.096 = 09.6%
E(RD) = 0.05 + 1.40 (0.09-0.05) = 0.106 = 10.6%
E(RE) = 0.05 + -0.30 (0.09-0.05) = 0.038 = 03.8% 5-113
 Stock/ security Price, Dividend, and
Rate of Return Estimates

Table 7.1 Price, Dividend, and Rate of Return Estimates

Current Price Expected Dividend Expected Future Rate

Stock (Pi ) Expected Price (Pt+1) (Dt+1) of Return (Percent)
A 25 27 0.50 10.0 %
B 40 42 0.50 6.2
C 33 39 1.00 21.2

5-114
 Comparison of Required Rate of Return to
Estimated Rate of Return
Table 7.2 Comparison of Required Rate of Return to Estimated Rate of Return

Required Return Estimated Return

Stock Beta E(Ri) Estimated Return Minus E(Ri) Evaluation
A 0.70 10.2% 10.0 -0.2 Properly Valued
B 1.00 12.0% 6.2 -5.8 Overvalued
C 1.15 12.9% 21.2 8.3 Undervalued
D 1.40 14.4% 3.3 -11.1 Overvalued
E -0.30 4.2% 8.0 3.8 Undervalued

RFR 0.1
5-115
 Can an investor holding one stock earn a
return commensurate with its risk?

No. Rational investors will minimize risk by

holding portfolios.
They bear only market risk, so prices and
returns reflect this lower risk.
The one-stock investor bears higher (stand-
alone) risk, so the return is less than that
required by the risk.

5-116
116
 How Is Market Risk Measured for
Individual Securities?
Market risk, which is relevant for stocks held in
well-diversified portfolios, is defined as the
contribution of a security to the overall riskiness
of the portfolio.
It is measured by a stocks beta coefficient, which
measures the stocks volatility relative to the
market.
What is the relevant risk for a stock held in
isolation?

5-117
117
Relevant Risk & Beta Coefficient
The risk of a security that cannot be diversied
away, or its market risk. This reects a securitys
contribution to the riskiness of a portfolio.
Beta Coefficient- A measure of market risk,
which is the extent to which the returns on a
given stock move with the stock market.
For example : A portfolio of such b =1.0 stocks
will move up and down with the broad market
averages, and it will be just as risky as the
averages. If b = 0.5, the stock is only half as
5-118
volatile as the market.
 Contd.
, a measure of the extent to which the
returns on a given stock move with the stock
market.
Stocks beta measures its contribution to
the riskiness of a portfolio, theoretically beta is
the correct measures of the stocks riskiness.
So, Beta Measures a stocks market risk, and
shows a stocks volatility relative to the
market.
Indicates how risky a stock is if the stock is
held in a well-diversified portfolio.
5-119
 Comments on beta coefficient
If beta = 1.0, the security is just as risky as
the average stock.
If beta > 1.0, the security is riskier than
average.
If beta < 1.0, the security is less risky than
average.
Most stocks have betas in the range of 0.5
to 1.5.

5-120
 Application of beta factor
The market risk of a stock is measured by
its beta coefficient, which is an
index of the stocks relative volatility.
Some benchmark betas follow:
b = 0.5: Stock is only half as volatile, or
risky, as an average stock.
b = 1.0: Stock is of average risk.
b = 2.0: Stock is twice as risky as an
average stock.
5-121
 Can the beta of a security be
negative?
Yes, if the correlation between Stock i
and the market is negative (i.e., i,m <
0).
If the correlation is negative, the
regression line would slope downward,
and the beta would be negative.
However, a negative beta is highly
unlikely.

5-122
Comparing expected return and
beta coefficients
Security Exp. Return Beta
HT 17.4% 1.30
Market 15.0 1.00
USR 13.8 0.89
T-Bills 8.0 0.00
Coll. 1.7 -0.87

Riskier securities have higher returns, so the

rank order is OK.

5-123
 EXAMPLE
(1). Suppose you observe the following situation:

Security Beta E.Return

Cooley , Inc. 1.6 19%
Moyer Co. 1.2 16%

If the risk free rate of return is 8%, are these securities

correctly priced? What would the risk-free rate have to be if
they are correctly priced?

