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CHAPTER 6

The Meaning and Measurement


of Risk and Return

CHAPTER ORIENTATION
In this chapter, we examine the factors that determine rates of return (discount rates) in the
capital markets. We are particularly interested in the relationship between risk and rates of
return. We look at risk both in terms of the riskiness of an individual security and that of a
portfolio of securities.

CHAPTER OUTLINE
I. Expected Return Defined and Measured

A. The expected benefits or returns to be received from an investment come


in the form of the cash flows the investment generates.
_
B. Conventionally, we measure the expected cash flow, X , as follows:
_
X = P(X1)X1 + P(X2)X2 + … + P(Xn)Xn

where n = the number of possible states of the economy


Xi = the cash flow in the ith state of the economy
P(Xi) = the probability of the ith cash flow

II. Risk Defined and Measured

A. Risk can be defined as the possible variation in cash flow about an


expected cash flow.

B. Statistically, risk may be measured by the standard deviation about the


expected cash flow.

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III. Rates of Return: The Investors’ Experience
A. Data have been compiled by Ibbotson and Associates on the actual returns for
various portfolios of securities from 1926-1998.
B. The following portfolios were studied:
1. Common stocks of large firms
2. Common stocks of small firms
3. Corporate bonds
4. Long-term U.S. government bonds
5. Intermediate U.S. government bonds
6. U.S. Treasury bills
C. Investors historically have received greater returns for greater risk-taking with
the exception of the long-term U.S. government bonds.
D. The only portfolio with returns consistently exceeding the inflation rate has
been common stocks.
IV. Risk and Diversification
A. The market rewards diversification. We can lower risk without sacrificing
expected return, and/or we can increase expected return without having to
assume more risk.
B. Diversifying among different kinds of assets is called asset allocation.
Compared to diversification within the different asset classes, the benefits
received are far greater through effective asset allocation.
C. Total variability can be divided into:
a. The variability of returns unique to the security (diversifiable or
unsystematic risk)
b. The risk related to market movements (nondiversifiable or
systematic risk)
D. By diversifying, the investor can eliminate the "unique" security risk. The
systematic risk, however, cannot be diversified away.
E. Measuring Market Risk
1. The characteristic line tells us the average movement in a firm's stock
price in response to a movement in the general market, such as the S&P
500 Index. The slope of the characteristic line, which has come to be
called beta, is a measure of a stock's systematic or market risk. The
slope of the line is merely the ratio of the "rise" of the line relative to the
"run" of the line.
2. If a security's beta equals one, a 10 percent increase (decrease) in market
returns will produce on average a 10 percent increase (decrease) in
security returns.
3. A security having a higher beta is more volatile and thus more risky
than a security having a lower beta value.

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F. A portfolio's beta is equal to the average of the betas of the stocks in the
portfolio.
G. Risk and diversification can be demonstrated by a comparison of three
portfolios consisting of short-term government securities, long-term
government bonds, and large-company stocks.
V. The Investor’s Required Rate of Return
A. The required rate of return is the minimum rate necessary to compensate an
investor for accepting the risk he or she associates with the purchase and
ownership of an asset.
B. Two factors determine the required rate of return for the investor:
1. The risk-free rate of interest which recognizes the time value of money.
2. The risk premium which considers the riskiness (variability of returns)
of the asset and the investor's attitude toward risk.
C. Capital asset pricing model--CAPM
1. The required rate of return for a given security can be expressed as
Required risk-free market risk-free
= rate + beta x  return - rate 
rate  
or
kj = krf + βj (km - krf)
2. Security market line
a. Graphically illustrates the CAPM.
b. Designates the risk-return trade-off existing in the market, where
risk is defined in terms of beta according to the CAPM equation.

