CHAPTER 3 RISK AND RETURN

OVERVIEW
Risk is an important concept in financial analysis, especially in terms of how it affects security prices and rates of return. Investment risk is associated with the probability of low or negative future returns. The riskiness of an asset can be considered in two ways: ( ! on a stand-alone basis, where the asset"s cash flows are analy#ed all by themselves, or ($! in a portfolio context, where the cash flows from a number of assets are combined and then the consolidated cash flows are analy#ed. In a portfolio conte%t, an asset"s risk can be divided into two components: ( ! a diversifiable risk component, which can be diversified away and hence is of little concern to diversified investors, and ($! a market risk component, which reflects the risk of a general stock market decline and which cannot be eliminated by diversification, hence does concern investors. &nly market risk is relevant' diversifiable risk is irrelevant to most investors because it can be eliminated. (n attempt has been made to )uantify market risk with a measure called beta. *eta is a measurement of how a particular firm"s stock returns move relative to overall movements of stock market returns. The Capital Asset Pricing Model (CAPM), using the concept of beta and investors" aversion to risk, specifies the relationship between market risk and the re)uired rate of return. This relationship can be visuali#ed graphically with the +ecurity ,arket -ine (+,-!. The slope of the +,- can change, or the line can shift upward or downward, in response to changes in risk or re)uired rates of return.

OUTLINE
With most investments, an individual or business spends money today with the expe tation o! earnin" even more money in the !uture# The on ept o! return provides investors with a onvenient way o! expressin" the !inan ial per!orman e o! an investment# &ne way of e%pressing an investment return is in dollar terms. .ollar return / (mount received 0 (mount invested.

RI+1 (2. R3T4R2 5-$

3%pressing returns in dollars is easy, but two problems arise. To make a meaningful 6udgment about the ade)uacy of the return, you need to know the scale (si#e! of the investment. 7ou also need to know the timing of the return.

The solution to the scale and timing problems of dollar returns is to e%press investment results as rates of return, or percentage returns. Rate of return /

(mount received (mount invested . (mount invested

The rate of return calculation 8normali#es9 the return by considering the return per unit of investment. 3%pressing rates of return on an annual basis solves the timing problem. Rate of return is the most common measure of investment performance. Ris$ re!ers to the han e that some un!avorable event will o ur# Investment ris$ is related to the probability o! a tually earnin" less than the expe ted return% thus, the "reater the han e o! low or ne"ative returns, the ris$ier the investment# (n asset"s risk can be analy#ed in two ways: ( ! on a stand-alone basis, where the asset is considered in isolation, and ($! on a portfolio basis, where the asset is held as one of a number of assets in a portfolio. 2o investment will be undertaken unless the e%pected rate of return is high enough to compensate the investor for the perceived risk of the investment. The probability distribution for an event is the listing of all the possible outcomes for the event, with mathematical probabilities assigned to each. (n event"s probability is defined as the chance that the event will occur. The sum of the probabilities for a particular event must e)ual .:, or :: percent.

RI+1 (2. R3T4R2 5-5

T e expected rate of return ( r ! is the sum of the products of each possible outcome times its associated probability;it is a weighted average of the various possible outcomes, with the weights being their probabilities of occurrence:

3%pected rate of return / r / <i ri .

i/
=here the number of possible outcomes is virtually unlimited, continuous probability distributions are used in determining the e%pected rate of return of the event. The tighter, or more peaked, the probability distribution, the more likely it is that the actual outcome will be close to the e%pected value, and, conse)uently, the less likely it is that the actual return will end up far below the e%pected return. Thus, the tighter the probability distribution, the lower the risk assigned to a stock.

&ne measure for determining the tightness of a distribution is the standard deviation, .

+tandard deviation / /

i/

( r i - r ! <i .

The standard deviation is a probability-weighted average deviation from the e%pected value, and it gives you an idea of how far above or below the e%pected value the actual value is likely to be. (nother useful measure of risk is the coefficient of variation (C!), which is the standard deviation divided by the e%pected return. It shows the risk per unit of return, and it provides a more meaningful basis for comparison when the e%pected returns on two alternatives are not the same:
>oefficient of variation (>?! /

,ost investors are risk averse. This means that for two alternatives with the same e%pected rate of return, investors will choose the one with the lower risk.

