Chapter 4: Risk and Return: An Overview of Capital Market Theory

Problem 1
Purchase price of L&Ts share
Number of shares purchased 1 Jan. 2004
Share price on sale after one year 31 Dec. 2004
Total dividend received
Capital gain per share: 215 - 212
Total capital gain: 3 100
Total return: 700 + 300
Percentage return: 1,000/(212 100)

212
100
215
700
3
300
1000
4.72%

Problem 2
Closing price last year, Rs
Dividend per share, Rs
Closing price current year, Rs
Dividend yield: 5/50
Capital gain percentage: (57 50)/50
Percentage total share return: 5/50 + (57 50)/50

50
5
57
10%
14%
24%

Problem 3
Purchase price, Rs
Number of shares purchased
Total price paid for shares, Rs
Par value of Telcos share, Rs
Dividend rate
Dividend per share (Rs): 10 15%
Total dividend (Rs): 1.50 200
Realised amount from sale of shares after one year, Rs
Capital gain: 18,500 17,400
Dividend yield: 1.50/87 or 300/17,400
Capital gain percentage: 1,100/17,400
Total rupee return: 300 + 1,100
Total percentage return: 1,400/17,400 or 1.72% + 6.32%

87
200
17,400
10
15%
1.5
300
18,500
1,100
1.72%
6.32%
1,400
8.05%

Problem 4

90
125+ 4,535
4, 250=
+
1
( 1+r ) (1+ r )2
By trial and error = 5 . 8%
Problem 5
Nominal rate of return
Inflation rate
Real rate of return:1.17 = (1 + real rate) (1.055)
Real rate = 1.17/1.055 - 1

17%
5.50%
10.90%

Problem 6
Share price Hind & Nirmala - two years ago, Rs
Fall in Hind price after one year
Increase in Hind price after two years
Hinds share price after two years, Rs: 100 0.88 1.12

100
-12%
12%
98.56

Fall in Nirmalas price after one year

Increase in Nirmalas price after two years
Nirmalas share price after two years, Rs: 100 1.12 0.88

12%
-12%
98.56

Problem 7
7-year holding period return:
(1.153 0.945 1.173 1.25 1.168 1.095 1.288) -1 = 1.63 or 163%
Compound rate of return:

1.63
1.15

= 1. 153 0 . 945 1 .173 1 .25 1 .168 1 . 095 1 . 2881=1.15 or115

Problem 8
Year
1
2
3
4
5
Sum
Average
Variance
Stdev

(ri - 9.7%)2
Return, r
5.30%
0.19%
15.60%
0.35%
-7.30%
2.88%
15.00%
0.28%
19.80%
1.02%
48.40%
4.73%
9.68%
0.0118317
0.10877362
10.88%

Problem 9

Year
Rapid growth
Moderate growth
Recession
Expected return
Variance
Stdev

Return, r
Prob.
19.50%
14.00%
7.00%

(ri - 12.73%)2
r prob.
Prob
0.15
2.93%
0.07%
0.55
7.70%
0.01%
0.3
2.10%
0.10%
12.73%
0.18%
4.20%

Problem 10

Return, Ri

Probability,
p
20
18
8
0
-6

0.10
0.45
0.30
0.05
0.1
ER

Expected
Return, ER
Rip
2.0
8.1
2.4
0.0
-0.6
11.9

Deviation
(Ri - ER)
8.1
6.1
-3.9
-11.9
-17.9

Square of
Deviation
(Ri - ER)2
65.61
37.21
15.21
141.61
320.41
(Ri - ER)2p

66.99=8.18

STDEV, s
Problem 11
Security X
Return
Rx

Probability Exp. Return Deviation

p
ER = Rxp (Rx - ER)
30
20
10

0.1
0.2
0.4

3
4
4

Sq. Deviation
(Rx - ER)2
19
9
-1

361
81
1

5
-10

0.2
0.1
ER

1
-1
11

-6
-21

36
441
(Rx - ER)2
920

104 =10 .2

STDEV, s
Security Y
Return
Ry

Probability Exp. Return Deviation

p
ER = Ryp (Ry - ER)
-20
10
20
30
40

0.05
0.25
0.30
0.30
0.1
ERy

-1.0
2.5
6.0
9.0
4.0
20.5

Sq. Deviation
(Ry - ER)2

-40.5
-10.5
-0.5
9.5
19.5

1640.25
110.25
0.25
90.25
380.25
(Ry - ER)2
2221.25

STDEV, s

174 . 45=13 .22

Portfolio of Security XY
Probability, Deviation, X Dev. x Prob.
X
px

(Rx - ERx)
0.10
0.20
0.40
0.20
0.10

Var. X
varx

19
9
-1
-6
-21

Var. Y
vary

104

(Rx - ERx)p

py

1.9
1.8
-0.4
-1.2
-2.1

Weight X
wx

174.75

Probability, Y

0.5

0.05
0.25
0.30
0.30
0.10

Sq. weight X
w2x
0.25

The formula for calculating the standard deviation of portfolio of X and Y securities is as follows:

s p = s2x w2x +s 2y w2y + 2 wx w y cov ar xy

104 0 . 25+174 . 75 0 . 25+2 0 . 5 0 . 5 -16 . 03
61. 67 = 7 . 85
Problem 12
Security P
Probability,
p
0.3
0.4
0.3
STDEV, P
Market portfolio M

Return, RP
30
20
0
ER

Exp. ret
R P x pP

Deviation
(RP - ERP)
9
8
0
17

13
3
-17

Return , RM

Exp. ret.
RM x pM

-10
20
30
ERM

Deviation
(RM - ERM)

-3
8
9
14

-24
6
16

P
Standard
deviation

576
36
256
varM
M

M
11.87

Covariance
Correlation
Beta

Deviation sq.
(RM - ERM)2

16.25

corrPM = covarPM/sM sP
bata = corrPMsPsM / s2M

Problem 13
Return
Year
1
2
3
4
5
6
7
Average

Share
portfolio
Treasury Bills Risk premium
22.50%
11.40%
11.10%
-6.80%
9.80%
-16.60%
26.80%
10.50%
16.30%
24.60%
9.90%
14.70%
3.20%
9.20%
-6.00%
15.70%
8.90%
6.80%
12.30%
11.20%
1.10%
14.04%
10.13%
3.91%

Realised premium is based on historical data, and as we can see from the above table, in some years it can be negative. The
average risk premium is expected to be positive when a very long period of time, covering various phases of economic
cycles, is considered.
Problem 14
Return
Economic state
Growth
Decline
Stagnation
Average

Prob.
0.2
0.3
0.5

Expected return

Market
Treasury Bills Market
28.50%
9.70%
5.70%
-5.00%
9.50%
-1.50%
17.90%
9.20%
8.95%
13.80%
9.47%
4.38%

Problem 15

S=

020 . 0
=2. 0
10 . 0

S equal to -2 implies that zero return is positioned 2 standard deviations to the left of the expected value of the probability distributions of possible retu
The probability of being less than 2 standard deviations from the expected value is 0.0228 (see Annexure Table F). This means that there is 2.28%
probability that the return will be zero or less. There is about 67% probability that the return would range between 10% and 30%. There is 95% chance
the return will be between zero [20% - 2 10%] and 40% [20% + 2 10%].
Problem 16

S=

30 . 022. 0
=0 . 32
25 . 0

S equal to 0.32 lies to the right of the expected value. From Annexure Table F, we find that there is about 12.6 % probability that the return will be 30%

 66.99=8.18

Product
(Ri - ER)2p
6.56
16.74
4.56
7.08
32.04
66.99
8.18

Product
(Rx - ER)2p
36.1
16.2
0.4

7.2
44.1
(Rx - ERx)2p
104
10.20

Product
(Ry- ER)2p
82.0125
27.5625
0.075
27.075
38.025
(Ry - ER)2p

74 . 45=13 .22

174.75
13.22

Covariance
Deviation, Y Dev. x Prob. (Rx - ERx)p
(Ry - Ery)
-40.5
-10.5
-0.5
9.5
19.5

Weight Y
wy
0.5

(Ry - Ery)2p
-2.03
-2.63
-0.15
2.85
1.95
Covxy
Sq weight Y
wy2
0.25

Deviation sq.
(RP - ERP)2 (RP - ERP)2p
169
9
289
varP

50.7
3.6
86.7
141
11.87

x (Ry - Ery)2p
-3.85
-4.73
0.06
-3.42
-4.10
-16.03
Cov. XY
covxy
-16.03

Var XY
varxy

SD XY
sxy
61.67

7.85

[(RP - ERP) [(RP - ERP)

(RM - ERM)2pM (RM - ERM)] (RM - ERM)]p
172.8
14.4
76.8
264

-312
18
-272
covarPM

16.25

-168
-0.871
-0.636

Expected return
Risk
Treasury Bills premium
1.94%
3.76%
2.85%
-4.35%
4.60%
4.35%
3.13%
1.25%

probability distributions of possible returns.

F). This means that there is 2.28%
een 10% and 30%. There is 95% chance that

% probability that the return will be 30% or more.

-93.6
7.2
-81.6
-168