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UNIVERSITY OF TECHNOLOGY

Unit 4: Risk and Return. TUTORIAL QUESTIONS

1. If a company's beta were to double, would its returns double? (5.6)

ks = krf + (km – krf) ßs

Where: ks = the required return of the security, krf = the nominal risk free rate, km = the
average return on the market, ßs = Beta of the security, (km - krf) ßs = the risk premium of
the security

(km - krf) = the market risk premium, i.e. the premium the market provides over the risk
free rate

According to the Security Market Line (SML) equation, an increase in beta will increase
a company’s expected return by an amount equal to the market risk premium times the
change in beta. For example, assume that the risk-free rate is 6 percent, and the market
risk premium is 5 percent. If the company’s beta doubles from 0.8 to 1.6 its expected
return increases from 10 percent to 14 percent. Therefore, in general, a company’s
expected return will not double when its beta doubles.

2. Security A has an expected return of 7%, a standard deviation of expected returns of 35%,
a correlation coefficient with the market of -0.3, and a beta coefficient of -0.5. Security B
has an expected return of 12%, a standard deviation of returns of 10%, a correlation
coefficient with the market of 0.7, and a beta coefficient of 1.0. Which security is riskier?
Why? (5-2)

Security A is less risky if held in a diversified portfolio because of its negative correlation
with other stocks. In a single-asset portfolio, Security A would be more risky because A
> B and CVA > CVB.

Coefficient of variation = Standard deviation/ return

3. ERCI Corporation is a holding company with four main subsidiaries. The percentage of
its business coming from each of the subsidiaries, and their respective betas are as
follows: (ST-3)
SUBSIDIARY % OF BUSINESS BETA
Electric Utility 60% 0.70
Cable Company 25% 0.90
Real Estate 10% 1.30
International/Special Projects 5% 1.50

(i) What is the holding company's beta?


(ii) Assume that the risk free rate is 6% and the market premium is 5%. What is the holding
company's required rate of return?
(iii) ECRI is considering a change in its strategic focus. It will reduce its reliance on
the electric utility subsidiary, so the percentage of its business from this subsidiary will be
50%. At the same time it will increase its reliance on the international/special projects

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division, so the percentage of its business from that division will rise to 15%. What will
be the shareholders' required rate of return if they make these changes.

i) bp = (0.6)(0.7) + (0.25)(0.90) + (0.1)(1.30) + (0.05)(1.5)


= 0.42 + 0.225 + 0.13 + 0.075 = 0.85

ii) ks = krf + (km – krf) ßs


ks = 6% + 5% * 0.85
= 10.25%

iii) bp = (0.5)(0.7) + (0.25)(0.90) + (0.1)(1.30) + (0.15)(1.5)


= 0.35 + 0.225 + 0.13 + 0.225 = 0.93

ks = krf + (km – krf) ßs


ks = 6% + 5% * 0.93
= 10.65%

4. A stock's expected return has the following distribution:


Demand for the Probability of this Rate of return if this
Company's Products demand occurring demand occurs____
Weak 0.1 (50%)
Below Average 0.2 (5%)
Average 0.4 16%
Above Average 0.2 25%
Strong 0.1 60%

Calculate the stock's expected return, standard deviation, and coefficient of variation (5-1)

k̂ = (0.1)(-50%) + (0.2)(-5%) + (0.4)(16%) + (0.2)(25%) + (0.1)(60%)


= 11.40%.

2 = (-50% - 11.40%)2(0.1) + (-5% - 11.40%)2(0.2) + (16% - 11.40%)2(0.4)


+ (25% - 11.40%)2(0.2) + (60% - 11.40%)2(0.1)

2 = 712.44;  = 26.69%.

26.69%
CV = = 2.34.
11.40%

5. An individual has $35,000 invested in a stock that has a beta of 0.8 and $40,000 invested
in a stock with a beta of 1.4. If these are the only investments in her portfolio, what is her
portfolio's beta? (5-2)

Investment Beta
$35,000 0.8
40,000 1.4
Total $75,000

bp = ($35,000/$75,000)(0.8) + ($40,000/$75,000)(1.4) = 1.12.

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6. Assume that the risk free rate is 6% and the expected return on the market is 13%. What
is the expected rate of return on a stock that has a beta of .7? (5-4)

kRF = 6%; kM = 13%; b = 0.7; k = ?

k = kRF + (kM - kRF)b


= 6% + (13% - 6%)0.7
= 10.9%.

7. Assume the risk free rate is 5% and the market premium is 6%, What is the expected
return for the overall stock market? What is the required rate of return on a stock that has
a beta of 1.2? (5-3)

kRF = 5%; RPM = 6%; kM = ?

kM = 5% + (6%)1 = 11%.

k when b = 1.2 = ?

k = 5% + 6%(1.2) = 12.2%.

