After reading this chapter, students should be able to:

Define dollar return and rate of return.

Define risk and calculate the expected rate of return, standard deviation,
and coefficient of variation for a probability distribution.
Specify how risk aversion influences required rates of return.
Graph diversifiable risk and arket risk! explain which of these is
relevant to a well"diversified investor.
State the basic proposition of the #apital Asset $ricing %odel &#A$%' and
explain how and why a portfolio(s risk ay be reduced.
)xplain the significance of a stock(s beta coefficient, and use the
Security %arket *ine to calculate a stock(s required rate of return.
*ist changes in the arket or within a fir that would cause the required
rate of return on the fir(s stock to change.
+dentify concerns about beta and the #A$%.
)xplain how stock price volatility is ore likely to iply risk than
earnings volatility.
Harcourt, Inc. Learning Objectives: 6 - 1
Chapter 6
Risk and Rates of Return
LEARNING OBJECTIVE
,isk analysis is an iportant topic, but it is difficult to teach at the
introductory level. -e .ust try to give students an intuitive overview of how
risk can be defined and easured, and leave a technical treatent to advanced
courses. /ur priary goals are to be sure students understand &0' that
investent risk is the uncertainty about returns on an asset, &1' the concept
of portfolio risk, and &2' the effects of risk on required rates of return.
-hat we cover, and the way we cover it, can be seen by scanning
Blueprints, #hapter 3. 4or other suggestions about the lecture, please see
the 5*ecture Suggestions6 in #hapter 1, where we describe how we conduct our
classes.
DA7S /8 #9A$:),: 2 /4 ;< DA7S &;="inute periods'
Lecture Suggestions: 6 - ! Harcourt, Inc.
LECT"RE "GGETION
3"0 a. :he probability distribution for coplete certainty is a vertical
line.
b. :he probability distribution for total uncertainty is the >"axis fro
" to ?.
3"1 Security A is less risky if held in a diversified portfolio because of
its negative correlation with other stocks. +n a single"asset portfolio,
Security A would be ore risky because
A
@
A
and #B
A
@ #B
A
.
3"2 a. 8o, it is not riskless. :he portfolio would be free of default risk
and liquidity risk, but inflation could erode the portfolio(s
purchasing power. +f the actual inflation rate is greater than that
expected, interest rates in general will rise to incorporate a larger
inflation preiu &+$' and""as we shall see in #hapter <""the value
of the portfolio would decline.
b. 8o, you would be sub.ect to reinvestent rate risk. 7ou ight expect
to 5roll over6 the :reasury bills at a constant &or even increasing'
rate of interest, but if interest rates fall, your investent incoe
will decrease.
c. A C.S. governent"backed bond that provided interest with constant
purchasing power &that is, an indexed bond' would be close to
riskless. :he C.S. :reasury currently issues indexed bonds.
3"D a. :he expected return on a life insurance policy is calculated .ust as
for a coon stock. )ach outcoe is ultiplied by its probability of
occurrence, and then these products are sued. 4or exaple, suppose
a 0"year ter policy pays E0=,=== at death, and the probability of
the policyholder(s death in that year is 1 percent. :hen, there is a
F< percent probability of Gero return and a 1 percent probability of
E0=,===:
)xpected return H =.F<&E=' ? =.=1&E0=,===' H E1==.
:his expected return could be copared to the preiu paid.
Generally, the preiu will be larger because of sales and
adinistrative costs, and insurance copany profits, indicating a
negative expected rate of return on the investent in the policy.
b. :here is a perfect negative correlation between the returns on the
life insurance policy and the returns on the policyholder(s huan
capital. +n fact, these events &death and future lifetie earnings
capacity' are utually exclusive.
Harcourt, Inc. Answers and Solutions: 6 - #
AN$ER TO EN%-O&-C'A(TER )"ETION
c. $eople are generally risk averse. :herefore, they are willing to pay
a preiu to decrease the uncertainty of their future cash flows. A
life insurance policy guarantees an incoe &the face value of the
policy' to the policyholder(s beneficiaries when the policyholder(s
future earnings capacity drops to Gero.
3"; :he risk preiu on a high"beta stock would increase ore.
,$
.
H ,isk $reiu for Stock . H &k
%
" k
,4
'b
.
.
+f risk aversion increases, the slope of the S%* will increase, and so
will the arket risk preiu &k
%
" k
,4
'. :he product b
'
k
"
k
&
. ,4 %
is the
risk preiu of the .th stock. +f b
.
is low &say, =.;', then the
product will be sall! ,$
.
will increase by only half the increase in
,$%
.
9owever, if b
.
is large &say, 1.=', then its risk preiu will rise by
twice the increase in ,$
%
.
3"3 According to the Security %arket *ine &S%*' equation, an increase in
beta will increase a copany(s expected return by an aount equal to the
arket risk preiu ties the change in beta. 4or exaple, assue that
the risk"free rate is 3 percent, and the arket risk preiu is ;
percent. +f the copany(s beta doubles fro =.< to 0.3 its expected
return increases fro 0= percent to 0D percent. :herefore, in general,
a copany(s expected return will not double when its beta doubles.
3"I 7es, if the portfolio(s beta is equal to Gero. +n practice, however, it
ay be ipossible to find individual stocks that have a nonpositive
beta. +n this case it would also be ipossible to have a stock portfolio
with a Gero beta. )ven if such a portfolio could be constructed,
investors would probably be better off .ust purchasing :reasury bills,
or other Gero beta investents.
3"< 8o. 4or a stock to have a negative beta, its returns would have to
logically be expected to go up in the future when other stocks( returns
were falling. Just because in one year the stock(s return increases
when the arket declined doesn(t ean the stock has a negative beta. A
stock in a given year ay ove counter to the overall arket, even
though the stock(s beta is positive.
Answers and Solutions: 6 - * Harcourt, Inc.
3"0
k
K H &=.0'&";=L' ? &=.1'&";L' ? &=.D'&03L' ? &=.1'&1;L' ? &=.0'&3=L'
H 00.D=L.

1
H &";=L " 00.D=L'
1
&=.0' ? &";L " 00.D=L'
1
&=.1' ? &03L " 00.D=L'
1
&=.D'
? &1;L " 00.D=L'
1
&=.1' ? &3=L " 00.D=L'
1
&=.0'

1
H I01.DD! H 13.3FL.
#B H
00.D=L
13.3FL
H 1.2D.
3"1 +nvestent Aeta
E2;,=== =.<
D=,=== 0.D
:otal EI;,===
b
p
H &E2;,===MEI;,==='&=.<' ? &ED=,===MEI;,==='&0.D' H 0.01.
3"2 k
,4
H ;L! ,$
%
H 3L! k
%
H N
k
%
H ;L ? &3L'0 H 00L.
k
s
when b H 0.1 H N
k
s
H ;L ? 3L&0.1' H 01.1L.
3"D k
,4
H 3L! k
%
H 02L! b H =.I! k
s
H N
k
s
H k
,4
? &k
%
" k
,4
'b
H 3L ? &02L " 3L'=.I
H 0=.FL.
3"; a. k H 00L! k
,4
H IL! ,$
%
H DL.
k H k
,4
? &k
%
O k
,4
'b
00L H IL ? DLb
DL H DLb
b H 0.
Harcourt, Inc. Answers and Solutions: 6 - +
OL"TION TO EN%-O&-C'A(TER (ROBLE,
b. k
,4
H IL! ,$
%
H 3L! b H 0.
k H k
,4
? &k
%
O k
,4
'b
k H IL ? &3L'0
k H 02L.
3"3 a.
%
k
K
H &=.2'&0;L' ? &=.D'&FL' ? &=.2'&0<L' H 02.;L.
J
k
K
H &=.2'&1=L' ? &=.D'&;L' ? &=.2'&01L' H 00.3L.
b.
%
H P&=.2'&0;L " 02.;L'
1
? &=.D'&FL " 02.;L'
1
? &=.2'&0<L " 02.;L'
1
Q
0M1
H 0D.<;L H 2.<;L.

J
H P&=.2'&1=L " 00.3L'
1
? &=.D'&;L " 00.3L'
1
? &=.2'&01L " 00.3L'
1
Q
0M1
H 2<.3DL H 3.11L.
c. #B
%
H
02.;L
2.<;L
H =.1F.
#B
J
H
00.3L
3.11L
H =.;D.
3"I a.

=
=
n
0 i
i i
k $ k
K
.
7
k
K
H =.0&"2;L' ? =.1&=L' ? =.D&1=L' ? =.1&1;L' ? =.0&D;L'
H 0DL versus 01L for >.
b. H

n
0 i
i
1
i
$ ' k
K
k & .

1
>
H &"0=L " 01L'
1
&=.0' ? &1L " 01L'
1
&=.1' ? &01L " 01L'
1
&=.D'
? &1=L " 01L'
1
&=.1' ? &2<L " 01L'
1
&=.0' H 0D<.<L.