(2). Suppose the risk-free rate is 8%. The expected return on the
market is 14%. If a particular stock has a beta of .60, what is
its expected return based on the CAPM? If another stock has
an expected return of 20%, what must its beta be?
5-124
124
 EXAMPLE contd.
(3). Suppose the-risk free rate is 4%, the market risk
premium is 8.6%, and a particular stock has a beta of
1.3. Based on the CAPM, what is the expected return
on this stock? What would be expected rate of return if
the the beta were to double?
(4). Consider the following information on two securities.
Which has greater total risk? Which has greater
systematic risk? Greater unsystematic risk? Which
assets will have a higher risk premium ?
Security Std. Deviation Beta
A 40% .50
B 20% 1.50
5-125
125
 ANSWER: 1
If we compute the reward-to-risk ratios(CAPM),
we get (19%-8%)/1.6=6.875% for Cooley versus
6.675% for Moyer. Relative to Cooley, Moyers
expected return is too low, so its price is too high.
If they are correctly priced, then they must offer
the same reward-to-risk ratio. The risk free rate of
return would have to be such that:
(19% - Rf - ) / 1.6 = (16% - Rf ) / 1.2
With a little algebraic change, we find that the risk-
free rate must be 7%:
(19% - Rf) = (16% - Rf) (1.6/1.2)
19% - 16% x (4/3) = Rf Rf x (4/3) ie Rf =7%
5-126
126
 ANSWER: 2
Since the expected return on the market is
14%, the market risk premium is 14% - 8% = 6% (
risk-free rate is 8%). The first stock has a beta of
0.60, so its expected return is 8% + 0.60x6% =
11%.
For the second stock, notice that the risk
premium is 20% - 8% = 12%. Since this is twice as
large as the market risk premium, the beta must be
exactly equal to 2. We can verify this using the
CAPM:
CAPM = Rf + (Rm Rf) x i
20% = 8% + (14% - 8% ) x i
i = 12%/6% ie i = 2.0
5-127
127
 Answer : 3

With a beta of 1.3 , the risk premium for

the stock would be 1.3 x 8.6 or 11.18 % .
The risk free rate is 4%. , so the expected rate
of return is 15.18 %. If the beta doubles to
2.6 , the risk premium would double to 22.36
%, so the expected rate of return would be
26.36 % ( 22.36 +4).

5-128
128
 (5). The risk-free rate is currently 9%. A stock has
a beta of 0.70 and an expected return of 12%.
(a). What is the expected return on a portfolio
that is equally invested in the two assets?
(b). If a portfolio of the two assets has a beta of
0.50 what are the portfolio weights?
(c). If a portfolio of the two assets has a
expected return of 10% what is its beta?
(d). If a portfolio of the two assets as a beta of
1.50, what are the portfolio weights? How do we
interpret the weights for the risk-free assets?

5-129
129
The Security Market Line (SML)
The securities market line is a graphical
representation of the CAPM model. It is
similar to the CML, only for specific
securities. The security market line
(SML) is the relationship between
expected return and risk of the
investment. For measuring the
relationship, Beta is shown on the x axis,
and the required rate of return is on
the y axis.
5-130
The Security Market Line (SML)
The CAPM actually depicts the SML,
and not the CML, due to the CAPM
equation involving the Beta of a single
asset. The required rate of return (on the y
axis of the SML) is the minimum expected
rate of return necessary to induce an
investor to purchase an asset. It is
composed of the RFRR and the risk
premium.