8. Stocks A and B have the following historical returns:


Year Stock A (KA) Stock B (KB)
2002 (10%) (3%)
2003 18.50% 21.29%
2004 38.67% 44.25%
2005 14.33% 3.67%
2006 33.00% 28.30%

(i) Calculate the average return for each stock during the period 2002 to 2006. Assume that
someone held a portfolio consisting of 50% A and 50% B. What would have been their
realized rate of return on the portfolio in each year from 2002 to 2006? What would have
been the average return on the portfolio during this period?
(ii) Calculate the standard deviation of returns for each stock and for the portfolio. (ST-2)

KA = [(-10%) + 18.5% + 38.67% + 14.33% + 33%]/5


= 94.5%/ 5 = 18.9

KB = [(-3%) + 21.29% + 44.25% + 3.67% + 28.3%]/5


= 94.51%/ 5 = 18.902
Year Stock A (KA) Stock B (KB) KAB
2002 (10%) (3%) (6.5%)
2003 18.50% 21.29% 19.90%
2004 38.67% 44.25% 41.46%
2005 14.33% 3.67% 9.00%
2006 33.00% 28.30% 30.65%
KAvg 18.90%

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σ2X =[(-10% - 18.9%)2 + (18.5% - 18.9%)2 + (38.67% - 18.9%)2
+ (14.33% - 18.9%)2+ (33% - 18.9%)2 ] / n-1
= [ 835.21 + 0.16 + 390.85 + 20.88 + 198.81]/ n-1
= √361.48
= 19.01

σ2X =[(-3% - 18.9%)2 + (21.29% - 18.9%)2 + (44.25% - 18.9%)2


+ (3.67% - 18.9%)2+ (28.3% - 18.9%)2 ] / n-1
= [ 479.61 + 5.71 + 642.62 + 231.95 + 88.36]/ n-1
= √362.06
= 19.02

σ2X =[(-6.5% - 18.9%)2 + (19.9% - 18.9%)2 + (41.46% - 18.9%)2


+ (9% - 18.9%)2+ (30.65% - 18.9%)2 ] / n-1
= [ 645.16 + 1 + 508.95 + 98.01 + 138.06]/ n-1
= √347.79
= 18.64

9. Stocks X and Y have the following probability distributions of expected future returns (5-
6)
PROBABILITY X% Y%
0.1 (10) (35)
0.2 2 0
0.4 12 20
0.2 20 25
0.1 38 45

(i) Calculate the expected rate of return, k, for stock Y (kX = 12%)
(ii) Calculate the standard deviation of expected return for stock X. (That for Y is
20.35%)
(iii) Calculate the coefficient of variation for stock Y
n

a. k̂   Pk
i1
i i .

k̂Y = 0.1(-35%) + 0.2(0%) + 0.4(20%) + 0.2(25%) + 0.1(45%)


= 14% versus 12% for X.

b.  =  (k
i 1
i
 k̂)2 Pi .

σ2X = (-10% - 12%)2(0.1) + (2% - 12%)2(0.2) + (12% - 12%)2(0.4)


+ (20% - 12%)2(0.2) + (38% - 12%)2(0.1) = 148.8%.

X = 12.20% versus 20.35% for Y.

CVX = X/ k̂ X = 12.20%/12% = 1.02, while

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CVY = 20.35%/14% = 1.45.

If Stock Y is less highly correlated with the market than X, then it might have a lower
beta than Stock X, and hence be less risky in a portfolio sense.

10. A stock has a required rate of return of 11%. The risk free rate is 7%, and the market risk
premium is 4% (i) calculate the stock's beta
(ii) If the market risk premium increases to 6%, what will happen to the stock's required
rate of return? Assume the risk free rate and the stock's beta remain unchanged. (5-5)

a. k = 11%; kRF = 7%; RPM = 4%.

k = kRF + (kM – kRF)b


11% = 7% + 4%b
4% = 4%b
b = 1.

b. kRF = 7%; RPM = 6%; b = 1.

k = kRF + (kM – kRF)b


k = 7% + (6%)1
k = 13%.

11. Suppose you hold a diversified portfolio consisting of $7,500 investment in each of 20
different common stocks. The portfolio bets is 1.12. Now, suppose you decide to sell one
of the stocks in your portfolio with a beta equal to 1.0 for $7,500 and to use these
proceeds to buy another stock for your portfolio. Assume the new stock's beta is 1.75.
Calculate the new portfolio's beta. (5-8)

$142,500 $7,500
Old portfolio beta = $150,000 (b) + $150,000 (1.00)
1.12 = 0.95b + 0.05
1.07 = 0.95b
1.1263 = b.

New portfolio beta = 0.95(1.1263) + 0.05(1.75) = 1.1575  1.16.