>
H 01.1=L versus 1=.2;L for 7.
#B
>
H
>
M
k
K
>
H 01.1=LM01L H 0.=1, while
#B
7
H 1=.2;LM0DL H 0.D;.
+f Stock 7 is less highly correlated with the arket than >, then it
ight have a lower beta than Stock >, and hence be less risky in a
portfolio sense.
3"< a. k
A
H k
,4
? &k
%
" k
,4
'b
A
01L H ;L ? &0=L " ;L'b
A
01L H ;L ? ;L&b
A
'
IL H ;L&b
A
'
0.D H b
A
.
b. k
A
H ;L ? ;L&b
A
'
k
A
H ;L ? ;L&1'
k
A
H 0;L.
3"F a. k
i
H k
,4
? &k
%
" k
,4
'b
i
H FL ? &0DL " FL'0.2 H 0;.;L.
b. 0. k
,4
increases to 0=L:
k
%
increases by 0 percentage point, fro 0DL to 0;L.
k
i
H k
,4
? &k
%
" k
,4
'b
i
H 0=L ? &0;L " 0=L'0.2 H 03.;L.
1. k
,4
decreases to <L:
k
%
decreases by 0L, fro 0DL to 02L.
k
i
H k
,4
? &k
%
" k
,4
'b
i
H <L ? &02L " <L'0.2 H 0D.;L.
c. 0. k
%
increases to 03L:
k
i
H k
,4
? &k
%
" k
,4
'b
i
H FL ? &03L " FL'0.2 H 0<.0L.
1. k
%
decreases to 02L:
k
i
H k
,4
? &k
%
" k
,4
'b
i
H FL ? &02L " FL'0.2 H 0D.1L.
3"0= /ld portfolio beta H
E0;=,===
E0D1,;==
&b' ?
E0;=,===
EI,;==
&0.=='
0.01 H =.F;b ? =.=;
0.=I H =.F;b
0.0132 H b.
8ew portfolio beta H =.F;&0.0132' ? =.=;&0.I;' H 0.0;I; 0.03.
Alternative Solutions:
0. /ld portfolio beta H 0.01 H &=.=;'b
0
? &=.=;'b
1
? ... ? &=.=;'b
1=
0.01 H

' b &
i
&=.=;'
i
b H 0.01M=.=; H 11.D.
8ew portfolio beta H &11.D " 0.= ? 0.I;'&=.=;' H 0.0;I; 0.03.
Harcourt, Inc. Answers and Solutions: 6 - -
1.
i
b excluding the stock with the beta equal to 0.= is 11.D " 0.=
H
10.D, so the beta of the portfolio excluding this stock is b H
10.DM0F H 0.0132. :he beta of the new portfolio is:
0.0132&=.F;' ? 0.I;&=.=;' H 0.0;I; 0.03.
3"00 $ortfolio beta H
ED,===,===
ED==,===
&0.;=' ?
ED,===,===
E3==,===
&"=.;='
?
ED,===,===
E0,===,===
&0.1;' ?
ED,===,===
E1,===,===
&=.I;'
H &=.0'&0.;' ? &=.0;'&"=.;=' ? &=.1;'&0.1;' ? &=.;'&=.I;'
H =.0; " =.=I; ? =.201; ? =.2I; H =.I31;.
k
p
H k
,4
? &k
%
" k
,4
'&b
p
' H 3L ? &0DL " 3L'&=.I31;' H 01.0L.
Alternative solution: 4irst, calculate the return for each stock using
the #A$% equation Pk
,4
? &k
%
" k
,4
'bQ, and then calculate the weighted
average of these returns.
k
,4
H 3L and k
%
" k
,4
H <L.
Stock +nvestent Aeta k H k
,4
? &k
%
" k
,4
'b -eight
A E D==,=== 0.;= 0<L =.0=
A 3==,=== &=.;=' 1 =.0;
# 0,===,=== 0.1; 03 =.1;
D 1,===,=== =.I; 01 =.;=
:otal ED,===,=== 0.==
k
p
H 0<L&=.0=' ? 1L&=.0;' ? 03L&=.1;' ? 01L&=.;=' H 01.0L.
3"01 4irst, calculate the beta of what reains after selling the stock:
b
p
H 0.0 H &E0==,===ME1,===,==='=.F ? &E0,F==,===ME1,===,==='b
,
0.0H =.=D; ? &=.F;'b
,
b
,
H 0.00=;.
b
8
H &=.F;'0.00=; ? &=.=;'0.D H 0.01;.
3"02 -e know that b
,
H 0.;=, b
S
H =.I;, k
%
H 02L, k
,4
H IL.
k
i
H k
,4
? &k
%
" k
,4
'b
i
H IL ? &02L " IL'b
i
.
k
,
H IL ? 3L&0.;=' H 03.=L
k
S
H IL ? 3L&=.I;' H 00.;


D.;L
3"0D k
>
H 0=L! b
>
H =.F!
>
H 2;L.
k
7
H 01.;L! b
7
H 0.1!
7
H 1;L.
k
,4
H 3L! ,$
%
H ;L.
a. #B
>
H 2;LM0=L H 2.;. #B
7
H 1;LM01.;L H 1.=.
b. 4or diversified investors the relevant risk is easured by beta.
:here"fore, the stock with the higher beta is ore risky. Stock 7
has the higher beta so it is ore risky than Stock >.
c. k
>
H 3L ? ;L&=.F'
k
>
H 0=.;L.
k
7
H 3L ? ;L&0.1'
k
7
H 01L.
d. k
>
H 0=.;L!
>
k
K
H 0=L.
k
7
H 01L!
7
k
K
H 01.;L.
Stock 7 would be ost attractive to a diversified investor since its
expected return of 01.;L is greater than its required return of 01L.
e. b
p
H &EI,;==ME0=,==='=.F ? &E1,;==ME0=,==='0.1


H =.3I;= ? =.2=


H =.FI;=.
k
p
H 3L ? ;L&=.FI;'
k
p
H 0=.<I;L.
f. +f ,$
%
increases fro ;L to 3L, the stock with the highest beta will
have the largest increase in its required return. :herefore, Stock 7
will have the greatest increase.
#heck:
k
>
H 3L ? 3L&=.F'


H 00.DL. +ncrease 0=.;L to 00.DL.
k
7
H 3L ? 3L&0.1'


H 02.1L. +ncrease 01L to 02.1L.
3"0; a. &E0 illion'&=.;' ? &E='&=.;' H E=.; illion.
b. 7ou would probably take the sure E=.; illion.
c. ,isk averter.
d. 0. &E0.0; illion'&=.;' ? &E='&=.;' H E;I;,===, or an expected profit
of EI;,===.
1. EI;,===ME;==,=== H 0;L.
Harcourt, Inc. Answers and Solutions: 6 - .
2. :his depends on the individual(s degree of risk aversion.
D. Again, this depends on the individual.
;. :he situation would be unchanged if the stocks( returns were
perfectly positively correlated. /therwise, the stock portfolio
would have the sae expected return as the single stock &0;
percent' but a lower standard deviation. +f the correlation
coefficient between each pair of stocks was a negative one, the
portfolio would be virtually riskless. Since r for stocks is
generally in the range of ?=.3 to ?=.I, investing in a portfolio
of stocks would definitely be an iproveent over investing in the
single stock.
3"03 a.
k
K
%
H =.0&IL' ? =.1&FL' ? =.D&00L' ? =.1&02L' ? =.0&0;L' H 00L.
k
,4
H 3L. &given'
:herefore, the S%* equation is
k
i
H k
,4
? &k
%
" k
,4
'b
i
H 3L ? &00L " 3L'b
i
H 3L ? &;L'b
i
.
b. 4irst, deterine the fund(s beta, b
4
. :he weights are the percentage
of funds invested in each stock.
A H E03=ME;== H =.21
A H E01=ME;== H =.1D
# H E<=ME;== H =.03
D H E<=ME;== H =.03
) H E3=ME;== H =.01
b
4
H =.21&=.;' ? =.1D&1.=' ? =.03&D.=' ? =.03&0.=' ? =.01&2.='
H =.03 ? =.D< ? =.3D ? =.03 ? =.23 H 0.<.
8ext, use b
4
H 0.< in the S%* deterined in $art a:
k
K
4
H 3L ? &00L " 3L'0.< H 3L ? FL H 0;L.
c. k
8
H ,equired rate of return on new stock H 3L ? &;L'1.= H 03L.
An expected return of 0; percent on the new stock is below the 03
percent required rate of return on an investent with a risk of b H
1.=. Since k
8
H 03L @
k
K
8
H 0;L, the new stock should not be
purchased. :he expected rate of return that would ake the fund
indifferent to purchasing the stock is 03 percent.
3"0I :he answers to a, b, c, and d are given below:
k
A
k
A
$ortfolio
0FFI &0<.==L' &0D.;=L' &03.1;L'
0FF< 22.== 10.<= 1I.D=
0FFF 0;.== 2=.;= 11.I;
1=== &=.;=' &I.3=' &D.=;'
1==0 1I.== 13.2= 13.3;
%ean 00.2= 00.2= 00.2=
Std. Dev. 1=.IF 1=.I< 1=.02
#oef. Bar. 0.<D 0.<D 0.I<
e. A risk"averse investor would choose the portfolio over either Stock A
or Stock A alone, since the portfolio offers the sae expected return
but with less risk. :his result occurs because returns on A and A
are not perfectly positively correlated &r
AA
H =.<<'.
3"0< a. b
>
H 0.2DI0! b
7
H =.3;=<.
b. k
>
H 3L ? &;L'0.2DI0 H 01.I2;;L.
k
7
H 3L ? &;L'=.3;=< H F.1;D=L.
c. b
p
H =.<&0.2DI0' ? =.1&=.3;=<' H 0.1=I<.
k
p
H 3L ? &;L'0.1=I< H 01.=DL.
Alternatively,
k
p
H =.<&01.I2;;L' ? =.1&F.1;DL' H 01.=DL.
d. Stock > is undervalued, because its expected return exceeds its
required rate of return.
Harcourt, Inc. Answers and Solutions: 6 - 11
3"0F :he detailed solution for the spreadsheet proble is available both on
the instructor(s resource #D",/% and on the instructor(s side of the
9arcourt #ollege $ublishers( web site:
http:MMwww.harcourtcollege.coMfinanceMconcise2e.
3"1= :he detailed solution for the cyberproble is available on the
instructor(s side of the 9arcourt #ollege $ublishers( web site:
http:MMwww.harcourtcollege.coMfinanceMconcise2e.
Computer/Internet Applications: 6 - 1! Harcourt, Inc.
(REA%'EET (ROBLE,
C/BER(ROBLE,
,erri00 &in1h In12
Risk and Return
6-21 ASSUME THAT YOU RECENTLY GRADUATED WITH A MAJOR IN FINANCE, AND YOU
JUST LANDED A JOB AS A FINANCIAL PLANNER WITH MERRILL FINCH INC., A
LARGE FINANCIAL SERVICES CORPORATION. YOUR FIRST ASSIGNMENT IS TO
INVEST $100,000 FOR A CLIENT. BECAUSE THE FUNDS ARE TO BE INVESTED
IN A BUSINESS AT THE END OF ONE YEAR, YOU HAVE BEEN INSTRUCTED TO
PLAN FOR A ONE-YEAR HOLDING PERIOD. FURTHER, YOUR BOSS HAS
RESTRICTED 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 BLAN"S LATER.#
RETURNS ON ALTERNATIVE INVESTMENTS