5-131
 Contd.
Along the x-axis of the graph we have the Beta,
while on the y-axis we have the expected return
for a given level of risk.
The idea is that any security that falls exactly at
any point on the line is fairly valued. If the
security is at any point above the line we would
basically know that the security is undervalued as
it offers a greater return for the given level of risk.
If the security is below the line we know that the
security is overvalued as the return it offers is not
adequate for the given level of risk. 5-132
Sample Calculations of security return
for SML
RP = E(rM) - rf = .08 rf = .03

x = 1.25
E(rx) = .03 + 1.25(.08) = .13 or 13%

y = .6
E(ry) = .03 + .6(.08) = .078 or 7.8%

5-133
 Graph of Sample Calculations
E(r)
SML
E(rx)=13%
E(rM)=11%

E(ry)=7.8%
rf=3%

y = M = x =
0.6 1.0 1.25 5-134
Comments
The higher the rate of security
beta the higher the rate of return.

5-135
 The Security Market Line (SML):
Calculating required rates of return
SML is applicable mainly for measuring individual
security or asset's relative risk (systematic risk)
compared to market risk.

SML: ki = kRF + (kM kRF) i

Assume kRF = 8% and kM = 15%.

The market (or equity) risk premium is
RPM = kM kRF = 15% 8% = 7%.

5-136
 Market Risk Premium and its significance.
Market Risk Premium- The additional return
over the risk-free rate needed to compensate
investors for assuming an average amount of
risk.
Significance
Additional return over the risk-free rate needed to
compensate investors for assuming an average
amount of risk.
Its size depends on the perceived risk of the stock
market and investors degree of risk aversion.
Varies from year to year, but most estimates
suggest that it ranges between 4% and 8% per
year. 5-137
Calculating required rates of return with
CAPM

kHT = 8.0% + (15.0% - 8.0%)(1.30)

= 8.0% + (7.0%)(1.30)
= 8.0% + 9.1% = 17.10%
kM = 8.0% + (7.0%)(1.00) = 15.00%
kUSR = 8.0% + (7.0%)(0.89) = 14.23%
kT-bill = 8.0% + (7.0%)(0.00) = 8.00%
kColl = 8.0% + (7.0%)(-0.87) = 1.91%

5-138
 Pricing security with CAPM
Expected vs. Required returns
^
k k
^
HT 17.4% 17.1% Undervalued (k k)
^
Market 15.0 15.0 Fairly valued (k k)
^
USR 13.8 14.2 Overvalued (k k)
^
T - bills 8.0 8.0 Fairly valued (k k)
^
Coll. 1.7 1.9 Overvalued (k k)

5-139
 Portfolio Beta
Equally-weighted two-stock portfolio
Create a portfolio with 50% invested in HT
and 50% invested in Collections.
The beta of a portfolio is the weighted
average of each of the stocks betas.

P = wHT HT + wColl Coll

P = 0.5 (1.30) + 0.5 (-0.87)
P = 0.215

5-140
 Calculating portfolio required returns
The required return of a portfolio is the weighted
average of each of the stocks required returns.
kP = wHT kHT + wColl kColl
kP = 0.5 (17.1%) + 0.5 (1.9%)
kP = 9.5%
As per CAPM Model - using the portfolios beta,
portfolio expected Rate of Return can be
Calculated as follows expected return.
kP = kRF + (kM kRF) P
kP = 8.0% + (15.0% 8.0%) (0.215)
kP = 9.5%
5-141
 Factors that change the SML
What if investors raise inflation expectations by
3%, what would happen to the SML?

ki (%)
D I = 3% SML2
18 SML1
15
11
8
Risk, i
0 0.5 1.0 1.5 5-142
 Factors that change the SML
What if investors risk aversion increased,
causing the market risk premium to increase
by 3%, what would happen to the SML?
ki (%) SML2
D RPM = 3%
18 SML1
15
11
8
Risk, i
0 0.5 1.0 1.5 5-143
 Verifying the CAPM empirically
The CAPM has not been verified
completely.
Statistical tests have problems that make
verification almost impossible.
Some argue that there are additional risk
factors, other than the market risk
premium, that must be considered.