RI+1 (2. R3T4R2 5-@

In a market dominated by risk-averse investors, riskier securities must have higher e%pected returns, as estimated by the marginal investor, than less risky securities, for if this situation does not hold, buying and selling in the market will force it to occur. &n asset held as part o! a port!olio is less ris$y than the same asset held in isolation# This is important, be ause most !inan ial assets are not held in isolation% rather, they are held as parts o! port!olios# 'rom the investor(s standpoint, what is important is the return on his or her port!olio, and the port!olio(s ris$)not the !a t that a parti ular sto $ "oes up or down# Thus, the ris$ and return o! an individual se urity should be analy*ed in terms o! how it a!!e ts the ris$ and return o! the port!olio in whi h it is held# The e%pected return on a portfolio,
r p , is the weighted average of the e%pected returns on the individual assets in the

portfolio, with the weights being the fraction of the total portfolio invested in each asset: r p = "i r i .
i= n

The riskiness of a portfolio, p , is generally not a weighted average of the standard deviations of the individual assets in the portfolio' the portfolio"s risk will be smaller than the weighted average of the assets" As. The riskiness of a portfolio depends not only on the standard deviations of the individual stocks, but also on the correlation bet"een t e stocks. The correlation coefficient, , measures the tendency of two variables to move together. =ith stocks, these variables are the individual stock returns. .iversification does nothing to reduce risk if the portfolio consists of perfectly positively correlated stocks. (s a rule, the riskiness of a portfolio will decline as the number of stocks in the portfolio increases. Bowever, in the real world, where the correlations among the individual stocks are generally positive but less than C .:, some, but not all, risk can be eliminated. In the real world, it is impossible to form completely riskless stock portfolios. .iversification can reduce risk, but cannot eliminate it.

RI+1 (2. R3T4R2 5-D

=hile very large portfolios end up with a substantial amount of risk, it is not as much risk as if all the money were invested in only one stock. (lmost half of the riskiness inherent in an average individual stock can be eliminated if the stock is held in a reasonably welldiversified portfolio, which is one containing @: or more stocks. #iversifiable risk is that part of the risk of a stock which can be eliminated. It is caused by events that are uni)ue to a particular firm. Market risk is that part of the risk which cannot be eliminated, and it stems from factors which systematically affect most firms, such as war, inflation, recessions, and high interest rates. It can be measured by the degree to which a given stock tends to move up or down with the market. Thus, market risk is the relevant risk, which reflects a security"s contribution to the portfolio"s risk. The Capital Asset Pricing Model is an important tool for analy#ing the relationship between risk and rates of return. The model is based on the proposition that any stock"s re)uired rate of return is e)ual to the risk-free rate of return plus a risk premium, which reflects only the risk remaining after diversification. Its primary conclusion is: The relevant riskiness of an individual stock is its contribution to the riskiness of a well-diversified portfolio. The tenden y o! a sto $ to move with the mar$et is re!le ted in its beta oe!!i ient, b, whi h is a measure o! the sto $(s volatility relative to that o! an avera"e sto $# (n average-risk stock is defined as one that tends to move up and down in step with the general market. *y definition it has a beta of .:. ( stock that is twice as volatile as the market will have a beta of $.:, while a stock that is half as volatile as the market will have a beta coefficient of :.D. +ince a stock"s beta measures its contribution to the riskiness of a portfolio, beta is the theoretically correct measure of the stock"s riskiness. The beta coefficient of a portfolio of securities is the weighted average of the individual securities" betas:

bp /

w b.
i i i/

+ince a stock"s beta coefficient determines how the stock affects the riskiness of a diversified portfolio, beta is the most relevant measure of any stock"s risk. The +apital &sset ,ri in" -odel .+&,-/ employs the on ept o! beta, whi h measures ris$ as the relationship between a parti ular sto $(s movements and the movements o! the

RI+1 (2. R3T4R2 5-E

overall sto $ mar$et# The +&,- uses a sto $(s beta, in on0un tion with the avera"e investor(s de"ree o! ris$ aversion, to al ulate the return that investors re1uire, r s, on that parti ular sto $# The $ecurity Market %ine ($M%) shows the relationship between risk as measured by beta and the re)uired rate of return for individual securities. The +,- e)uation can be used to find the re)uired rate of return on +tock i:
Re)uired Rate of Return (H!