ESTIMATED RATE OF RETURN

STATE OF THE T- HIGH COLLEC- U.S. MAR"ET 2-STOC"
ECONOMY PROB. BILLS TECH TIONS RUBBER PORTFOLIO
PORTFOLIO
RECESSION 0.1 $.0% -22.0% 2$.0% 10.0%& -1'.0%
'.0%
BELOW AVG 0.2 $.0 -2.0 1(.) -10.0 1.0
AVERAGE 0.( $.0 20.0 0.0 ).0 1*.0 10.0
ABOVE AVG 0.2 $.0 '*.0 -10.0 (*.0 2+.0
BOOM 0.1 $.0 *0.0 -20.0 '0.0 ('.0 1*.0
,-HAT
,
- # 1.)% 1'.$% 1*.0%
STD DEV # 0.0 1'.( 1$.$ 1*.' '.'
COEF OF VAR CV# ).+ 1.( 1.0 0.'
BETA .# -0.$) 0.$+
&NOTE THAT THE ESTIMATED RETURNS OF U.S. RUBBER DO NOT ALWAYS MOVE IN
THE SAME DIRECTION AS THE OVERALL ECONOMY. FOR E/AMPLE, WHEN THE
ECONOMY IS BELOW AVERAGE, CONSUMERS PURCHASE FEWER TIRES THAN THEY
WOULD IF THE ECONOMY WAS STRONGER. HOWEVER, IF THE ECONOMY IS IN A
FLAT-OUT RECESSION, A LARGE NUMBER OF CONSUMERS WHO WERE PLANNING TO
PURCHASE A NEW CAR MAY CHOOSE TO WAIT AND INSTEAD PURCHASE NEW TIRES
FOR THE CAR THEY CURRENTLY OWN. UNDER THESE CIRCUMSTANCES, WE WOULD
Harcourt, Inc. Integrated Case: 6 - 1#
INTEGRATE% CAE
E/PECT U.S. RUBBER0S STOC" PRICE TO BE HIGHER IF THERE IS A RECESSION
THAN IF THE ECONOMY WAS JUST BELOW AVERAGE.
Integrated Case: 6 - 1* Harcourt, Inc.
MERRILL FINCH0S ECONOMIC FORECASTING STAFF HAS DEVELOPED
PROBABILITY ESTIMATES FOR THE STATE OF THE ECONOMY, AND ITS SECURITY
ANALYSTS HAVE DEVELOPED A SOPHISTICATED COMPUTER PROGRAM, WHICH WAS
USED TO ESTIMATE THE RATE OF RETURN ON EACH ALTERNATIVE UNDER EACH
STATE OF THE ECONOMY. HIGH TECH INC. IS AN ELECTRONICS FIRM!
COLLECTIONS INC. COLLECTS PAST-DUE DEBTS! AND U.S. RUBBER
MANUFACTURES TIRES AND VARIOUS OTHER RUBBER AND PLASTICS PRODUCTS.
MERRILL FINCH ALSO MAINTAINS A 1MAR"ET PORTFOLIO2 THAT OWNS A MAR"ET-
WEIGHTED FRACTION OF ALL PUBLICLY TRADED STOC"S! YOU CAN INVEST IN
THAT PORTFOLIO, AND THUS OBTAIN AVERAGE STOC" MAR"ET RESULTS. GIVEN
THE SITUATION AS DESCRIBED, ANSWER THE FOLLOWING 3UESTIONS.
A. 1. WHY IS THE T-BILL0S RETURN INDEPENDENT OF THE STATE OF THE ECONOMY4
DO T-BILLS PROMISE A COMPLETELY RIS"-FREE RETURN4
ANSWER5 PS9/- S3"0 :9,/CG9 S3"I 9),).Q :9) < $),#)8: :"A+** ,):C,8 D/)S 8/:
D)$)8D /8 :9) S:A:) /4 :9) )#/8/%7 A)#ACS) :9) :,)ASC,7 %CS: &A8D
-+**' ,)D))% :9) A+**S A: $A, ,)GA,D*)SS /4 :9) S:A:) /4 :9) )#/8/%7.
:9) :"A+**S A,) ,+SR"4,)) +8 :9) D)4AC*: ,+SR S)8S) A)#ACS) :9)
< $),#)8: ,):C,8 -+** A) ,)A*+S)D +8 A** $/SS+A*) )#/8/%+# S:A:)S.
9/-)B),, ,)%)%A), :9A: :9+S ,):C,8 +S #/%$/S)D /4 :9) ,)A* ,+SR"4,))
,A:), SA7 2 $),#)8:, $*CS A8 +84*A:+/8 $,)%+C%, SA7 ; $),#)8:. S+8#)
:9),) +S C8#),:A+8:7 AA/C: +84*A:+/8, +: +S C8*+R)*7 :9A: :9)
,)A*+S)D ,)A* ,A:) /4 ,):C,8 -/C*D )TCA* :9) )>$)#:)D 2 $),#)8:. 4/,
)>A%$*), +4 +84*A:+/8 AB),AG)D 3 $),#)8: /B), :9) 7)A,, :9)8 :9)
,)A*+S)D ,)A* ,):C,8 -/C*D /8*7 A) <L " 3L H 1L, 8/: :9) )>$)#:)D 2
$),#)8:. :9CS, +8 :),%S /4 $C,#9AS+8G $/-),, :"A+**S A,) 8/:
,+SR*)SS.
A*S/, +4 7/C +8B)S:)D +8 A $/,:4/*+/ /4 :"A+**S, A8D ,A:)S :9)8
D)#*+8)D, 7/C, 8/%+8A* +8#/%) -/C*D 4A**! :9A: +S, :"A+**S A,)
)>$/S)D :/ ,)+8B)S:%)8: ,A:) ,+SR. S/, -) #/8#*CD) :9A: :9),) A,) 8/
:,C*7 ,+SR"4,)) S)#C,+:+)S +8 :9) C8+:)D S:A:)S. +4 :9) :,)ASC,7
S/*D +84*A:+/8"+8D)>)D, :A>")>)%$: A/8DS, :9)7 -/C*D A) :,C*7
,+SR*)SS, AC: A** A#:CA* S)#C,+:+)S A,) )>$/S)D :/ S/%) :7$) /4 ,+SR.
A. 2. WHY ARE HIGH TECH0S RETURNS E/PECTED TO MOVE WITH THE ECONOMY WHEREAS
COLLECTIONS0 ARE E/PECTED TO MOVE COUNTER TO THE ECONOMY4
Harcourt, Inc. Integrated Case: 6 - 1+
ANSWER5 PS9/- S3"< 9),).Q 9+G9 :)#9(S ,):C,8S %/B) -+:9, 9)8#) A,)
$/S+:+B)*7 #/,,)*A:)D -+:9, :9) )#/8/%7, A)#ACS) :9) 4+,%(S SA*)S,
A8D 9)8#) $,/4+:S, -+** G)8),A**7 )>$),+)8#) :9) SA%) :7$) /4 C$S A8D
D/-8S AS :9) )#/8/%7. +4 :9) )#/8/%7 +S A//%+8G, S/ -+** 9+G9 :)#9.
/8 :9) /:9), 9A8D, #/**)#:+/8S +S #/8S+D),)D A7 %A87 +8B)S:/,S :/ A)
A 9)DG) AGA+8S: A/:9 AAD :+%)S A8D 9+G9 +84*A:+/8, S/ +4 :9) S:/#R
%A,R): #,AS9)S, +8B)S:/,S +8 :9+S S:/#R S9/C*D D/ ,)*A:+B)*7 -)**.
S:/#RS SC#9 AS #/**)#:+/8S A,) :9CS 8)GA:+B)*7 #/,,)*A:)D -+:9 &%/B)
#/C8:), :/' :9) )#/8/%7. &8/:): +8 A#:CA*+:7, +: +S A*%/S:
+%$/SS+A*) :/ 4+8D S:/#RS :9A: A,) )>$)#:)D :/ %/B) #/C8:), :/ :9)
)#/8/%7. )B)8 #/**)#:+/8S S9A,)S 9AB) $/S+:+B) &AC: */-' #/,,)*A:+/8
-+:9 :9) %A,R):.'
B. CALCULATE THE E/PECTED RATE OF RETURN ON EACH ALTERNATIVE AND FILL IN
THE BLAN"S ON THE ROW FOR ,
-
IN THE TABLE ABOVE.
ANSWER5 PS9/- S3"F A8D S3"0= 9),).Q :9) )>$)#:)D ,A:) /4 ,):C,8, k
K
, +S
)>$,)SS)D AS 4/**/-S:

=
=
n
0 i
i i
k $ k
K
.
9),) $
i
+S :9) $,/AAA+*+:7 /4 /##C,,)8#) /4 :9) i:9 S:A:), k
i
+S :9)
)S:+%A:)D ,A:) /4 ,):C,8 4/, :9A: S:A:), A8D n +S :9) 8C%A), /4
S:A:)S. 9),) +S :9) #A*#C*A:+/8 4/, 9+G9 :)#9:
k
K
9+G9 :)#9
H =.0&"11.=L'

?