5-144
 Self test questions
Explain the following statement: An asset
held as part of a portfolio is generally less
risky than the same asset held in isolation.
What is meant by perfect positive
correlation, perfect negative correlation,
and zero correlation?
In general, can the riskiness of a portfolio
be reduced to zero by increasing the
number of stocks in the portfolio? Explain.
5-145
 Contd.
What is an average-risk stock? What will
be its beta?
Why is beta the theoretically correct
measure of a stocks riskiness?
If you plotted the returns on a
particular stock versus those on the
Dow Jones Index over the past 5 years,
what would the slope of the regression line
you obtained indicate about the stocks
market risk?
5-146
 Contd.
o Differentiate among the expected rate of return (k
), the required rate of return (k), and the realized
return.
o What happens to the SML graph when risk
aversion increases or decreases?
o What would the SML look like if investors were
indifferent to risk, that is, if they had zero risk
aversion?

5-147
 Contd.
o How can a rm inuence its market risk as
reected in its beta?
o Does earnings volatility necessarily imply risk?
Explain.
o Why is stock price volatility more likely to imply
risk than earnings volatility?

5-148
 Problem -1: (Portfolio Expected Returns)
Security Investible fund ERR Weight

p 3000 0.15 0.23

Q 4000 0.20 0.12
R 6000 0.10 0.19
S 10000 0.14 0.32
T 8000 0.11 0.25
Total= 31,000 1.00

N
The E (rp)= = wi * E (ri)
i=1
= 0.23*0.15+0.12*0.20+0.19*0.10+0.32*.014+0.25*0.11
= 0.1498 = 14.98%. So, PERR = 15% (Approx)

5-149
 Exercises

5-1 : Security A has an expected return of 7

percent, a standard deviation of expected returns
of 35 percent, a correlation coefficient with the
market of -0.3, and a beta coefficient of -0.5.
Security B has an expected return of 12 percent,
a standard deviation of returns of 10 percent, a
correlation with the market of 0.7, and a beta
coefcient of 1.0. Which security is riskier? Why?

5-150
Starter problem 5.1:

5-151
 Starter problem :5.2 & 5.3
5.2 : An individual has $35,000 invested in a
stock that has a beta of 0.8 and $40,000
invested in a stock with a beta of 1.4. If these
are the only two investments in her portfolio,
what is her portfolios beta?
5.3 : Assume that the risk-free rate is 5 percent
and the market risk premium is 6 percent.
What is the expected return for the overall
stock market? What is the required rate of
return on a stock that has a beta of 1.2 ?

5-152
 Starter problem :5.4 & 5.5
5.4: Assume that the risk-free rate is 6 percent and the
expected return on the market is 13 percent. What is the
required rate of return on a stock that has a beta of 0.7?

5.5 : A stock has a required return of 11 percent. The risk-

free rate is 7 percent, and the market risk premium is 4
percent

a. What is the stocks beta?

b. If the market risk premium increases to 6 percent,
what will happen to the stocks required rate of
return? Assume the risk-free rate and the
stocks beta remain unchanged.

5-153
Exercise-5.6 (P-209)

5-154
 5.7
Suppose you hold a diversified portfolio
consisting of a $7,500 investment in each
of 20 different common stocks. The
portfolio beta is equal to 1.12. Now,
suppose you have decided to sell one of
the stocks in your portfolio with a beta
equal to 1.0 for $7,500 and to use these
proceeds to buy another stock for your
portfolio. Assume the new stocks beta is
equal to 1.75. Calculate your portfolios
new beta.
5-155
 5.8
Suppose you are the money manager of a $4
million investment fund. The fund consists of 4
stocks with the following investments and betas:
STOCK INVESTMENT BETA
A $ 400,000 1.50
B 600,000 (0.50)
C 1,000,000 1.25
D 2,000,000 0.75
If the markets required rate of return is 14
percent and the risk-free rate is 6 percent,
what is the funds required rate of return?

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 5.9, 5.10
You have a $2 million portfolio consisting of a
$100,000 investment in each of 20 different
stocks. The portfolio has a beta equal to 1.1.
You are considering selling $100,000 worth of
one stock that has a beta equal to 0.9 and using
the proceeds to purchase another stock that has
a beta equal to 1.4. What will be the new beta of
your portfolio following this transaction?

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 5.9, 5.10

Stock R has a beta of 1.5, Stock S has a beta

of 0.75, the expected rate of return on an
average stock is 13 percent, and the risk-free
rate of return is 7 percent. By how much does
the required return on the riskier stock exceed
the required return on the less risky
stock?