+,- / r i / rRF C (r, - rRF!bi

r, r RF

,arket risk premium

:.D

.:

Risk, bi

+,-: ri / rRF C (r, 0 rRF!bi. Bere rRF is the rate of interest on risk-free securities, bi is the ith stock"s beta, and r, is the return on the market or, alternatively, on an average stock. The term r, 0 rRF is the market risk premium, &PM. This is a measure of the additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. In the >(<,, the market risk premium, r, 0 rRF, is multiplied by the stock"s beta coefficient to determine the additional premium over the risk-free rate that is re)uired to compensate investors for the risk inherent in a particular stock. This premium may be larger or smaller than the premium re)uired on an average stock, depending on the riskiness of that stock in relation to the overall market as measured by the stock"s beta. The risk premium calculated by (r, 0 rRF!bi is added to the risk-free rate, rRF (the rate on Treasury securities!, to determine the total rate of return re)uired by investors on a particular stock, rs. The slope of the +,-, (r, 0 rRF!, shows the increase in the re)uired rate of return for a one unit increase in risk. It reflects the degree of risk aversion in the economy. The risk-free (also known as the nominal, or )uoted! rate of interest consists of two elements: ( ! a real inflation-free rate of return, rG, and ($! an inflation premium, I<, e)ual to the anticipated rate of inflation. The real rate on long-term Treasury bonds has historically ranged from $ to @ percent, with a mean of about 5 percent.

RI+1 (2. R3T4R2 5-I

(s the e%pected rate of inflation increases, a higher premium must be added to the real risk-free rate to compensate for the loss of purchasing power that results from inflation.

(s risk aversion increases, so do the risk premium and, thus, the slope of the +,-. The greater the average investor"s aversion to risk, then ( ! the steeper the slope of the line, ($! the greater the risk premium for all stocks, and (5! the higher the re)uired rate of return on all stocks. ,any factors can affect a company"s beta. =hen such changes occur, the re)uired rate of return also changes. ( firm can influence its market risk, hence its beta, through changes in the composition of its assets and also through its use of debt. ( company"s beta can also change as a result of e%ternal factors such as increased competition in its industry, the e%piration of basic patents, and the like. 'or a mana"ement whose primary "oal is sto $ pri e maximi*ation, the overridin" onsideration is the ris$iness o! the !irm(s sto $, and the relevant ris$ o! any physi al asset must be measured in terms o! its e!!e t on the sto $(s ris$ as seen by investors# & number o! re ent studies have raised on erns about the validity o! the +&,-# ( recent study by Fama and French found no historical relationship between stocks" returns and their market betas. They found two variables which are consistently related to stock returns: ( ! a firm"s si#e and ($! its marketJbook ratio. (fter ad6usting for other factors, they found that smaller firms have provided relatively high returns, and that returns are higher on stocks with low marketJbook ratios. *y contrast, after controlling for firm si#e and marketJbook ratios, they found no relationship between a stock"s beta and its return. (s an alternative to the traditional >(<,, researchers and practitioners have begun to look to more general multi-beta models that encompass the >(<, and address its shortcomings. In the multi-beta model, market risk is measured relative to a set of factors that determine the behavior of asset returns, whereas the >(<, gauges risk only relative to the market return. The risk factors in the multi-beta model are all nondiversifiable sources of risk. Earnin"s volatility does not ne essarily imply investment ris$# 2ou have to thin$ about the auses o! the volatility be!ore rea hin" any on lusions as to whether earnin"s volatility indi ates ris$# 3owever, sto $ pri e volatility does si"ni!y ris$ .ex ept !or sto $s that are