=.1&"1.=L'

?

=.D&1=.=L'

?

=.1&2;.=L'

?
=.0&;=.=L'
H 0I.DL.
-) CS) :9) SA%) 4/,%C*A :/ #A*#C*A:) k(S 4/, :9) /:9), A*:),8A:+B)S:

k
K
:"A+**S
H <.=L.
k
K
#/**)#:+/8S
H 0.IL.
k
K
C.S.,CAA),
H 02.<L.

k
K
%
H 0;.=L.
Integrated Case: 6 - 16 Harcourt, Inc.
C. YOU SHOULD RECOGNI6E THAT BASING A DECISION SOLELY ON E/PECTED
RETURNS IS ONLY APPROPRIATE FOR RIS"-NEUTRAL INDIVIDUALS. SINCE YOUR
CLIENT, LI"E VIRTUALLY EVERYONE, IS RIS" AVERSE, THE RIS"INESS OF
EACH ALTERNATIVE IS AN IMPORTANT ASPECT OF THE DECISION. ONE
POSSIBLE MEASURE OF RIS" IS THE STANDARD DEVIATION OF RETURNS.
1. CALCULATE THIS VALUE FOR EACH ALTERNATIVE, AND FILL IN THE BLAN" ON
THE ROW FOR IN THE TABLE ABOVE.
ANSWER5 PS9/- S3"00 A8D S3"01 9),).Q :9) S:A8DA,D D)B+A:+/8 +S #A*#C*A:)D AS
4/**/-S:
H

n
0 i
i
1
i
$ ' k
K
k & .

9+G9 :)#9
H P&"11.=

"

0I.D'
1
&=.0'

?

&"1.=

"

0I.D'
1
&=.1'

?

&1=.=

"
0I.D'
1
&=.D'
? &2;.= " 0I.D'
1
&=.1' ? &;=.= " 0I.D'
1
&=.0'QU
H
D=0.D
H 1=.=L.
9),) A,) :9) S:A8DA,D D)B+A:+/8S 4/, :9) /:9), A*:),8A:+B)S:

:"A+**S
H =.=L.

#/**)#:+/8S
H 02.DL.

C.S. ,CAA),
H 0<.<L.

%
H 0;.2L.
C. 2. WHAT TYPE OF RIS" IS MEASURED BY THE STANDARD DEVIATION4
ANSWER5 PS9/- S3"02 :9,/CG9 S3"0; 9),).Q :9) S:A8DA,D D)B+A:+/8 +S A %)ASC,)
/4 A S)#C,+:7(S &/, A $/,:4/*+/(S' S:A8D"A*/8) ,+SR. :9) *A,G), :9)
S:A8DA,D D)B+A:+/8, :9) 9+G9), :9) $,/AAA+*+:7 :9A: A#:CA* ,)A*+S)D
,):C,8S -+** 4A** 4A, A)*/- :9) )>$)#:)D ,):C,8, A8D :9A: */SS)S
,A:9), :9A8 $,/4+:S -+** A) +8#C,,)D.
Harcourt, Inc. Integrated Case: 6 - 1-
C. '. DRAW A GRAPH THAT SHOWS ROUGHLY THE SHAPE OF THE PROBABILITY
DISTRIBUTIONS FOR HIGH TECH, U.S. RUBBER, AND T-BILLS.
Integrated Case: 6 - 13 Harcourt, Inc.
ANSWER5
/8 :9) AAS+S /4 :9)S) DA:A, 9+G9 :)#9 +S :9) %/S: ,+SR7 +8B)S:%)8:,
:"A+**S :9) *)AS: ,+SR7.
D. SUPPOSE YOU SUDDENLY REMEMBERED THAT THE COEFFICIENT OF VARIATION
CV# IS GENERALLY REGARDED AS BEING A BETTER MEASURE OF STAND-ALONE
RIS" THAN THE STANDARD DEVIATION WHEN THE ALTERNATIVES BEING
CONSIDERED HAVE WIDELY DIFFERING E/PECTED RETURNS. CALCULATE THE
MISSING CV7, AND FILL IN THE BLAN"S ON THE ROW FOR CV IN THE TABLE
ABOVE. DOES THE CV PRODUCE THE SAME RIS" RAN"INGS AS THE STANDARD
DEVIATION4
ANSWER5 PS9/- S3"03 A8D S3"0I 9),).Q :9) #/)44+#+)8: /4 BA,+A:+/8 &#B' +S A
S:A8DA,D+S)D %)ASC,) /4 D+S$),S+/8 AA/C: :9) )>$)#:)D BA*C)! +: S9/-S
:9) A%/C8: /4 ,+SR $), C8+: /4 ,):C,8.
#B H
k
K
.
#B
:"A+**S
H =.=LM<.=L H =.=.
#B
9+G9 :)#9
H 1=.=LM0I.DL H 0.0.
#B
#/**)#:+/8S
H 02.DLM0.IL H I.F.
#B
C.S. ,CAA),
H 0<.<LM02.<L H 0.D.
Harcourt, Inc. Integrated Case: 6 - 1.
Probability of
Occurrence
Rate of Return (%)
T-Bi00s
"22 Ru44er
'i5h Te1h
-60 -45 -30 -15 0 15 30 45 60

#B
%
H 0;.2LM0;.=L H 0.=.
-9)8 -) %)ASC,) ,+SR $), C8+: /4 ,):C,8, #/**)#:+/8S, -+:9 +:S */-
)>$)#:)D ,):C,8, A)#/%)S :9) %/S: ,+SR7 S:/#R. :9) #B +S A A)::),
%)ASC,) /4 A8 ASS):(S S:A8D"A*/8) ,+SR :9A8 A)#ACS) #B #/8S+D),S
A/:9 :9) )>$)#:)D BA*C) A8D :9) D+S$),S+/8 /4 A D+S:,+AC:+/8""A
S)#C,+:7 -+:9 A */- )>$)#:)D ,):C,8 A8D A */- S:A8DA,D D)B+A:+/8
#/C*D 9AB) A 9+G9), #9A8#) /4 A */SS :9A8 /8) -+:9 A 9+G9 AC: A
9+G9 k
K
.
E. SUPPOSE YOU CREATED A 2-STOC" PORTFOLIO BY INVESTING $*0,000 IN HIGH
TECH AND $*0,000 IN COLLECTIONS.
1. CALCULATE THE E/PECTED RETURN
8
,
-
#, THE STANDARD DEVIATION
8
#, AND
THE COEFFICIENT OF VARIATION CV
8
# FOR THIS PORTFOLIO AND FILL IN THE
APPROPRIATE BLAN"S IN THE TABLE ABOVE.
ANSWER5 PS9/- S3"0< :9,/CG9 S3"10 9),).Q :/ 4+8D :9) )>$)#:)D ,A:) /4 ,):C,8
/8 :9) :-/"S:/#R $/,:4/*+/, -) 4+,S: #A*#C*A:) :9) ,A:) /4 ,):C,8 /8
:9) $/,:4/*+/ +8 )A#9 S:A:) /4 :9) )#/8/%7. S+8#) -) 9AB) 9A*4 /4
/C, %/8)7 +8 )A#9 S:/#R, :9) $/,:4/*+/(S ,):C,8 -+** A) A -)+G9:)D
AB),AG) +8 )A#9 :7$) /4 )#/8/%7. 4/, A ,)#)SS+/8, -) 9AB): k
p
H
=.;&"11L' ? =.;&1<L' H 2L. -) -/C*D D/ S+%+*A, #A*#C*A:+/8S 4/, :9)
/:9), S:A:)S /4 :9) )#/8/%7, A8D G): :9)S) ,)SC*:S:
S:A:) $/,:4/*+/
,)#)SS+/8 2.=L
A)*/- AB),AG) 3.D
AB),AG) 0=.=
AA/B) AB),AG) 01.;
A//% 0;.=
8/- -) #A8 %C*:+$*7 $,/AAA+*+:+)S :+%)S /C:#/%)S +8 )A#9 S:A:) :/
G): :9) )>$)#:)D ,):C,8 /8 :9+S :-/"S:/#R $/,:4/*+/, F.3 $),#)8:.
A*:),8A:+B)*7, -) #/C*D A$$*7 :9+S 4/,%C*A,
k H w
i
k
i
H =.;&0I.DL' ? =.;&0.IL' H F.3L,
Integrated Case: 6 - !6 Harcourt, Inc.
-9+#9 4+8DS k AS :9) -)+G9:)D AB),AG) /4 :9) )>$)#:)D ,):C,8S /4 :9)
+8D+B+DCA* S)#C,+:+)S +8 :9) $/,:4/*+/.
+: +S :)%$:+8G :/ 4+8D :9) S:A8DA,D D)B+A:+/8 /4 :9) $/,:4/*+/ AS
:9) -)+G9:)D AB),AG) /4 :9) S:A8DA,D D)B+A:+/8S /4 :9) +8D+B+DCA*
S)#C,+:+)S, AS 4/**/-S:

p
w
i
&
i
' ? w
.
&
.
' H =.;&1=L' ? =.;&02.DL' H 03.IL.
9/-)B),, :9+S +S 8/: #/,,)#:""+: +S 8)#)SSA,7 :/ CS) A D+44),)8:
4/,%C*A, :9) /8) 4/, :9A: -) CS)D )A,*+),, A$$*+)D :/ :9) :-/"
S:/#R $/,:4/*+/(S ,):C,8S.
:9) $/,:4/*+/(S D)$)8DS J/+8:*7 /8 &0' )A#9 S)#C,+:7(S A8D
&1' :9) #/,,)*A:+/8 A):-))8 :9) S)#C,+:+)S( ,):C,8S. :9) A)S: -A7 :/
A$$,/A#9 :9) $,/A*)% +S :/ )S:+%A:) :9) $/,:4/*+/(S ,+SR A8D ,):C,8
+8 )A#9 S:A:) /4 :9) )#/8/%7, A8D :9)8 :/ )S:+%A:)
p
-+:9 :9)
4/,%C*A. G+B)8 :9) D+S:,+AC:+/8 /4 ,):C,8S 4/, :9) $/,:4/*+/, -) #A8
#A*#C*A:) :9) $/,:4/*+/(S A8D #B AS S9/-8 A)*/-:

p
H P&2.= " F.3'
1
&=.0' ? &3.D " F.3'
1
&=.1' ? &0=.= " F.3'
1
&=.D'
? &01.; " F.3'
1
&=.1' ? &0;.= " F.3'
1
&=.0'Q
U
H 2.2L.
#B
p
H 2.2LMF.3L H =.2D.
E. 2. HOW DOES THE RIS"INESS OF THIS 2-STOC" PORTFOLIO COMPARE WITH THE
RIS"INESS OF THE INDIVIDUAL STOC"S IF THEY WERE HELD IN ISOLATION4
ANSWER5 PS9/- S3"11 :9,/CG9 S3"1; 9),).Q CS+8G )+:9), /, #B AS /C, S:A8D"
A*/8) ,+SR %)ASC,), :9) S:A8D"A*/8) ,+SR /4 :9) $/,:4/*+/ +S
S+G8+4+#A8:*7 *)SS :9A8 :9) S:A8D"A*/8) ,+SR /4 :9) +8D+B+DCA*
S:/#RS. :9+S +S A)#ACS) :9) :-/ S:/#RS A,) 8)GA:+B)*7 #/,,)*A:)D""
-9)8 9+G9 :)#9 +S D/+8G $//,*7, #/**)#:+/8S +S D/+8G -)**, A8D B+#)
B),SA. #/%A+8+8G :9) :-/ S:/#RS D+B),S+4+)S A-A7 S/%) /4 :9) ,+SR
+89),)8: +8 )A#9 S:/#R +4 +: -),) 9)*D +8 +S/*A:+/8, i.e., +8 A 0"
S:/#R $/,:4/*+/.
OPTIONAL 3UESTION
Harcourt, Inc. Integrated Case: 6 - !1
DOES THE E/PECTED RATE OF RETURN ON THE PORTFOLIO DEPEND ON THE PERCENTAGE OF
THE PORTFOLIO INVESTED IN EACH STOC"4 WHAT ABOUT THE RIS"INESS OF THE
PORTFOLIO4
ANSWER5 CS+8G A S$,)ADS9)): %/D)*, +:(S )AS7 :/ BA,7 :9) #/%$/S+:+/8 /4 :9)
$/,:4/*+/ :/ S9/- :9) )44)#: /8 :9) $/,:4/*+/(S )>$)#:)D ,A:) /4
,):C,8 A8D S:A8DA,D D)B+A:+/8:
Integrated Case: 6 - !! Harcourt, Inc.
9+G9 :)#9 $*CS #/**)#:+/8S
L +8 9+G9 :)#9
k
K
p