ANSWERS TO
END-OF-CHAPTER QUESTIONS

6-1. a. The investor's required rate of return is the minimum rate of return necessary to
attract an investor to purchase or hold a security.
b. Risk is the potential variability in returns on an investment. Thus, the greater
the uncertainty as to the exact outcome, the greater is the risk. Risk may be
measured in terms of the standard deviation or by the variance term, which is
simply the standard deviation squared.
c. A large standard deviation of the returns indicates greater riskiness associated
with an investment. However, whether the standard deviation is large relative
to the returns has to be examined with respect to other investment opportunities.
Alternatively, probability analysis is a meaningful approach to capture greater
understanding of the significance of a standard deviation figure. However, we

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have chosen not to incorporate such an analysis into our explanation of the
valuation process.
6-2. a. Unique risk is the variability in a firm's stock price that is associated with the
specific firm and not the result of some broader influence. An employee strike
is an example of a company-unique influence.
b. Systematic risk is the variability in a firm's stock price that is the result of
general influences within the industry or resulting from overall market or
economic influences. A general change in interest rates charged by banks is an
example of systematic risk.
6-3. Beta indicates the responsiveness of a security's return to changes in the market returns.
Beta is multiplied by the market risk premium and added to the risk-free rate of return
to calculate a required rate of return.
6-4. The security market line is a graphical representation of the risk-return trade off that
exists in the market. The line indicates the minimum acceptable rate of return for
investors given the level of risk. Since the security market line results from actual
market transactions, the relationship not only represents the risk-return preferences of
investors in the market but also represents the investors' available opportunity set.
6-5. The beta for a portfolio is equal to the weighted average of the individual stock betas,
weighted by the percentage invested in each stock.
6-6. If a stock has a great amount of variability about its characteristic line (the graph of the
stock's returns against the market's returns), then it has a high amount of unsystematic
or company-unique risk. If, however, the stock's returns closely follow the market
movements, then there is little unsystematic risk.
6-7. Data have been compiled by Ibbotson and Associates on the actual returns for the
following portfolios of securities from 1926-1998.
1. Common stocks of large firms
2. Common stocks for small firms
3. Corporate bonds
4. Long-term U.S. government bonds
5. Intermediate U.S. government bonds
6. U.S. Treasury bills
Investors historically have received greater returns for greater risk-taking with the
exception of the U.S. government bonds. Also, the only portfolio with returns
consistently exceeding the inflation rate has been common stocks.
6-8. Through diversification, we can potentially accomplish one of two results: (1) We can
decrease the variability in returns without lowering the expected rate of return of the
portfolio, or (2) we can increase the expected rate of return without increasing the
variability in returns. The extent of these effects are in part determined by the types of
assets in the portfolio. For instance, diversification has greater effect when investing in
different types of assets, such as government securities and stocks, rather than just
investing in different stocks.

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SOLUTIONS TO
END-OF-CHAPTER PROBLEMS
6-1.
(A) (B) (A) x (B) Weighted
Probability Return Expected Return Deviation

P(ki) (ki) k (ki - k )2P(ki)

.15 6% .90% 2.22


.30 9 2.7 0.22
.40 10 4.00 0.01
.15 15 2.25 3.98
_
k = 9.85% σ2 = 6.99%
σ = 2.64%

Yes, Carter should invest in the security. The level of risk is not excessive.

6-2. Investment A:

(A) (B) (A) x (B) Weighted


Probability Return Expected Return Deviation

P(ki) (ki) k (ki - k )2P(ki)

0.3 11% 3.3% 4.8%


0.4 15 6.0 0.0
0.3 19 5.7 4.8
_
k = 15.0% σ2 = 9.6%
σ = 3.10%
Investment B

(A) (B) (A) x (B) Weighted


Probability Return Expected Return Deviation

P(ki) (ki) k (ki - k )2P(ki)

0.2 -5% -1.0% 41.472%


0.3 6 1.8 3.468
0.3 14 4.2 6.348
0.2 22 4.4 31.752
_
k = 9.4% σ2 = 83.04%
σ = 9.11%
Investment A is better. It has a higher expected return with less risk.

