Chapter13

•Return, Risk, and the

Security Market Line

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter 13 – Index of Sample
Problems
• Slide # 02 - 03 Expected return of individual stock
• Slide # 04 - 05 Standard deviation of individual stock
• Slide # 06 - 07 Portfolio weights
• Slide # 08 - 18 Portfolio expected return
• Slide # 19 - 22 Portfolio standard deviation
• Slide # 23 - 26 Portfolio beta
• Slide # 27 - 32 Capital asset pricing model
• Slide # 33 - 35 Reward-to-risk ratio
 2: Expected return of individual
stock
You own 500 shares of ABC, Inc. This stock has the following
expected returns given the various possible states of the
economy.

State of Probability of Rate of Return

Economy State of Economy if State Occurs
Boom .20 28%
Normal .70 12%
Recession .10 -40%

What is your expected return on this stock?

3: Expected return of individual
stock

E r  (.20  .28)  (.70  .12)  (.10  .40)

 .056  .084  .04
 .10
 10%
 4: Standard deviation of individual
stock
A stock has returns of 6.8%, 9.2%, -4.3% and 18.7% over the last
four years, respectively.

What is the standard deviation of this stock assuming the returns

are normally distributed?
5: Standard deviation of individual
stock

(.068  .076) 2  (.092  .076) 2  (.043  .076) 2  (.187  .076) 2


4 1
.000064  .000256  .014161 .012321

3
.026802

3
.068  .092  .043  .187
 . 008934 Er 
4
 .0945 .304
 9.45% 
4
 .076
 6: Portfolio weights

You own 50 shares of Stock A and 200 shares of stock B. Stock A

sells for $30 a share and stock B sells for $22 a share.

What are the portfolio weights for each stock?

 7: Portfolio weights

Stock Number of Price per Total Portfolio

Shares Share Value Weight
A 50 $30 $1,500 25.4%
B 200 $22 $4,400 74.6%
Totals $5,900 100.0%
 8: Portfolio expected return

You have $3,600 invested in stock A and $5,400 invested in stock

B. Stock A has an expected return of 11% and stock B has an
expected return of 7%.

What is the expected return of your portfolio?

 9: Portfolio expected return

Stock Expected Return Amount Invested Portfolio Weight

A 11% $3,600 40%
B 7% $5,400 60%
Totals $9,000 100%

E r  (.40  .11)  (.60  .07)

 .044  .042
 .086
 8.6%
 10: Portfolio expected return

Your portfolio consists of the following stocks:

Stock Expected Return Number of Shares Stock Price

A 9% 640 $25
B 14% 250 $40
C 7% 700 $20

What is the expected return on your portfolio?

 11: Portfolio expected return

Expected Number Price Stock Portfolio

Stock Return of Shares per Share Value Weight
A 9% 640 $25 $16,000 40%
B 14% 250 $40 $10,000 25%
C 7% 700 $20 $14,000 35%
Totals $40,000 100%

E r  (.40  .09)  (.25  .14)  (.35  .07)

 .036  .035  .0245
 .0955
 9.55%
 12: Portfolio expected return

You have a portfolio with an expected return of 12.94%. Your

portfolio consists of stock A and stock B only. Stock A has an
expected return of 18% and stock B has an expected return of 7%.

What are the portfolio weights?

13: Portfolio expected return

Er portfolio  (w A  E r A )  (w B  E r B )
.1294  [ w A  .18]  [(1  w A )  .07]
.1294  .18w A  .07  .07 w A
.0594  .11w A
w A  .54
w A  54%

.1294  [.54  .18]  [(1  .54)  .07]

.1294  .0972  .0322
.1294  .1294
 14: Portfolio expected return

State of Probability of Rate of Return

Economy State of Economy if State Occurs
Boom .15 18%
Normal .60 11%
Recession .25 2%

What is the expected return on this portfolio?

15: Portfolio expected return

E r  (.15  .18)  (.60  .11)  (.25  .02)

 .027  .066  .005
 .098
 9.8%
 16: Portfolio expected return

State of Probability of Rate of Return if State Occurs

Economy State of Economy Stock A Stock B Stock C
Boom .20 17% 13% 40%
Normal .50 8% 6% 13%
Recession .30 -12% -5% -50%

Your portfolio consists of 50% stock A, 40% stock B and

10% stock C.

What is the expected return on your portfolio?

