Chapter 10: Risk and Return: Lessons from Market History 10.1 a. b.

Capital gains = $56 $52 = $4 per share; Total capital gains is $2000 ( $4 x 500) Total dollar returns = Dividends + Capital Gains = $1,000 + ($4 x 500) = $3,000 On a per share basis, this calculation is $2 + $4 = $6 per share c. On a per share basis, $6/$52 = 0.1153 or 11.53% On a total dollar basis, $3,000/(500*$52) = 0.1153 or 11.53% d. No, you do not need to sell the shares to include the capital gains in the computation of the returns. The capital gain is included whether or not you realize the gain. Since you could realize the gain if you choose, you should include it. (Note that for tax purposes, you must sell the stock.) The capital gain is the appreciation of the stock price. Find the amount that Seth paid for the stock one year ago by dividing his total investment by the number of shares he purchased ($62.50 = $12,500 / 200). Because the price of the stock increased from $62.50 per share to $69.75 per share, he earned a capital gain of $7.25 per share (=$69.75 $62.50). Capital Gain = (Pt+1 Pt) (Number of Shares) = ($69.75 $62.50) (200) = $1,450

10.2

a.

Seths capital gain is $1,450. b. The total dollar return is equal to the dividend income plus the capital gain. He received $750 in dividend income, as stated in the problem, and received $1,450 in capital gains, as found in part (a). Total Dollar Gain = Dividend income + Capital gain = $750 + $1,450 = $2,200 Seths total dollar return is $2,200. c. The percentage return is the total dollar gain on the investment as of the end of year 1 divided by the initial investment of $12,500. Rt+1 = [Divt+1 + (Pt+1 Pt)] / Pt = [$750 + $1,450] / $12,500 = 0.176

The percentage return is 17.60%. b. The dividend yield is equal to the dividend payment divided by the purchase price of the stock. Dividend Yield = Div1 / Pt

Answers to EndofChapter Problems

B121

= $750 / $12,500 = 0.06 The stocks dividend yield is 6.00%. 10.3 Apply the percentage return formula. Note that the stock price declined during the period. Since the stock price decline was greater than the dividend, your return was negative. Rt+1 = [Divt+1 + (Pt+1 Pt)] / Pt = [$1.75 + ($33 $40)] / $40 = 0.13125 The percentage return is 0.13125 10.4 To find the real return we need to use the Fisher equation. Rewriting the Fisher equation to solve for the real return, r, in terms of the nominal return, R, and the expected inflation, , we get: r = [(1 + R) / (1 + )] 1 Year
Year 1973 1974 1975 1976 1977 1978 1979 1980 Sum

Tbill return Tbill Return 9.36 12.3 9.52 5.87 9.45 8.44 9.69 11.2 75.81

Inflation
Inflation 4.78 7.68 7.05 9.10 7.64 7.90 11.01 12.23 67.39

Real return
Real Return 4.37 4.29 2.31 2.96 1.68 0.50 1.19 0.92 5.04

a.

The average return for Tbills over this period was: Average return = 75.81 / 8 Average return = 9.47% And the average inflation rate was: Average inflation = 67.39 / 8 Average inflation = 8.42%

b.

Using the equation for variance, we find the variance for Tbills over this period was: Variance = 1/7[(.0936 .0947)2 + (.01233 .0947)2 + (.0952 .0947)2 + (.0587 .0947) 2 + (.0945 .0947) 2 + (.0844 .0947) 2 + (.0969 .0947) 2 + (.112 .0947) 2] Variance = 0.00035721 And the standard deviation for Tbills was:

Answers to EndofChapter Problems

B122

Standard deviation = (0.00035721)1/2 Standard deviation = 0.0189 or 1.89% The variance of inflation over this period was: Variance = 1/7[(.0478 .0842)2 + (.0768 .0842) 2 + (.0705 .0842) 2 + (.091 .0842) 2 + (.0764 .0842) 2+ (.079 .0842) 2 + (.1101 .0842) 2 + (.1223 .0842) 2] Variance = 0.00054289 And the standard deviation of inflation was: Standard deviation = (0.00054289)1/2 Standard deviation = 0.0233 or 2.33% c. The average observed real return over this period was: Average observed real return = 5.04 / 8 Average observed real return = 0.63% d. The statement that Tbills have no risk refers to the fact that there is only an extremely small chance of the government defaulting, so there is little default risk. Since Tbills are short term, there is also very limited interest rate risk. However, as this example shows, there is inflation risk, i.e. the purchasing power of the investment can actually decline over time even if the investor is earning a positive return.