Alternative Solutions:

1. Old portfolio beta = 1.12 = (0.05)b1 + (0.05)b2 + ... + (0.05)b20

1.12 = ( b )(0.05)
i

 b = 1.12/0.05 = 22.4.
i

New portfolio beta = (22.4 - 1.0 + 1.75)(0.05) = 1.1575  1.16.

2.  b excluding the stock with the beta equal to 1.0 is 22.4 - 1.0 =
i

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21.4, so the beta of the portfolio excluding this stock is b = 21.4/19 = 1.1263. The beta
of the new portfolio is:
1.1263(0.95) + 1.75(0.05) = 1.1575  1.16.

12. Suppose you are the money manager of a $4 million investment fund. The fund consists
of 4 stocks with the following investments and betas:
STOCK INVESTMENT BETA
A $400,000 1.50
B $600,000 (0.50)
C $1,000,000 1.25
D $2,000,000 0.75
If the market required rate of return is 14% and the risk free rate is 6%, what is the fund's
required rate of return? (5-9)

$400,000 $600,000
Portfolio beta = $4,000,000 (1.50) + $4,000,000 (-0.50)
$1,000,000 $2,000,000
+ $4,000,000 (1.25) + $4,000,000 (0.75)
bp = (0.1)(1.5) + (0.15)(-0.50) + (0.25)(1.25) + (0.5)(0.75)
= 0.15 - 0.075 + 0.3125 + 0.375 = 0.7625.

kp = kRF + (kM - kRF)(bp) = 6% + (14% - 6%)(0.7625) = 12.1%.

Alternative solution: First, calculate the return for each stock using the CAPM equation
[kRF + (kM - kRF)b], and then calculate the weighted average of these returns.

kRF = 6% and (kM - kRF) = 8%.

Stock Investment Beta k = kRF + (kM - kRF)b Weight


A $ 400,000 1.50 18% 0.10
B 600,000 (0.50) 2 0.15
C 1,000,000 1.25 16 0.25
D 2,000,000 0.75 12 0.50
Total $4,000,000 1.00

kp = 18%(0.10) + 2%(0.15) + 16%(0.25) + 12%(0.50) = 12.1%.

13. You have been managing a $5 million portfolio which has a beta of 1.25 and a required
rate of return of 12%. The current risk-free rate is 5.25%. Assume that you receive
another $500,000. If you invest this money in a stock with beta 0.75, what will be the
required rate of return on your $5.5 million portfolio? (5-17)

Step 1: Determine the market risk premium from the CAPM:


0.12 = 0.0525 + (kM - kRF)1.25
(kM - kRF) = 0.054.

Step 2: Calculate the beta of the new portfolio:


The beta of the new portfolio is ($500,000/$5,500,000)(0.75) +
($5,000,000/$5,500,000)(1.25) = 1.2045.

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Step 3: Calculate the required return on the new portfolio:
The required return on the new portfolio is:
5.25% + (5.4%)(1.2045) = 11.75%.

14. Stock X has an expected return of 10%, a beta coefficient of 0.9, and standard deviation
of expected returns of 35%. Stock Y has an expected return of 12.5%, a beta of 1.2, and
standard deviation 25%. The risk free rate is 6%, and the market risk premium is 5%.
(i) calculate each stock's coefficient of variation
(ii) Which stock is riskier for diversified investor's?
(iii) Calculate each stock's required rate of return.
(iv) Calculate the required return of a portfolio that has $7,500 invested in stock X and
$2,500 invested in stock Y
(v) If the market risk premium increased to 6%, which of the two stocks would have the
largest increase in their required returns? (5-11)
k̂ X = 10%; bX = 0.9; X = 35%.
k̂ Y = 12.5%; bY = 1.2; Y = 25%.
kRF = 6%; RPM = 5%.

a. CVX = 35%/10% = 3.5. CVY = 25%/12.5% = 2.0.

b. For diversified investors the relevant risk is measured by beta. Therefore, the stock
with the higher beta is more risky. Stock Y has the higher beta so it is more risky than
Stock X.

c. kX = 6% + 5%(0.9)
kX = 10.5%.

kY = 6% + 5%(1.2)
kY = 12%.
d. kX = 10.5%; k̂X = 10%.
kY = 12%; k̂Y = 12.5%.

Stock Y would be most attractive to a diversified investor since its expected return of
12.5% is greater than its required return of 12%.

e. bp = ($7,500/$10,000)0.9 + ($2,500/$10,000)1.2
= 0.6750 + 0.30
= 0.9750.
kp = 6% + 5%(0.975)
kp = 10.875%.

f. If RPM increases from 5% to 6%, the stock with the highest beta will have the largest
increase in its required return. Therefore, Stock Y will have the greatest increase.
Check:
kX = 6% + 6%(0.9)
= 11.4%. Increase 10.5% to 11.4%.

kY = 6% + 6%(1.2)
= 13.2%. Increase 12% to 13.2%.
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