RI+1 (2. R3T4R2 5-K

ne"atively orrelated with the mar$et, whi h are !ew and !ar between, i! they exist at all/#

4EL'5TE4T 6UE4TION4
7e!initional 8# 9# :# ;# <# =# ># ?# @# 8A# 88# Investment risk is associated with the LLLLLLLLLLLLL of low or negative returns' the greater the chance of loss, the riskier the investment. ( listing of all possible LLLLLLLLLL, with a probability assigned to each, is known as a probability LLLLLLLLLLLLLL. =eighting each possible outcome of a distribution by its LLLLLLLLLLLLL of occurrence and summing the results give the e%pected LLLLLLLL of the distribution. &ne measure of the tightness of a probability distribution is the LLLLLLLLLL LLLLLLLLLLL, a probability-weighted average deviation from the e%pected value. Investors who prefer outcomes with a high degree of certainty to those that are less certain are described as being LLLLLL LLLLLLLL. &wning a portfolio of securities enables investors to benefit from LLLLLLLLLLLLLLLLL. .iversification of a portfolio can result in lower LLLLLL for the same level of return. .iversification of a portfolio is achieved by selecting securities that are not perfectly LLLLLLLLLLLL correlated with each other. That part of a stock"s risk that can be eliminated is known as LLLLLLLLLLLLLLL risk, while the portion that cannot be eliminated is called LLLLLLLL risk. The LLLLLL coefficient measures a stock"s relative volatility as compared with a stock market inde%. ( stock that is twice as volatile as the market would have a beta coefficient of LLLLL, while a stock with a beta of :.D would be only LLLLLL as volatile as the market.

RI+1 (2. R3T4R2 5-M

89# 8:# 8;# 8<# 8=# 8># 8?# 8@# 9A# 98# 99#

The beta coefficient of a portfolio is the LLLLLLLLLL LLLLLLLLL of the betas of the individual stocks. The minimum e%pected return that will induce investors to buy a particular security is the LLLLLLLLLL rate of return. The security used to measure the LLLLLL-LLLLLL rate is the return available on 4. +. Treasury securities. The risk premium for a particular stock may be calculated by multiplying the market risk premium times the stock"s LLLLLL LLLLLLLLLLLLL. ( stock"s re)uired rate of return is e)ual to the LLLLLL-LLLLLL rate plus the stock"s LLLLLL LLLLLLLLL. The risk-free rate on a short-term Treasury security is made up of two parts: the LLLLLL LLLLLL-LLLLLL rate plus a(n! LLLLLLLLLLL premium. >hanges in investors" risk aversion alter the LLLLLLL of the +ecurity ,arket -ine. The concept of LLLLLLLL provides investors with a convenient way of e%pressing the financial performance of an investment. (n event"s LLLLLLLLLLLLL is defined as the chance that the event will occur. Investment returns can be e%pressed in LLLLLLLL terms or as LLLLLLL LLLL LLLLLLLL, or percentage returns. The LLLLLLLLLLLLL LLLL LLLLLLLLLLL shows the risk per unit of return, and it provides a more meaningful basis for comparison when the e%pected returns on two alternatives are not the same.

+on eptual 9:# The 7-a%is intercept of the +ecurity ,arket -ine (+,-! indicates the re)uired rate of return on an individual stock with a beta of .:. a# True 9;# b# False

If a stock has a beta of #ero, it will be riskless when held in isolation. a# True b# False

RI+1 (2. R3T4R2 5- :

9<#

( group of $:: stocks each has a beta of .:. =e can be certain that each of the stocks was positively correlated with the market. a# True b# False

9=#

Refer to +elf-Test Nuestion $D. If we combined these same $:: stocks into a portfolio, market risk would be reduced below the average market risk of the stocks in the portfolio. a# True b# False

9>#

Refer to +elf-Test Nuestion $E. The standard deviation of the portfolio of these $:: stocks would be lower than the standard deviations of the individual stocks. a# True b# False