10.5

Use the nominal returns, R, on each of the securities and the average inflation rate, , to calculate the real return, r. r = [(1 + R) / (1 + )] 1 From the table, the average inflation rate over the period 1979 to 2003 was 4.13%. a. The average nominal return on Canadian common stocks is 12.0312%. Apply the formula for the real return, r. r = [(1 + R) / (1 + )] 1 = [(1 + 0.120312) / (1 + 0.0413)] 1 = 0.07588 The real return on largecompany stocks is 7.588%. b. The average nominal return on longterm corporate bonds is 11.9972%. Apply the formula for the real return, r. r = [(1 + R) / (1 + )] 1 = [(1 + 0.119972) / (1 + 0.0413)] 1 = 0.07555

Answers to EndofChapter Problems

B123

The real return on longterm corporate bonds is 7.555%. c. The average nominal return on Canadian TBills is 8.2868%. Apply the formula for the real return, r. r = [(1 + R) / (1 + )] 1 = [(1 + 0.082868) / (1 + 0.0413)] 1 = 0.03992 The real return on longterm Canadian TBills is 3.992%. 10.6 The difference between risky returns on common stocks and riskfree returns on Treasury bills is called the risk premium. The average risk premium was 4.17 percent (= 0.1097 0.068) over the period. The expected return on common stocks can be estimated as the current return on Treasury bills, 3.9 percent, plus the average risk premium, 4.17 percent. Risk Premium = Average common stock return Average Treasury bill return = 0.1097 0.068 = 0.0417 E(R) = Treasury bill return + Average risk premium = 0.039 + 0.0417 = 0.0807 The expected return on common stocks is 8.07 percent. 10.7 Below is a diagram that depicts the stocks price movements. Two years ago, each stock had the same price, P0. Over the first year, General Materials stock price increased by 9 percent, or (1.09) P0. Standard Fixtures stock price declined by 9 percent, or (0.91) P0. Over the second year, General Materials stock price decreased by 9 percent, or (0.91) (1.09) P0, while Standard Fixtures stock price increased by 9 percent, or (1.09) (0.91) P0. Today, each of the stocks is worth 99.19% of its original value. 2 years ago General Materials Standard Fixtures 10.8 a.
Year 7 6 5 4 R 0.046 0.015 0.619 0.078 (RE(R))^2 0.10814702 0.088718878 0.11299202 0.041966449

1 year ago (1.09) P0 (0.91) P0

Today (1.09) (0.91) P0 (0.91) (1.09) P0 = (0.9919) P0 = (0.9919) P0

P0 P0

Answers to EndofChapter Problems

B124

3 2 last E(R) Total

0.244 0.899 0.201 0.2828

0.001509878 0.37963202 0.006700592

0.739666857

Note, because the data are historical data, the appropriate denominator in the calculation of the variance is T1. 10.9 a.
Year 7 6 5 4 3 2 Last Common Stock 39.1 6.1 22.4 56.8 7.5 41.3 15.9 Treasury Bills 11.6 7.1 8.9 12.3 9.1 7.9 6.9 Realized Risk Premium 27.5 13.2 13.5 44.5 1.6 33.4 22.8

b.

The average risk premium is 11.61%.

c.

Yes, it is possible for the observed risk premium to be negative. This can happen in any single year. The average risk premium over many years should be positive. For Treasury Bills : In any state, the return on the Treasury Bills is 3.6%, so the expected return on TBills is 3.6% Economic State Recession Moderate Growth Rapid Expansion Prob. (P) 0.20 0.5 0.30 Return if State Occurs PReturn 0.112 0.0224 0.114 0.057 0.216 0.0648 Expected Return = 0 .0994

10.10

a.

b.