17: Portfolio expected return

E r boom  (.50  .17)  (.40  .13)  (.10  .40)

 .085  .052  .04
 .177

E r normal  (.50  .08)  (.40  .06)  (.10  .13)

 .04  .024  .013
 .077

E r recession  (.50  .12)  (.40  .05)  (.10  .50)

 -.06  .02  .05
 -.130
 18: Portfolio expected return

State of Probability of Expected Return

Economy State of Economy if State Occurs
Boom .20 . 177
Normal .50 .077
Recession .30 -.130

E r portfolio  (.20  .177)  (.50  .077)  (.30  .130)

 .0354  .0385  .039
 .0349
 3.49%
 19: Portfolio standard deviation

State of Probability of Rate of Return if State Occurs

Economy State of Economy Stock A Stock B Stock C
Boom .10 24% 5%
14%
Normal .70 11% 6%
9%
Recession .20 -30% 7%
-5%

Your portfolio consists of 30% stock A, 50% stock B and

20% stock C.

What is the standard deviation of your portfolio?

20: Portfolio standard deviation

E r boom  (.30  .24)  (.50  .05)  (.20  .14)

 .072  .025  .028
 .125

E r normal  (.30  .11)  (.50  .06)  (.20  .09)

 .033  .03  .018
 .081

E r recession  (.30  .30)  (.50  .07)  (.20  .05)

 -.09  .035  .01
 -.065
 21: Portfolio standard deviation

State of Probability of Expected Return

Economy State of Economy if State Occurs
Boom .10 . 125
Normal .70 .081
Recession .20 -.065

E r portfolio  (.10  .125)  (.70  .081)  (.20  .065)

 .0125  .0567  .013
 .0562
 22: Portfolio standard deviation

State of Probability of Expected Return

Economy State of Economy if State Occurs
Boom .10 . 125
Normal .70 .081
Recession .20 -.065
Portfolio expected return = .0562

 portfolio  .10  (.125  .0562) 2  .70  (.081  .0562) 2  .20  (.065  .0562) 2
 .10  .004733 .70  .000615  .20  .014689
 .000473  .000431 .002938
 .003842
 .061984
 6.20%
 23: Portfolio beta

Your portfolio consists of the following stocks:

Stock Portfolio Weight Beta

A 20% .76
B 30% 1.89
C 40% 1.05
D 10% .34

What is the beta of your portfolio?

 24: Portfolio beta

 portfolio  (.20  .76)  (.30 1.89)  (.40 1.05)  (.10  .34)

 .152  .567  .42  .034
 1.173
 1.17 (rounded)
 25: Portfolio beta

You want to create a portfolio that has a risk level equal to the
overall market. Your portfolio will consist of the following
securities:

Security Portfolio Weight Beta

Stock A ? 1.4
Treasury bills ? ?

What do the portfolio weights need to be?

 26: Portfolio beta

 portfolio  ( w A   A )  ( w B   B )
1.0  [ w A 1.4]  [(1  w A )  0]
1.0  1.4w A  0
w A  .7143
w A  71.43%

Weight of Stock A = 71.43%

Weight of Treasury bills = 100% - 71.43% = 28.57%
 27: Capital asset pricing model

You own shares of Big Burgers, Inc. This stock has a beta of 1.24.
U.S. Treasury bills are returning 3.4%. The return on the market is
11.4%.

What is the expected return on Big Burgers, Inc.?

28: Capital asset pricing model

E r  rf    (rm  rf )
 .034  [1.24  (.114  .034)]
 .034  [1.24  .08]
 .034  .0992
 .1332
 13.32%
 29: Capital asset pricing model

You own shares of International Coffees. The expected return on

this stock is 16%. The risk-free rate is 3% and the market risk
premium is 7%.

What is the beta of the International Coffees stock?

30: Capital asset pricing model

E r  rf    (rm  rf )
.16  .03  (   .07)
.13  .07 
  1.857
 31: Capital asset pricing model

A stock has a beta of .86 and an expected return of 13.5%. The

risk-free rate is 4%.

What is the expected return on the market?

32: Capital asset pricing model

E r  rf    (rm  rf )
.135  .04  .86  (rm  .04)
.135  .04  .86rm  .0344
.1294  .86rm
rm  .1505
rm  15.05%
 33: Reward-to-risk ratio

Stock Beta Expected Return

A .42 6.6%
B 1.23 11.8%
C .89 9.8%

Are these stocks correctly priced if the risk-free rate is 3% and

the market risk premium is 8%?
34: Reward-to-risk ratio

E r  r f    (rm  rf )

E r A  .03  (.42  .08)  .0636

E r B  .03  (1.23  .08)  .1284

E r C  .03  (.89  .08)  .1012

 35: Reward-to-risk ratio

Expected CAPM Stock

Stock Return Return Pricing

A 6.6% 6.36% underpriced

B 11.8% 12.84% overpriced
C 9.8% 10.12% overpriced
Chapter13

• End of Chapter 13

McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.