9?#

+uppose rRF / IH and r, / $H. If investors became more risk averse, r, would be likely to decrease. a# True b# False

9@#

Refer to +elf-Test Nuestion $K. The re)uired rate of return for a stock with b / :.D would increase more than for a stock with b / $.:. a# True b# False

:A#

Refer to +elf-Test Nuestions $K and $M. If the e%pected rate of inflation increased, the re)uired rate of return on a b / $.: stock would rise by more than that of a b / :.D stock. a# True b# False

:8#

=hich is the best measure of risk for an asset held in a well-diversified portfolioO a# ?ariance b# +tandard deviation # *eta d# +emi-variance e# 3%pected value

:9#

In a portfolio of three different stocks, which of the following could not be trueO a# b# # d# The riskiness of the portfolio is less than the riskiness of each stock held in isolation. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks. The beta of the portfolio is less than the beta of each of the individual stocks. The beta of the portfolio is greater than the beta of one or two of the individual

RI+1 (2. R3T4R2 5-

stocks. e# The beta of the portfolio is e)ual to the beta of one of the individual stocks. ::# If investors e%pected inflation to increase in the future, and they also became more risk averse, what could be said about the change in the +ecurity ,arket -ine (+,-!O a# b# # d# e# :;# The +,- would shift up and the slope would increase. The +,- would shift up and the slope would decrease. The +,- would shift down and the slope would increase. The +,- would shift down and the slope would decrease. The +,- would remain unchanged.

=hich of the following statements is most correctO a# The +,- relates re)uired returns to firms" market risk. The slope and intercept of this line cannot be controlled by the financial manager. b# The slope of the +,- is determined by the value of beta. # If you plotted the returns of a given stock against those of the market, and if you found that the slope of the regression line was negative, then the >(<, would indicate that the re)uired rate of return on the stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is e%pected to continue on into the future. d# If investors become less risk averse, the slope of the +ecurity ,arket -ine will increase. e# +tatements a and c are both true.

:<#

=hich of the following statements is most correctO a# 2ormally, the +ecurity ,arket -ine has an upward slope. Bowever, at one of those unusual times when the yield curve on bonds is downward sloping, the +,- will also have a downward slope. b# The market risk premium, as it is used in the >(<, theory, is e)ual to the re)uired rate of return on an average stock minus the re)uired rate of return on an average company"s bonds. # If the marginal investor"s aversion to risk decreases, then the slope of the yield curve would, other things held constant, tend to increase. If e%pectations for inflation also increased at the same time risk aversion was decreasing;say the e%pected inflation rate rose from D percent to K percent;the net effect could possibly result in a parallel upward shift in the +,-. d# (ccording to the te%t, it is theoretically possible to combine two stocks, each of which would be )uite risky if held as your only asset, and to form a $-stock portfolio that is riskless. Bowever, the stocks would have to have a correlation coefficient of e%pected future returns of - .:, and it is hard to find such stocks in the real world.

RI+1 (2. R3T4R2 5- $

e# 3ach of the above statements is false. :=# =hich of the following statements is most correctO a# The e%pected future rate of return, r , is always above the past reali#ed rate of return, r , e%cept for highly risk-averse investors. b# The e%pected future rate of return, r , is always belo" the past reali#ed rate of return, r , e%cept for highly risk-averse investors. # The e%pected future rate of return, r , is always belo" the re)uired rate of return, r, e%cept for highly risk-averse investors. d# There is no logical reason to think that any relationship e%ists between the e%pected future rate of return, r , on a security and the security"s re)uired rate of return, r. e# 3ach of the above statements is false. :># =hich of the following statements is most correctO a# +omeone who is highly averse to risk should invest in stocks with high betas (above C .:!, other things held constant. b# The returns on a stock might be highly uncertain in the sense that they could actually turn out to be much higher or much lower than the e%pected rate of return (that is, the stock has a high standard deviation of returns!, yet the stock might still be regarded by most investors as being less risky than some other stock whose returns are less variable. # The standard deviation is a better measure of risk when comparing securities than the coefficient of variation. This is true because the standard deviation 8standardi#es9 risk by dividing each security"s variance by its e%pected rate of return. d# ,arket risk can be reduced by holding a large portfolio of stocks, and if a portfolio consists of all traded stocks, market risk will be completely eliminated. e# The market risk in a portfolio declines as more stocks are added to the portfolio, and the risk decline is linear, that is, each additional stock reduces the portfolio"s risk by the same amount.