The expected risk premium is the difference between the expected market return and expected T Bill return = 0.0994 0.036 = 0.0634 or 6.34%

10.11

a and b.
Answers to EndofChapter Problems B125

Small Company Stocks R 0.491 0.305 0.05 0.12 0.14 Average RE( R) (RE( R)^2 0.3378 0.11410884 0.1518 0.02304324 0.2032 0.04129024 0.2732 0.07463824 0.0132 0.00017424 Total 0.2532548

0.1532 Variance =0.2523548/51 =0.0633137

Large Company Common Stocks R RE( R) (RE( R))^2 0.47 0.3678 0.13527684 0.291 0.1888 0.03564544 -0.296 -0.3982 0.15856324 -0.05 -0.1522 0.02316484 0.096 -0.0062 3.84400E-05 Total 0.3526888

Total Average

0.1022 Variance = 0.3526888/ (51) = 0.0881

Note, because the data are historical returns, the appropriate denominator in the calculation of the variance is T1. 10.12 Canadian Common Stocks Year 1988 1989 1990 1991 1992 1993 Average R 0.1108 0.2137 -0.148 0.1202 0.0143 0.3255 -0.148 RE( R)
0.00471667 0.10761667 -0.2540833 0.01411667 -0.0917833 0.21941667 -0.2540833 1

(RE( R)^2
2.22469E-05 0.011581347 0.06455834 0.00019928 8.424E-03 4.814E-02 0.06455834 = 0.02659

Variance = 0.13298/5

Small Cap Stocks

Answers to EndofChapter Problems B126

Year

R RE( R) (RE( R))^2 1988 0.0546 -0.066367 0.0044045 1989 0.1066 -0.014367 0.0002064 1990 -0.2732 -0.394167 0.1553674 1991 0.1851 0.064133 0.0041131 1992 0.1301 0.009133 8.342E-05 1993 0.5226 0.401633 1.613E-01 Average 0.1210 Sum 0.3254841 Variance = 0.3254841/5 = 0.0650968

LongTerm Bonds Year 1988 1989 1990 1991 1992 1993 Average R 0.113 0.1517 0.0432 0.2530 0.1157 0.2209 RE( R) (RE( R))^2

-0.03658 0.00133834 0.00212 0.00000448 -0.10638 0.01131741 0.10342 0.01069501 -0.03388 0.00114808 0.07132 0.00508607 0.1496 Sum 0.0295894 Variance = 0.0295894/5 = 0.00591788

Canada TBills Year 1988 1989 1990 1991 1992 1993 Average R RE( R) (RE( R))^2 0.0894 -0.00452 2.040E-05 0.1195 0.025583 0.0006545 0.1328 0.038883 0.0015119 0.099 0.005083 2.584E-05 0.0665 -0.02742 0.0007517 0.0563 -0.03762 1.415E-03 0.093917 Sum 0.0043793 Variance = 0.0043793/5 = 0.00087586

Because these data are historical data, the proper divisor for computing the variance is T1. Thus, the variance of the returns of each security is the sum of the squared deviations divided by five. 10.13 The range with 95% probability is: [ 10.8%, 47.6%] [ 18.42 14.6, 18.4+214.6]

Answers to EndofChapter Problems

B127

10.14

The following data was downloaded in March, 2005 for BCE, and has been provided for illustrative purposes only.
Closing Price 43.61 40.050 38.200 37.840 37.790 36.900 33.750 28.280 26.220 26.260 27.000 24.590 28.28 Return 0.089 0.048 0.010 0.001 0.024 0.093 0.193 0.079 (0.002) (0.027) 0.098 (0.130)

Oct07 Sep07 Aug07 Jul07 Jun07 May07 Apr07 Mar07 Feb07 Jan07 Dec06 Nov06 Oct06

Assume that on October 31, 2006, the investment of $1,000 was made in BCE stock. On October 31, 2007, this investment would now be worth: $1,000 x $43.61/28.28 = $1542.08