p
=L 0.IL 02.DL
0= 2.2 0=.=
1= D.F 3.I
2= 3.D 2.2
D= <.= =.=
;= F.3 2.2
3= 00.0 3.I
I= 01.I 0=.=
<= 0D.2 02.D
F= 0;.< 03.I
0== 0I.D 1=.=
:9) )>$)#:)D ,A:) /4 ,):C,8 /8 :9) $/,:4/*+/ +S %),)*7 A *+8)A,
#/%A+8A:+/8 /4 :9) :-/ S:/#R(S )>$)#:)D ,A:)S /4 ,):C,8. 9/-)B),,
$/,:4/*+/ ,+SR +S A8/:9), %A::),.
p
A)G+8S :/ 4A** AS 9+G9 :)#9 A8D
#/**)#:+/8S A,) #/%A+8)D! +: ,)A#9)S S),/ A: D= $),#)8: 9+G9 :)#9!
A8D :9)8 +: A)G+8S :/ ,+S). 9+G9 :)#9 A8D #/**)#:+/8S #A8 A)
#/%A+8)D :/ 4/,% A 8)A, S),/ ,+SR $/,:4/*+/ A)#ACS) :9)7 A,) B),7
#*/S) :/ A)+8G $),4)#:*7 8)GA:+B)*7 #/,,)*A:)D! :9)+, #/,,)*A:+/8
#/)44+#+)8: +S
"=.FFF<. &8/:): C84/,:C8A:)*7, -) #A88/: 4+8D A87 A#:CA* S:/#RS
-+:9 r H "0.=.'
F. SUPPOSE AN INVESTOR STARTS WITH A PORTFOLIO CONSISTING OF ONE
RANDOMLY SELECTED STOC". WHAT WOULD HAPPEN 1# TO THE RIS"INESS AND
2# TO THE E/PECTED RETURN OF THE PORTFOLIO AS MORE AND MORE RANDOMLY
SELECTED STOC"S WERE ADDED TO THE PORTFOLIO4 WHAT IS THE IMPLICATION
FOR INVESTORS4 DRAW A GRAPH OF THE TWO PORTFOLIOS TO ILLUSTRATE YOUR
ANSWER.
Harcourt, Inc. Integrated Case: 6 - !#
ANSWER5 PS9/- S3"13 A8D S3"1I 9),).Q
en!ity
0
Portfolio of "toc#!
$it% #
&
' 16%
One "toc#
16
%
:9) S:A8DA,D D)B+A:+/8 G):S S%A**), AS %/,) S:/#RS A,) #/%A+8)D +8
:9) $/,:4/*+/, -9+*) k
p
&:9) $/,:4/*+/(S ,):C,8' ,)%A+8S #/8S:A8:.
:9CS, A7 ADD+8G S:/#RS :/ 7/C, $/,:4/*+/, -9+#9 +8+:+A**7 S:A,:)D AS
A
0"S:/#R $/,:4/*+/, ,+SR 9AS A))8 ,)DC#)D.
+8 :9) ,)A* -/,*D, S:/#RS A,) $/S+:+B)*7 #/,,)*A:)D -+:9 /8)
A8/:9),""+4 :9) )#/8/%7 D/)S -)**, S/ D/ S:/#RS +8 G)8),A*, A8D B+#)
B),SA. #/,,)*A:+/8 #/)44+#+)8:S A):-))8 S:/#RS G)8),A**7 ,A8G) 4,/%
?=.; :/ ?=.I. A S+8G*) S:/#R S)*)#:)D A: ,A8D/% -/C*D /8 AB),AG)
9AB) A S:A8DA,D D)B+A:+/8 /4 AA/C: 2; $),#)8:. AS ADD+:+/8A* S:/#RS
A,) ADD)D :/ :9) $/,:4/*+/, :9) $/,:4/*+/(S S:A8DA,D D)B+A:+/8
D)#,)AS)S A)#ACS) :9) ADD)D S:/#RS A,) 8/: $),4)#:*7 $/S+:+B)*7
#/,,)*A:)D. 9/-)B),, AS %/,) A8D %/,) S:/#RS A,) ADD)D, )A#9 8)-
S:/#R 9AS *)SS /4 A ,+SR",)DC#+8G +%$A#:, A8D )B)8:CA**7 ADD+8G
ADD+:+/8A* S:/#RS 9AS B+,:CA**7 8/ )44)#: /8 :9) $/,:4/*+/(S ,+SR AS
%)ASC,)D A7 . +8 4A#:, S:AA+*+S)S A: AA/C: 1=.D $),#)8: -9)8 D=
/, %/,) ,A8D/%*7 S)*)#:)D S:/#RS A,) ADD)D. :9CS, A7 #/%A+8+8G
S:/#RS +8:/ -)**"D+B),S+4+)D $/,:4/*+/S, +8B)S:/,S #A8 )*+%+8A:)
A*%/S: /8)"9A*4 :9) ,+SR+8)SS /4 9/*D+8G +8D+B+DCA* S:/#RS. &8/:):
+: +S 8/: #/%$*):)*7 #/S:*)SS :/ D+B),S+47, S/ )B)8 :9) *A,G)S:
+8S:+:C:+/8A* +8B)S:/,S 9/*D *)SS :9A8 A** S:/#RS. )B)8 +8D)> 4C8DS
G)8),A**7 9/*D A S%A**), $/,:4/*+/ :9A: +S 9+G9*7 #/,,)*A:)D -+:9 A8
Integrated Case: 6 - !* Harcourt, Inc.
+8D)> SC#9 AS :9) SV$ ;== ,A:9), :9A8 9/*D A** :9) S:/#RS +8 :9)
+8D)>.'
:9) +%$*+#A:+/8 +S #*)A,: +8B)S:/,S S9/C*D 9/*D -)**"D+B),S+4+)D
$/,:4/*+/S /4 S:/#RS ,A:9), :9A8 +8D+B+DCA* S:/#RS. &+8 4A#:,
+8D+B+DCA*S #A8 9/*D D+B),S+4+)D $/,:4/*+/S :9,/CG9 %C:CA* 4C8D
+8B)S:%)8:S.' A7 D/+8G S/, :9)7 #A8 )*+%+8A:) AA/C: 9A*4 /4 :9)
,+SR+8)SS +89),)8: +8 +8D+B+DCA* S:/#RS.
G. 1. SHOULD PORTFOLIO EFFECTS IMPACT THE WAY INVESTORS THIN" ABOUT THE
RIS"INESS OF INDIVIDUAL STOC"S4
ANSWER5 PS9/- S3"1< :9,/CG9 S3"20 9),).Q $/,:4/*+/ D+B),S+4+#A:+/8 D/)S
A44)#: +8B)S:/,S( B+)-S /4 ,+SR. A S:/#R(S S:A8D"A*/8) ,+SR AS
%)ASC,)D A7 +:S /, #B, %A7 A) +%$/,:A8: :/ A8 C8D+B),S+4+)D
+8B)S:/,, AC: +: +S 8/: ,)*)BA8: :/ A -)**"D+B),S+4+)D +8B)S:/,. A
,A:+/8A*, ,+SR"AB),S) +8B)S:/, +S %/,) +8:),)S:)D +8 :9) +%$A#: :9A:
:9) S:/#R 9AS /8 :9) ,+SR+8)SS /4 9+S /, 9), $/,:4/*+/ :9A8 /8 :9)
S:/#R(S S:A8D"A*/8) ,+SR. S:A8D"A*/8) ,+SR +S #/%$/S)D /4
D+B),S+4+AA*) ,+SR, -9+#9 #A8 A) )*+%+8A:)D A7 9/*D+8G :9) S:/#R +8 A
-)**"D+B),S+4+)D $/,:4/*+/, A8D :9) ,+SR :9A: ,)%A+8S +S #A**)D
%A,R): ,+SR A)#ACS) +: +S $,)S)8: )B)8 -9)8 :9) )8:+,) %A,R):
$/,:4/*+/ +S 9)*D.
G. 2. IF YOU DECIDED TO HOLD A 1-STOC" PORTFOLIO, AND CONSE3UENTLY WERE
E/POSED TO MORE RIS" THAN DIVERSIFIED INVESTORS, COULD YOU E/PECT TO
BE COMPENSATED FOR ALL OF YOUR RIS"! THAT IS, COULD YOU EARN A RIS"
PREMIUM ON THAT PART OF YOUR RIS" THAT YOU COULD HAVE ELIMINATED BY
DIVERSIFYING4
ANSWER5 PS9/- S3"21 :9,/CG9 S3"2D 9),).Q +4 7/C 9/*D A /8)"S:/#R $/,:4/*+/,
7/C -+** A) )>$/S)D :/ A 9+G9 D)G,)) /4 ,+SR, AC: 7/C -/8(: A)
#/%$)8SA:)D 4/, +:. +4 :9) ,):C,8 -),) 9+G9 )8/CG9 :/ #/%$)8SA:) 7/C
4/, 7/C, 9+G9 ,+SR, +: -/C*D A) A AA,GA+8 4/, %/,) ,A:+/8A*,
D+B),S+4+)D +8B)S:/,S. :9)7 -/C*D S:A,: AC7+8G +:, A8D :9)S) AC7
/,D),S -/C*D D,+B) :9) $,+#) C$ A8D :9) ,):C,8 D/-8. :9CS, 7/C
Harcourt, Inc. Integrated Case: 6 - !+
S+%$*7 #/C*D 8/: 4+8D S:/#RS +8 :9) %A,R): -+:9 ,):C,8S 9+G9 )8/CG9
:/ #/%$)8SA:) 7/C 4/, :9) S:/#R(S D+B),S+4+AA*) ,+SR.
H. THE E/PECTED RATES OF RETURN AND THE BETA COEFFICIENTS OF THE
ALTERNATIVES AS SUPPLIED BY MERRILL FINCH0S COMPUTER PROGRAM ARE AS
FOLLOWS5
SECURITY RETURN
,
- # RIS" BETA#
HIGH TECH 1).(% 1.'0
MAR"ET 1*.0 1.00
U.S. RUBBER 1'.$ 0.$+
T-BILLS $.0 0.00
COLLECTIONS 1.) 0.$)#
1# WHAT IS A BETA COEFFICIENT, AND HOW ARE BETAS USED IN RIS"
ANALYSIS4 2# DO THE E/PECTED RETURNS APPEAR TO BE RELATED TO EACH
ALTERNATIVE0S MAR"ET RIS"4 '# IS IT POSSIBLE TO CHOOSE AMONG THE
ALTERNATIVES ON THE BASIS OF THE INFORMATION DEVELOPED THUS FAR4 USE
THE DATA GIVEN AT THE START OF THE PROBLEM TO CONSTRUCT A GRAPH THAT
SHOWS HOW THE T-BILL0S, HIGH TECH0S, AND COLLECTIONS0 BETA
COEFFICIENTS ARE CALCULATED. THEN DISCUSS WHAT BETAS MEASURE AND HOW
THEY ARE USED IN RIS" ANALYSIS.
ANSWER5 PS9/- S3"2; :9,/CG9 S3"D1 9),).Q
Integrated Case: 6 - !6 Harcourt, Inc.
Hi(% )ec%
(!lo&e ' beta ' 1.30)
*ar#et
(!lo&e ' beta ' 1.0)
+.". Rubber
(!lo&e ' beta ' 0.,-)
Return on "toc# i
(%)
Return on t%e *ar#et
(%)
40
.0
-.0 .0 40
-.0
&D,A- :9) 4,A%)-/,R /4 :9) G,A$9, $C: C$ :9) DA:A, :9)8 $*/: :9)
$/+8:S 4/, :9) %A,R): &D; *+8)' A8D #/88)#: :9)%, A8D :9)8 G): :9)
S*/$) AS 7M> H 0.=.' S:A:) :9A: A8 AB),AG) S:/#R, A7 D)4+8+:+/8,
%/B)S -+:9 :9) %A,R):. :9)8 D/ :9) SA%) -+:9 9+G9 :)#9 A8D C.S.
,CAA),. A):A #/)44+#+)8:S %)ASC,) :9) ,)*A:+B) B/*A:+*+:7 /4 A G+B)8
S:/#R B+S"A"B+S A8 AB),AG) S:/#R. :9) AB),AG) S:/#R(S A):A +S 0.=.
%/S: S:/#RS 9AB) A):AS +8 :9) ,A8G) /4 =.; :/ 0.;. :9)/,):+#A**7,
A):AS #A8 A) 8)GA:+B), AC: +8 :9) ,)A* -/,*D :9)7 A,) G)8),A**7
$/S+:+B).
A):AS A,) #A*#C*A:)D AS :9) S*/$) /4 :9) 5#9A,A#:),+S:+#6 *+8),
-9+#9 +S :9) ,)G,)SS+/8 *+8) S9/-+8G :9) ,)*A:+/8S9+$ A):-))8 A G+B)8
S:/#R A8D :9) G)8),A* S:/#R %A,R):.
AS )>$*A+8)D +8 A$$)8D+> 3A, -) #/C*D )S:+%A:) :9) S*/$)S, A8D
:9)8 CS) :9) S*/$)S AS :9) A):AS. +8 $,A#:+#), ; 7)A,S /4 %/8:9*7
DA:A, -+:9 3= /AS),BA:+/8S, -/C*D G)8),A**7 A) CS)D, A8D A #/%$C:),
-/C*D A) CS)D :/ /A:A+8 A *)AS: STCA,)S ,)G,)SS+/8 *+8).
:9) )>$)#:)D ,):C,8S A,) ,)*A:)D :/ )A#9 A*:),8A:+B)(S %A,R):
,+SR"":9A: +S, :9) 9+G9), :9) A*:),8A:+B)(S ,A:) /4 ,):C,8 :9) 9+G9),
+:S A):A. A*S/, 8/:) :9A: :"A+**S 9AB) S),/ ,+SR.
-) D/ 8/: 7): 9AB) )8/CG9 +84/,%A:+/8 :/ #9//S) A%/8G :9) BA,+/CS
A*:),8A:+B)S. -) 8))D :/ R8/- :9) ,)TC+,)D ,A:)S /4 ,):C,8 /8 :9)S)
A*:),8A:+B)S A8D #/%$A,) :9)% -+:9 :9)+, )>$)#:)D ,):C,8S.
I. THE YIELD CURVE IS CURRENTLY FLAT, THAT IS, LONG-TERM TREASURY BONDS
ALSO HAVE AN $ PERCENT YIELD. CONSE3UENTLY, MERRILL FINCH ASSUMES
THAT THE RIS"-FREE RATE IS $ PERCENT.
1. WRITE OUT THE SECURITY MAR"ET LINE SML# E3UATION, USE IT TO
CALCULATE THE RE3UIRED RATE OF RETURN ON EACH ALTERNATIVE, AND THEN
GRAPH THE RELATIONSHIP BETWEEN THE E/PECTED AND RE3UIRED RATES OF
RETURN.
ANSWER5 PS9/- S3"D2 :9,/CG9 S3"D3 9),).Q 9),) +S :9) S%* )TCA:+/8:
k
i
H k
,4
? &k
%
O k
,4
'b
i
.
Harcourt, Inc. Integrated Case: 6 - !-
+4 -) CS) :9) :"A+** 7+)*D AS A $,/>7 4/, :9) ,+SR"4,)) ,A:), :9)8
k
,4
H <L. 4C,:9),, /C, )S:+%A:) /4 k
%
H k
K
%
+S 0; $),#)8:. :9CS, :9)
,)TC+,)D ,A:)S /4 ,):C,8 4/, :9) A*:),8A:+B)S A,) AS 4/**/-S:
9+G9 :)#9: <L ? &0;L " <L'0.2= H 0I.0=L.
%A,R):: <L ? &0;L " <L'0.== H 0;.=L.
C.S. ,CAA),: <L ? &0;L " <L'=.<F H 0D.12L.
:"A+**S: <L ? &0;L " <L'= H <.=L.
#/**)#:+/8S: <L ? &0;L " <L'"=.<I H 0.F0L.
I. 2. HOW DO THE E/PECTED RATES OF RETURN COMPARE WITH THE RE3UIRED RATES
OF RETURN4
ANSWER5 -) 9AB) :9) 4/**/-+8G ,)*A:+/8S9+$S:
)>$)#:)D