RI+1 (2. R3T4R2 5- 5

4EL'5TE4T ,ROBLE-4
8# +tock ( has the following probability distribution of e%pected returns: <robability :. :.$ :.@ :.$ :. Rate of Return - DH : D : $D

=hat is +tock ("s e%pected rate of return and standard deviationO a# K.:H' M.DH b# K.:H' E.DH # D.:H' 5.DH 9# If rRF / DH, r, / +tock PO a# :# K.IH d# D.:H' E.DH e# D.:H' M.DH H, and b / .5 for +tock P, what is rP, the re)uired rate of return for b# E.IH # @.KH d# $.KH e# .MH

Refer to +elf-Test <roblem $. =hat would r P be if investors e%pected the inflation rate to increase by $ percentage pointsO a# K.IH b# E.IH # @.KH d# $.KH e# .MH

;#

Refer to +elf-Test <roblem $. =hat would rP be if an increase in investors" risk aversion caused the market risk premium to increase by 5 percentage pointsO r RF remains at D percent. a# K.IH b# E.IH # @.KH d# $.KH e# .MH

<#

Refer to +elf-Test <roblem $. =hat would kP be if investors e%pected the inflation rate to increase by $ percentage points and their risk aversion increased by 5 percentage pointsO a# K.IH b# E.IH # @.KH d# $.KH e# .MH

RI+1 (2. R3T4R2 5- @

=#

Qan ,iddleton owns a 5-stock portfolio with a total investment value e)ual to R5::,:::. +tock ( * > Total Investment R ::,::: ::,::: ::,::: R5::,::: *eta :.D .: .D

=hat is the weighted average beta of Qan"s 5-stock portfolioO a# :.M ># b# .5 # .: d# :.@ e# .$

The (pple Investment Fund has a total investment of R@D: million in five stocks. +tock $ 5 @ D Total Investment (,illions! R 5: : I: M: D: R@D: *eta :.@ .D 5.: $.: .:

=hat is the fund"s overall, or weighted average, betaO a# ?# . @ b# .$$ # .5D d# .@E e# .D5

Refer to +elf-Test <roblem I. If the risk-free rate is $ percent and the market risk premium is E percent, what is the re)uired rate of return on the (pple FundO a# $:.IEH b# M.M$H # K.K H d# I.E$H e# D.IIH

@#

+tock ( has a beta of .$, +tock * has a beta of :.E, the e%pected rate of return on an average stock is $ percent, and the risk-free rate of return is I percent. *y how much does the re)uired return on the riskier stock e%ceed the re)uired return on the less risky stockO a# @.::H b# 5.$DH # 5.::H d# $.D:H e# 5.IDH

8A#

7ou are managing a portfolio of : stocks which are held in e)ual dollar amounts. The current beta of the portfolio is .K, and the beta of +tock ( is $.:. If +tock ( is sold and the proceeds are used to purchase a replacement stock, what does the beta of the replacement stock have to be to lower the portfolio beta to .IO a# .@ b# .5 # .$ d# . e# .:

RI+1 (2. R3T4R2 5- D

88#

>onsider the following information for the (lachua Retirement Fund, with a total investment of R@ million. +tock ( * > . Total Investment R @::,::: E::,::: ,:::,::: $,:::,::: R@,:::,::: *eta .$ -:.@ .D :.K

The market re)uired rate of return is $ percent, and the risk-free rate is E percent. =hat is its re)uired rate of returnO a# M.MKH 89# b# :.@DH # .: H d# .D:H e# $.DEH

7ou are given the following distribution of returns: <robability :.@ :.D :. Return R5: $D -$:

=hat is the coefficient of variation of the e%pected dollar returnsO a# $:E.$D:: 8:# b# :.E5K5 # @.5E @ d# :.ID:: e# .$D::