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6-3. Security A:

(A) (B) (A) x (B) Weighted


Probability Return Expected Return Deviation

P(ki) (ki) k (ki - k )2P(ki)

0.2 - 2% -0.4% 69.9%


0.5 18 9.0 0.8
0.3 27 8.1 31.8
_
k = 16.7% σ2 = 102.5%
σ = 10.12%
Security B:

(A) (B) (A) x (B) Weighted


Probability Return Expected Return Deviation
P(ki) (ki) k (ki - k )2P(ki)

0.1 4% 0.4% 2.704%


0.3 6 1.8 3.072
0.4 10 4.0 0.256
0.2 15 3.0 6.728
_
k = 9.2% σ2 = 12.76%
σ = 3.57%

Security A Security B
_ _
k = 16.7% k = 9.2%
σ = 10.12% σ = 3.57%
We cannot say which investment is "better." It would depend on the investor's attitude
toward the risk-return trade-off.
Required rate Risk-free Market Risk
6-4. a.  of return  =  rate  + Beta Premium 
     
= 6% + 1.2 (16% - 6%)
= 18%
b. The 18 percent "fair rate" compensates the investor for the time value of money
and for assuming risk. However, only nondiversifiable risk is being considered,
which is appropriate.

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6-5. Eye-balling the characteristic line for the problem, the rise relative to the run is about
0.5. That is, when the S & P 500 return is eight percent Aram's expected return would
be about four percent. Thus, the beta is also approximately 0.5 (4 ÷ 8).

6-6.
Required
 Expected Market − Free  x Beta 
+ 
Risk-Free
− RiskRate   = Rate of
Rate  Return  Return

A 6.75% +  (12% − 6.75%) x 1.50  = 14.63%


B 6.75% +  (12% − 6.75%) x 0.90  = 11.48%
C 6.75% + (12% − 6.75%) x 0.70 = 10.43%
D 6.75% +  (12% − 6.75%) 1.15  = 12.79%
 x

6-7.
Required
Risk-Free
Rate of = + [(Market Return - Risk-Free Rate) X Beta]
Rate
Return
= 7.5% + [(11.5% - 7.5%) x 0.86]
= 10.94%

6-8. If the expected market return is 12.8 percent and the risk premium is 4.3 percent, the
riskless rate of return is 8.5 percent (12.8% - 4.3%). Therefore;

Tasaco = 8.5% + [(12.8% - 8.5%)] x 0.864 = 12.22%


LBM = 8.5% + [(12.8% - 8.5%)] x 0.693 = 11.48%
Exxos = 8.5% + [(12.8% - 8.5%)] x 0.575 = 10.97%

6-9. a.
Jazman Solomon
Time Price Return Price Return
1 $9 $27
2 11 22.22% 28 3.70%
3 10 -9.09 32 14.29
4 13 30.00 29 -9.38

b. A holding-period return indicates the rate of return you would earn if you
bought a security at the beginning of a time period and sold it at the end of the
period, such as the end of the month or year.

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6-10. a. Zemin Market

Month kt (kt - k )2 kt (kt - k )2

1 6.00% 18.75% 4.00% 6.25%


2 3.00 1.77 2.00 0.25
3 -1.00 7.13 1.00 0.25
4 -3.00 21.81 -2.00 12.25
5 5.00 11.09 2.00 0.25
6 0.00 2.79 2.00 0.25
Sum 10.00 63.34 9.00 19.50
Average
monthly 1.67% 1.5%
return
(Sum ÷ 6)
Annualized
average 20.00% 18.00%
returns
Variance 12.67% 3.90%
(Sum ÷ 5)
Standard
3.56% 1.97%
deviation
Required
Risk-Free
b. Rate of = + (Market Return - Risk-Free Rate) x Beta
Rate
Return
= 8% + [(18% - 8%) x 1.54] = 23.40%
c. Zemin's historical return of 20 percent is below what we would consider a fair
return of 23.4 percent, given the stock's systematic risk.
6-11. a. The portfolio expected return, k p, equals a weighted average of the individual
stock's expected returns.
kp = (0.20)(16%) + (0.30)(14%) + (0.15)(20%) + (0.25)(12%) +
(0.10)(24%)
= 15.8%
b. The portfolio beta, ßp, equals a weighted average of the individual stock betas
ßp = (0.20)(1.00) + (0.30)(0.85) + (0.15)(1.20) + (0.25)(0.60) +
(0.10)(1.60)
= 0.95

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c. Plot the security market line and the individual stocks