Using the information from the last column above, the geometric return = 0.0367 or 3.67% The average monthly return is: Total monthly returns from October 31/ 06 to October 31/07 = 0.4762/ 12 = 0.0397or 3.97% per month 10.15 The following information was downloaded in March, 2005 for Encana and is provided for illustrative purposes.
Oct07 Sep07 Aug07 Jul07 Jun07 May07 Apr07 Mar07 Feb07 Jan07 Dec06 Nov06 Oct06 Average Monthly Return Monthly Closing Price 69.700000 61.850000 58.500000 60.980000 61.450000 61.400000 52.450000 50.630000 48.570000 48.030000 45.950000 52.210000 47.490000 0.0351 Return (R) 0.126920 0.057265 (0.040669) (0.007648) 0.000814 0.170639 0.035947 0.042413 0.011243 0.045267 (0.119900) 0.099389 (RE(R))^2 0.008423578 0.000489517 0.005747003 0.001830848 0.001178246 0.018359922 0.000000651 0.000052898 0.000571064 0.000102550 0.024037500 0.004127989

Answers to EndofChapter Problems

B128

MINI CASE 1. 2. 3.

A Job at Deck Out My Yacht Corporation

The biggest advantage the mutual funds have is instant diversification. The mutual funds have a number of assets in the portfolio. Both the APR and EAR are infinite. The match is instantaneous, so the number of periods in a year is infinite. The advantage of the actively managed fund is the possibility of outperforming the market, which the fund has done over the past ten years. The major disadvantage is the likelihood of underperforming the market. In general, most mutual funds do not outperform the market for an extended period of time, and finding the funds that will outperform the market in the future beforehand is a daunting task. One factor that makes outperforming the market even more difficult is the management fee charged by the fund. The returns are the most volatile for the small cap fund because the stocks in this fund are the riskiest. This does not imply the fund is bad, just that the risk is higher, and therefore, the expected return is higher. You would want to invest in this fund if your risk tolerance is such that you are willing to take on the additional risk in expectation of a higher return. The higher expenses of the fund are expected. In general, small cap funds have higher expenses, in large part due to the greater cost of running the fund, including researching smaller stocks. The Sharpe ratio for each of the mutual funds and the company stocks are: M&M TSX Composite Index Fund = (11.48% 6.57%) / 15.82% = 0.3104 M&M SmallCap Fund = (16.68% 6.57%) / 19.64% = 0.5148 M&M Large Company Stock Fund = (11.85% 6.57%) / 15.41% = 0.3426 M&M Bond Fund = (9.67% 6.57%) / 10.83% =0.2862 Company Stock = (18% 6.57%) / 70% = 0.1633 The Sharpe ratio is most applicable for a diversified portfolio, and is least applicable for the company stock.

4.

5.

6.

This is a very openended question. The asset allocation depends on the risk tolerance of the individual. However, most students will be young, so in this case, the portfolio allocation should be more heavily weighted toward stocks. In any case, there should be little, if any, money allocated to the company stock. The principle of diversification indicates that an individual should hold a diversified portfolio. Investing heavily in company stock does not create a diversified portfolio. This is especially true since income comes from the company as well. If times get bad for the company, employees face layoffs, or reduced work hours. So, not only does the investment perform poorly, but income may be reduced as well. We only have to look at employees of Enron or WorldCom to see the potential for problems with investing in company stock. At most, 5 to 10 percent of the portfolio should be allocated to company stock. Age is a determinant in the decision. Older individuals should be less heavily weighted toward

Answers to EndofChapter Problems

B129

stocks. A commonly used rule of thumb is that an individual should invest 100 minus their age in stocks. Unfortunately, this rule of thumb tends to result in an underinvestment in stocks. Appendix 10A.1 The trend has been increasing over the past 200 years. It has been especially high since 1926, therefore, we should be cautious about assumptions we make about the current risk premium.

Answers to EndofChapter Problems

B130