If the risk-free rate is K percent, the e%pected return on the market is 5 percent, and the e%pected return on +ecurity Q is D percent, then what is the beta of +ecurity QO a# .@: b# :.M: # .$: d# .D: e# :.ID

RI+1 (2. R3T4R2 5- E

&N4WER4 TO 4EL'5TE4T 6UE4TION4

8# 9# :# ;# <# =# ># ?# @# 8A# 88# 9:# 9;# probability outcomes' distribution probability' return standard deviation risk averse diversification risk positively diversifiable' market beta $.:' half 89# 8:# 8;# 8<# 8=# 8># 8?# 8@# 9A# 98# 99# weighted average re)uired risk-free beta coefficient risk-free' risk premium real risk-free' inflation slope return probability dollar' rates of return coefficient of variation

b. The 7-a%is intercept of the +,- is rRF, which is the re)uired rate of return on a security with a beta of #ero. b. ( #ero beta stock could be made riskless if it were combined with enough other #ero beta stocks, but it would still have company-specific risk and be risky when held in isolation. a. *y definition, if a stock has a beta of .: it moves e%actly with the market. In other words, if the market moves up by I percent, the stock will also move up by I percent, while if the market falls by I percent, the stock will fall by I percent. b. ,arket risk is measured by the beta coefficient. The beta for the portfolio would be a weighted average of the betas of the stocks, so bp would also be .:. Thus, the market risk for the portfolio would be the same as the market risk of the stocks in the portfolio. a. 2ote that with a $::-stock portfolio, the actual returns would all be on or close to the regression line. Bowever, when the portfolio (and the market! returns are )uite high, some individual stocks would have higher returns than the portfolio, and some would have much lower returns. Thus, the range of returns, and the standard deviation, would be higher for the individual stocks. b. R<,, which is e)ual to r, rRF, would rise, leading to an increase in r,. b. The re)uired rate of return for a stock with b / :.D would increase less than the return on a stock with b / $.:.

9<#

9=#

9>#

9?# 9@#

RI+1 (2. R3T4R2 5- I

:A#

b. If the e%pected rate of inflation increased, the +,- would shift parallel due to an increase in rRF. Thus, the effect on the re)uired rates of return for both the b / :.D and b / $.: stocks would be the same. c. The best measure of risk is the beta coefficient, which is a measure of the e%tent to which the returns on a given stock move with the stock market. c. The beta of the portfolio is a weighted average of the individual securities" betas, so it could not be less than the betas of all of the stocks. (+ee +elf-Test <roblem E.! a. The increase in inflation would cause the +,- to shift up, and investors becoming more risk averse would cause the slope to increase. (This can be demonstrated by graphing the +,- lines on the same graph in +elf-Test <roblems $ through D.! e. +tatement b is false because the slope of the +,- is r , rRF. +tatement d is false because as investors become less risk averse the slope of the +,- decreases. +tatement a is correct because the financial manager has no control over r, or rRF. (r, rRF / slope and rRF / intercept of the +,-.! +tatement c is correct because the slope of the regression line is beta and beta would be negative' thus, the re)uired return would be less than the risk-free rate. d. +tatement a is false. The yield curve determines the value of rRF' however, +,- / rRF C (r, rRF!b. The average return on the market will always be greater than the riskfree rate' thus, the +,- will always be upward sloping. +tatement b is false because R<, is e)ual to r, rRF. rRF is e)ual to the risk-free rate, not the rate on an average company"s bonds. +tatement c is false. ( decrease in an investor"s aversion to risk would indicate a downward sloping yield curve. ( decrease in risk aversion and an increase in inflation would cause the +,- slope to decrease and to shift upward simultaneously. e. (ll the statements are false. For e)uilibrium to e%ist, the e%pected return must e)ual the re)uired return. b. +tatement b is correct because the stock with the higher standard deviation might not be highly correlated with most other stocks, hence have a relatively low beta, and thus not be very risky if held in a well-diversified portfolio. The other statements are simply false.