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 Gitman - Exercises
ST81 :Portfolio analysis You have been asked
for your advice in selecting a portfolio of assets
and have been given the following data:

You have been told that you can create two

portfoliosone consisting of assets A and B and
the other consisting of assets A and Cby
investing equal proportions (50%) in each of the
two component assets. 5-159
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a. What is the expected return for each asset over
the 3-year period?
b. What is the standard deviation for each assets
return?
c. What is the expected return for each of the two

portfolios?
d. How would you characterize the correlations of

returns of the two assets making up each of the two

portfolios identified in part c?
e. What is the standard deviation for each portfolio?

f. Which portfolio do you recommend? Why?

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ST-2: Beta and CAPM Currently under
consideration is an investment with a beta, b, of
1.50. At this time, the risk-free rate of return, RF, is
7%, and the return on the market portfolio of
assets, r m, is 10%. You believe that this investment
will earn an annual rate of return of 11%.
a. If the return on the market portfolio were to
increase by 10%, what would you expect to happen
to the investments return? What if the market
return were to decline by 10%?
b. Use the capital asset pricing model (CAPM) to

find the required return on this investment.

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c. On the basis of your calculation in part b, would
you recommend this investment? Why or why not?
d. Assume that as a result of investors becoming
less risk-averse, the market return drops by 1% to
9%. What impact would this change have on your
responses in parts b and c?
E81 : An analyst predicted last year that the stock

of Logistics, Inc., would offer a total return of at

least 10% in the coming year. At the beginning of
the year, the firm had a stock market value of $10
million. At the end of the year, it had a market value
of $12 million even though it experienced a loss, or
negative net income, of $2.5 million. 5-162
 Gitman - Exercises
Did the analysts prediction prove correct? Explain
using the values for total annual return.
E82 : Four analysts cover the stock of Fluorine
Chemical. One forecasts a 5% return for the coming
year. A second expects the return to be negative
5%. A third predicts a 10% return. A fourth expects
a 3% return in the coming year. You are relatively
confident that the return will be positive but not

large, so you arbitrarily assign probabilities of being

correct of 35%, 5%, 20%, and 40%, respectively, to
the analysts forecasts. Given these probabilities,
what is Fluorine Chemicals expected return for the
coming year? 5-163
 Gitman - Exercises
E83 : The expected annual returns are 15% for
investment 1 and 12% for investment 2. The
standard deviation of the first investments return is
10%; the second investments return has a standard
deviation of 5%. Which investment is less risky
based solely on standard deviation? Which
investment is less risky based on coefficient of
variation? Which is a better measure given that the
expected returns of the two investments are not the
same?

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 Gitman - Exercises
E84: Your portfolio has three asset classes. U.S.
government T-bills account for 45% of the portfolio,
large-company stocks constitute another 40%, and
small-company stocks make up the remaining 15%.
If the expected returns are 3.8% for the T-bills,
12.3% for the large-company stocks, and 17.4% for
the small-company stocks, what is the expected
return of the portfolio?
E-8.5: You wish to calculate the risk level of your

portfolio based on its beta. The five stocks in the

portfolio with their respective weights and betas are
shown in the accompanying table. Calculate the beta
of your portfolio. 5-165
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 Gitman - Exercises
P81 Rate of return Douglas Keel, a financial
analyst for Orange Industries, wishes to estimate the
rate of return for two similar-risk investments, X and
Y. Douglass research indicates that the immediate
past returns will serve as reasonable estimates of
future returns. A year earlier, investment X had a
market value of $20,000; investment Y had a market
value of $55,000. During the year, investment X
generated cash flow of $1,500 and investment Y
generated cash flow of $6,800. The current market
values of investments X and Y are $21,000 and
$55,000, respectively.
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 Gitman - Exercises
a. Calculate the expected rate of return on
investments X and Y using the most recent years
data.
b. Assuming that the two investments are equally
risky, which one should Douglas recommend? Why?

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