,)TC+,)D
,):C,8

,):C,8
S)#C,+:7 &
k
K' &k' #/8D+:+/8
9+G9 :)#9 0I.DL 0I.0L C8D),BA*C)D:
k
K @ k
%A,R): 0;.= 0;.= 4A+,*7

BA*C)D

&%A,R):

)TC+*+A,+C%'
C.S. ,CAA), 02.< 0D.1 /B),BA*C)D: k @
k
K
:"A+**S <.= <.= 4A+,*7 BA*C)D
#/**)#:+/8S 0.I 0.F /B),BA*C)D: k @
k
K
&8/:): :9) $*/: *//RS S/%)-9A: C8CSCA* +8 :9A: :9) >"A>+S )>:)8DS :/
:9) *)4: /4 S),/. -) 9AB) A 8)GA:+B) A):A S:/#R, 9)8#) A ,)TC+,)D
Integrated Case: 6 - !3 Harcourt, Inc.
..
1,
14
10
6
.
-.
-6
-..0 -1.0 0.0 1.0 ..0
Re/uire0 an0 12&ecte0
Rate! of Return (%)
3eta
4ollection!
+.". Rubber
Hi(% )ec%
"*56 #
i
' #
R7
8 (#
*
- #
R7
)b
i






' ,% 8 9%(b
i
)
#
R7
#
*
C
C
C
C
C
,):C,8 :9A: +S *)SS :9A8 :9) ,+SR"4,)) ,A:).' :9) :"A+**S A8D %A,R):
$/,:4/*+/ $*/: /8 :9) S%*, 9+G9 :)#9 $*/:S AA/B) +:, A8D #/**)#:+/8S
A8D C.S. ,CAA), $*/: A)*/- +:. :9CS, :9) :"A+**S A8D :9) %A,R):
$/,:4/*+/ $,/%+S) A 4A+, ,):C,8, 9+G9 :)#9 +S A G//D D)A* A)#ACS) +:S
)>$)#:)D ,):C,8 +S AA/B) +:S ,)TC+,)D ,):C,8, A8D #/**)#:+/8S A8D
C.S. ,CAA), 9AB) )>$)#:)D ,):C,8S A)*/- :9)+, ,)TC+,)D ,):C,8S.
I. '. DOES THE FACT THAT COLLECTIONS HAS AN E/PECTED RETURN THAT IS LESS
THAN THE T-BILL RATE MA"E ANY SENSE4
ANSWER5 #/**)#:+/8S +S A8 +8:),)S:+8G S:/#R. +:S 8)GA:+B) A):A +8D+#A:)S
8)GA:+B) %A,R): ,+SR""+8#*CD+8G +: +8 A $/,:4/*+/ /4 58/,%A*6 S:/#RS
-+** */-), :9) $/,:4/*+/(S ,+SR. :9),)4/,), +:S ,)TC+,)D ,A:) /4
,):C,8 +S A)*/- :9) ,+SR"4,)) ,A:). AAS+#A**7, :9+S %)A8S :9A:
#/**)#:+/8S +S A BA*CAA*) S)#C,+:7 :/ ,A:+/8A*, -)**"D+B),S+4+)D
+8B)S:/,S. :/ S)) -97, #/8S+D), :9+S TC)S:+/8: -/C*D A87 ,A:+/8A*
+8B)S:/, )B), %AR) A8 +8B)S:%)8: :9A: 9AS A 8)GA:+B) )>$)#:)D ,):C,8N
:9) A8S-), +S 57)S6""JCS: :9+8R /4 :9) $C,#9AS) /4 A *+4) /, 4+,)
+8SC,A8#) $/*+#7. :9) 4+,) +8SC,A8#) $/*+#7 9AS A 8)GA:+B) )>$)#:)D
,):C,8 A)#ACS) /4 #/%%+SS+/8S A8D +8SC,A8#) #/%$A87 $,/4+:S, AC:
ACS+8)SS)S AC7 4+,) +8SC,A8#) A)#ACS) :9)7 $A7 /44 A: A :+%) -9)8
8/,%A* /$),A:+/8S A,) +8 AAD S9A$). *+4) +8SC,A8#) +S S+%+*A,""+:
9AS A 9+G9 ,):C,8 -9)8 -/,R +8#/%) #)AS)S. A 8)GA:+B) A):A S:/#R +S
#/8#)$:CA**7 S+%+*A, :/ A8 +8SC,A8#) $/*+#7.
I. (. WHAT WOULD BE THE MAR"ET RIS" AND THE RE3UIRED RETURN OF A *0-*0
PORTFOLIO OF HIGH TECH AND COLLECTIONS4 OF HIGH TECH AND U.S.
RUBBER4
ANSWER5 PS9/- S3"DI A8D S3"D< 9),).Q 8/:) :9A: :9) A):A /4 A $/,:4/*+/ +S
S+%$*7 :9) -)+G9:)D AB),AG) /4 :9) A):AS /4 :9) S:/#RS +8 :9)
$/,:4/*+/. :9CS, :9) A):A /4 A $/,:4/*+/ -+:9 ;= $),#)8: 9+G9 :)#9
A8D ;= $),#)8: #/**)#:+/8S +S:

=
=
n
0 i
i i p
b w b .
b
p
H =.;&b
9+G9 :)#9
' ? =.;&b
#/**)#:+/8S
' H =.;&0.2=' ? =.;&O=.<I'
Harcourt, Inc. Integrated Case: 6 - !.
H =.10;,
k
p
H k
,4
? &k
%
" k
,4
'b
p
H <.=L ? &0;.=L " <.=L'&=.10;'
H <.=L ? IL&=.10;' H F.;0L F.;L.
4/, A $/,:4/*+/ #/8S+S:+8G /4 ;= $),#)8: 9+G9 :)#9 $*CS ;= $),#)8:
C.S. ,CAA),, :9) ,)TC+,)D ,):C,8 -/C*D A) 0;.I $),#)8::
b
p
H =.;&0.2=' ? =.;&=.<F' H 0.=F;.
k
p
H <.=L ? IL&0.=F;' H 0;.33;L 0;.IL.
J. 1. SUPPOSE INVESTORS RAISED THEIR INFLATION E/PECTATIONS BY ' PERCENTAGE
POINTS OVER CURRENT ESTIMATES AS REFLECTED IN THE $ PERCENT RIS"-FREE
RATE. WHAT EFFECT WOULD HIGHER INFLATION HAVE ON THE SML AND ON THE
RETURNS RE3UIRED ON HIGH- AND LOW-RIS" SECURITIES4
ANSWER5 PS9/- S3"DF A8D S3";= 9),).Q
9),) -) 9AB) $*/::)D :9) S%* 4/, A):AS ,A8G+8G 4,/% = :/ 1.=. :9)
AAS) #AS) S%* +S AAS)D /8 k
,4
H <L A8D k% H 0;L. +4 +84*A:+/8
)>$)#:A:+/8S +8#,)AS) A7 2 $),#)8:AG) $/+8:S, -+:9 8/ #9A8G) +8 ,+SR
AB),S+/8, :9)8 :9) )8:+,) S%* +S S9+4:)D C$-A,D &$A,A**)* :/ :9) AAS)
#AS) S%*' A7
Integrated Case: 6 - #6 Harcourt, Inc.
Re/uire0 an0 12&ecte0
Rate! of Return (%)
40
35
30
.5
.0
15
10
5
0.00 0.50 1.00 1.50 ..00
3eta
Increa!e0 Inflation
Ori(inal "ituation
Increa!e0 Ri!# :;er!ion
2 $),#)8:AG) $/+8:S. 8/-, k
,4
H 00L, k
%
H 0<L, A8D A** S)#C,+:+)S(
,)TC+,)D ,):C,8S ,+S) A7 2 $),#)8:AG) $/+8:S. 8/:) :9A: :9) %A,R):
,+SR $,)%+C%, k
%
" k
,4
, ,)%A+8S A: I $),#)8:AG) $/+8:S.
J. 2. SUPPOSE INSTEAD THAT INVESTORS0 RIS" AVERSION INCREASED ENOUGH TO
CAUSE THE MAR"ET RIS" PREMIUM TO INCREASE BY ' PERCENTAGE POINTS.
INFLATION REMAINS CONSTANT.# WHAT EFFECT WOULD THIS HAVE ON THE SML
AND ON RETURNS OF HIGH- AND LOW-RIS" SECURITIES4
ANSWER5 PS9/- S3";0 :9,/CG9 S3";; 9),).Q -9)8 +8B)S:/,S( ,+SR AB),S+/8
+8#,)AS)S, :9) S%* +S ,/:A:)D C$-A,D AA/C: :9) 7"+8:),#)$: &k
,4
'. k
,4
,)%A+8S A: < $),#)8:, AC: 8/- k
%
+8#,)AS)S :/ 0< $),#)8:, S/ :9)
%A,R): ,+SR $,)%+C% +8#,)AS)S :/ 0= $),#)8:. :9) ,)TC+,)D ,A:) /4
,):C,8 -+** ,+S) S9A,$*7 /8 9+G9",+SR &9+G9"A):A' S:/#RS, AC: 8/:
%C#9 /8 */-"A):A S)#C,+:+)S.
OPTIONAL 3UESTION
FINANCIAL MANAGERS ARE MORE CONCERNED WITH INVESTMENT DECISIONS RELATING TO
REAL ASSETS SUCH AS PLANT AND E3UIPMENT THAN WITH INVESTMENTS IN FINANCIAL
ASSETS SUCH AS SECURITIES. HOW DOES THE ANALYSIS THAT WE HAVE GONE THROUGH
RELATE TO REAL ASSET INVESTMENT DECISIONS, ESPECIALLY CORPORATE CAPITAL
BUDGETING DECISIONS4
ANSWER5 :9),) +S A G,)A: D)A* /4 S+%+*A,+:7 A):-))8 7/C, 4+8A8#+A* ASS):
D)#+S+/8S A8D A 4+,%(S #A$+:A* ACDG):+8G D)#+S+/8S. 9),) +S :9)
*+8RAG):
0. A #/%$A87 %A7 A) :9/CG9: /4 AS A $/,:4/*+/ /4 ASS):S. +4 :9)
#/%$A87 D+B),S+4+)S +:S ASS):S, A8D )S$)#+A**7 +4 +: +8B)S:S +8
S/%) $,/J)#:S :9A: :)8D :/ D/ -)** -9)8 /:9),S A,) D/+8G AAD*7, +:
#A8 */-), :9) BA,+AA+*+:7 /4 +:S ,):C,8S.
1. #/%$A8+)S /A:A+8 :9)+, +8B)S:%)8: 4C8DS 4,/% +8B)S:/,S, -9/ AC7
:9) 4+,%(S S:/#RS A8D A/8DS. -9)8 +8B)S:/,S AC7 :9)S) S)#C,+:+)S,
:9)7 ,)TC+,) A ,+SR $,)%+C% :9A: +S AAS)D /8 :9) #/%$A87(S ,+SR AS
:9)7 &+8B)S:/,S' S)) +:. 4C,:9),, S+8#) +8B)S:/,S +8 G)8),A* 9/*D
Harcourt, Inc. Integrated Case: 6 - #1
-)**"D+B),S+4+)D $/,:4/*+/S /4 S:/#RS A8D A/8DS, :9) ,+SR :9A: +S
,)*)BA8: :/ :9)% +S :9) S)#C,+:7(S %A,R): ,+SR, 8/: +:S S:A8D"
A*/8) ,+SR. :9CS, +8B)S:/,S B+)- :9) 4+,%(S ,+SR 4,/% A %A,R):
,+SR $),S$)#:+B).
2. :9),)4/,), -9)8 A %A8AG), %AR)S A D)#+S+/8 :/ AC+*D A 8)- $*A8:,
:9) ,+SR+8)SS /4 :9) +8B)S:%)8: +8 :9) $*A8: :9A: +S ,)*)BA8: :/
:9) 4+,%(S +8B)S:/,S &+:S /-8),S' +S +:S %A,R): ,+SR, 8/: +:S
S:A8D"A*/8) ,+SR. A##/,D+8G*7, %A8AG),S 8))D :/ R8/- 9/- $97S+#A*
ASS): +8B)S:%)8: D)#+S+/8S A44)#: :9)+, 4+,%(S A):A #/)44+#+)8:.
A $A,:+#C*A, ASS): %A7 *//R TC+:) ,+SR7 -9)8 B+)-)D +8 +S/*A:+/8,
AC: +4 +:S ,):C,8S A,) 8)GA:+B)*7 #/,,)*A:)D -+:9 ,):C,8S /8 %/S:
/:9), S:/#RS, :9) ASS): %A7 ,)A**7 9AB) */- ,+SR. -) -+** D+S#CSS
A** :9+S +8 %/,) D):A+* +8 /C, #A$+:A* ACDG):+8G D+S#CSS+/8S.
Integrated Case: 6 - #! Harcourt, Inc.
3A"0 a.
b H Slope H =.31. 9owever, b will depend on students( freehand line.
Csing a calculator, we find b H =.31.
b. Aecause b H =.31, Stock 7 is about 31 percent as volatile as the
arket! thus, its relative risk is about 31 percent that of an
average fir.
c. 0. Stand"alone risk as easured by would be greater, but beta and
hence systeatic &relevant' risk would reain unchanged. 9owever,
in a 0"stock portfolio, Stock 7 would be riskier under the new
conditions.
1. #A$% assues that copany"specific risk will be eliinated in a
portfolio, so the risk preiu under the #A$% would not be
affected. 9owever, if the scatter were wide, we would not have as
uch confidence in the beta, and this could increase the stockWs
riskiness and thus its risk preiu.
d. 0. :he stockWs variance and would not change, but the risk of the
stock to an investor holding a diversified portfolio would be
greatly reduced, because it would now have a negative correlation
with k
%
.
1. Aecause of a relative scarcity of such stocks and the beneficial
net effect on portfolios that include it, its 5risk preiu6 is
likely to be very low or even negative. :heoretically, it should
be negative.
e. :he following figure shows a possible set of probability
distributions. -e can be reasonably sure that the 0=="stock portfolio
Harcourt, Inc. Solutions to Appendix roblems: 6 - ##
OL"TION TO A((EN%I7 6A (ROBLE,
40
30
.0
10
30 .0 10 10 .0 30 40
#
<
(%)
#
*
(%)
!
!
! !
!
!
!
!
!
!
!
- - -
coprised of
b H =.31 stocks as described in #ondition 1 will be less risky than
the 5arket.6 9ence, the distribution for #ondition 1 will be ore
peaked than that of #ondition 2.
-e can also say on the basis of the available inforation that
7
is
saller than
%
! Stock 7(s market risk is only 31 percent of the
5arket,6 but it does have copany"specific risk, while the arket
portfolio does not, because it has been diversified away. 9owever,
we know fro the given data that
7
H 02.<L, while
%
H 0F.3L. :hus,
we have drawn the distribution for the single stock portfolio ore
peaked than that of the arket. :he relative rates of return are not
reasonable. :he return for any stock should be
k
i
H k
,4
? &k
%
O k
,4
'b
i
.
Stock 7 has b H =.31, while the average stock &%' has b H 0.=!
therefore,
k
y
H k
,4
? &k
%
O k
,4
'=.31 X k
%
H k
,4
? &k
%
O k
,4
'0.=.
A disequilibriu exists""Stock 7 should be bid up to drive its yield
down. %ore likely, however, the data siply reflect the fact that
past returns are not an exact basis for expectations of future
returns.
f. :he expected return could not be predicted with the historical
characteristic line because the increased risk should change the beta
used in the characteristic line.
g. :he beta would decline to =.;2. A decline indicates that the stock
has becoe less risky! however, with the change in the debt ratio the
Solutions to Appendix roblems: 6 - #* Harcourt, Inc.
-.,
=#
100
=#
*
=#
<
stock has actually becoe ore risky. +n periods of transition, when
the risk of the fir is changing, the beta can yield conclusions
exactly opposite to the actual facts. /nce the copanyWs risk
stabiliGes, the calculated beta should rise and should again
approxiate the true beta.
3A"1 a.
:he slope of the characteristic line is the stock(s beta coefficient.
Slope H
%
i
k
k
,un
,ise

= .
Slope
A
H Aeta
A
H
1= . 0; == . 1F
1= . 0; == . 1F

H 0.=.
Slope
A
H Aeta
A
H
1= . 0; == . 1F
0= . 02 == . 1=

H =.;.
b.
%
k
K
H =.0&"0DL' ? =.1&=L' ? =.D&0;L' ? =.1&1;L' ? =.0&DDL'
H "0.DL ? =L ? 3L ? ;L ? D.DL H 0DL.
:he graph of the S%* is as follows:
Harcourt, Inc. Solutions to Appendix roblems: 6 - #+
-5
5
10
15
.0
.5
30
35
5 10 15 .0 .5 30 35
#
i
(%)
#
*
(%)
"toc# :
"toc# 3
:he equation of the S%* is thus:
k
i
H k
,4
? &k
%
O k
,4
'b
i
H FL ? &0DL O FL'b
i
H FL ? &;L'b
i
.
c. ,equired rate of return on Stock A:
k
A
H k
,4
? &k
%
" k
,4
'b
A
H FL ? &0DL " FL'0.= H 0DL.
,equired rate of return on Stock A:
k
A
H FL ? &0DL " FL'=.; H 00.;=L.
d. )xpected return on Stock #:
#
k
K
H 0<L.
,eturn on Stock # if in equilibriu:
k
#
H k
,4
? &k
%
" k
,4
'b
#
H FL ? &0DL " FL'1 H 0FL 0<L H
#
k
K
.
:herefore, Stock # is not in equilibriu. )quilibriu will be
restored when the expected return on Stock # is driven up to 0F
percent. -ith an expected return of 0< percent on Stock #, investors
should sell it, driving its price down and its yield up.
Solutions to Appendix roblems: 6 - #6 Harcourt, Inc.
"*5
#
i
#R7 ' -%
1(#*) ' 14%
b
1.0