:8# :9# ::#

:;#

:<#

:=# :>#

RI+1 (2. R3T4R2 5- K

4OLUTION4 TO 4EL'5TE4T ,ROBLE-4

8# e. r A = :. (- DH! C :.$(:H! C :.@(DH! C :.$( :H! C :. ($D! / D.:H. ?ariance / :. (-:. D 0 :.:D!$ C :.$(:.: 0 :.:D!$ C :.@(:.:D 0 :.:D!$ C :.$(:. : 0 :.:D!$ C :. (:.$D 0 :.:D!$ / :.::M. +tandard deviation / 9# :#
:.::M / :.:M@M / M.DH.

d. rP / rRF C (r, 0 rRF!bP / DH C (

H 0 DH! .5 / $.KH.

c. rP / rRF C (r, 0 rRF!bP / IH C ( 5H 0 IH! .5 / @.KH. ( change in the inflation premium does not change the market risk premium (r, rRF! since both r, and rRF are affected.

;# <# =#

b. rP / rRF C (r, 0 rRF!bP / DH C ( @H 0 DH! .5 / E.IH. a. rP / rRF C (r, 0 rRF!bP / IH C ( EH 0 IH! .5 / K.IH. c. The calculation of the portfolio"s beta is as follows: bp / ( J5!(:.D! C ( J5!( .:! C ( J5!( .D! / .:.
D

>#

d.

b p / w i bi
i/

R 5: R : RI: RM: RD: ( : .@ ! + ( .D! + (5.:! + ($.:! + ( .:! = .@E. R@D: R@D: R@D: R@D: R@D:

?#

a. rp / rRF C (r, 0 rRF!bp / $H C (EH! .@E / $:.IEH.

RI+1 (2. R3T4R2 5- M

@#

c. =e know b( / .$:, b* / :.E:' r, / $H, and rRF / IH. ri / rRF C (r, 0 rRF!bi / IH C ( $H 0 IH!bi. r( / IH C DH( .$:! / 5.:H. r* / IH C DH(:.E:! / :.:H. r( 0 r* / 5H 0 :H / 5H.

8A#

e. First find the beta of the remaining M stocks: .K / :.M(bR! C :. (b(! .K / :.M(bR! C :. ($.:! .K / :.M(bR! C :.$ .E / :.M(bR! bR / .IK. 2ow find the beta of the new stock that produces bp / .I. .I / :.M( .IK! C :. (b2! .I / .E C :. (b2! :. / :. (b2! b2 / .:.

88#

c. .etermine the weight each stock represents in the portfolio: Investment @::,::: E::,::: ,:::,::: $,:::,::: % *eta. . .. .. .. bp / :.K5D: / <ortfolio beta

=rite out the +,- e)uation, and substitute known values including the portfolio beta. +olve for the re)uired portfolio return. rp / rRF C (r, 0 rRF!bp / EH C ( $H 0 EH!:.K5D: / EH C D.: H / .: H.

RI+1 (2. R3T4R2 5 - $:

89#

b. 4se the given probability distribution of returns to calculate the e%pected value, variance, standard deviation, and coefficient of variation.
<i

ri

P i ri

ri

( ri r !

( ri r ! $

P ( ri r ! $

:.@ :.D :.

% R5: % $D % -$:
r

/ R $.: / $.D / -$.: / R$$.D

R5: - R$$.D $D - $$.D -$: - $$.D

/ / /

R I.D $.D -@$.D

DE.$D R $$.D:: E.$D 5. $D ,K:E.$D K:.E$D $ / ?ariance /

R$:E.$D:

! of r is R$:E.$D =R @.5E @ . The standard deviation ( 4se the standard deviation and the e%pected return to calculate the coefficient of variation: R @.5E @JR$$.D / :.E5K5.

8:#

a. 4se the +,- e)uation, substitute in the known values, and solve for beta. rRF / KH' r, / 5H' rQ / DH. rQ DH IH bQ / rRF C (r, 0 rRF!bQ / KH C ( 5H 0 KH!bQ / (DH!bQ / .@.