25.00 5

20.00 3

P1
15.00 M
2
10.00 4

5.00

0.00
0.00 0.50 1.00 1.50 2.00
Beta

d. A "winner" may be defined as a stock that falls above the security market line,
which means these stocks are expected to earn a return exceeding what should
be expected given their beta or systematic risk. In the above graph, these stocks
include 1, 3, and 5. "Losers" would be those stocks falling below the security
market line, which are represented by stocks 2 and 4 ever so slightly.

e. Our results are less than certain because we have problems estimating the
security market line with certainty. For instance, we have difficulty in
specifying the market portfolio

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6-12 a. Holding-period returns

Month and Year S&P 500 Index Ford

Mar-05 1,180.59 11.33


Apr-05 1,156.85 -2.0% 9.11 -19.6%
May-05 1,191.50 3.0% 9.98 9.5%
Jun-05 1,191.33 0.0% 10.24 2.6%
Jul-05 1,234.18 3.6% 10.74 4.9%
Aug-05 1,220.33 -1.1% 9.97 -7.2%
Sep-05 1,228.81 0.7% 9.86 -1.1%
Oct-05 1,207.01 -1.8% 8.32 -15.6%
Nov-05 1,249.48 3.5% 8.13 -2.3%
Dec-05 1,248.29 -0.1% 7.72 -5.0%
Jan-06 1,280.08 2.5% 8.58 11.1%
Feb-06 1,280.66 0.0% 7.97 -7.1%
Mar-06 1,291.24 0.8% 7.96 -0.1%
Sum 9.2% -29.9%

b.
S&P 500 Ford
Average 0.8% -2.5%
Std dev 2.0% 9.2%

c.
15.0%

10.0%
y = 3.7802x - 0.0539

5.0%

0.0%
-15.0% -10.0% -5.0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Ford

-5.0%

-10.0%

-15.0%

-20.0%

-25.0%
S&P 500

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d. Ford returns are positively correlated to the S&P 500 returns with a steep slope
implying considerable systematic risk and a lot of variability relative to the
characteristic line, implying a lot of unsystematic risk.

SOLUTION TO MINI CASE


a. Holding-period returns for S&P 500 Index, Wal-Mart, and Target
S&P 500 Wal-Mart Target
Month Rt (Rt - R)^2 Rt (Rt - R)^2 Rt (Rt - R)^2
2004 March S&P 500 Wal-Mart Target
April -5.56% 0.309% -4.51% 0.203% -3.71% 0.137%
May -2.54% 0.064% -2.23% 0.050% 3.07% 0.094%
June -2.34% 0.055% -5.80% 0.336% -4.99% 0.249%
July 3.51% 0.123% 0.97% 0.009% 2.66% 0.071%
August 6.22% 0.387% -0.64% 0.004% 2.25% 0.051%
September 3.85% 0.148% 1.01% 0.010% 1.50% 0.023%
October 2.94% 0.086% 1.35% 0.018% 10.54% 1.111%
November 0.87% 0.008% -3.45% 0.119% 2.40% 0.058%
December 0.98% 0.010% 1.46% 0.021% 1.39% 0.019%
2005 January 0.28% 0.001% -0.80% 0.006% -2.23% 0.050%
February 4.70% 0.221% -1.51% 0.023% 0.10% 0.000%
March 0.60% 0.004% -2.91% 0.084% -1.57% 0.025%
April 5.02% 0.252% -5.93% 0.351% -7.22% 0.521%
May 2.04% 0.042% 0.19% 0.000% 15.71% 2.467%
June 1.04% 0.011% 2.05% 0.042% 1.32% 0.017%
July -1.66% 0.028% 2.39% 0.057% 7.98% 0.636%
August -0.48% 0.002% -8.90% 0.791% -8.51% 0.724%
September 0.13% 0.000% -2.54% 0.064% -3.39% 0.115%
October 1.28% 0.016% 7.96% 0.634% 7.24% 0.524%
November -3.03% 0.092% 2.64% 0.070% -3.91% 0.153%
December 0.26% 0.001% -3.62% 0.131% 2.73% 0.074%
2006 January 0.78% 0.006% -1.47% 0.022% -0.40% 0.002%
February 1.25% 0.016% -1.63% 0.026% -0.64% 0.004%
March 4.92% 0.242% 4.14% 0.172% -4.39% 0.193%
Sum 25.05% 2.121% -21.74% 3.246% 17.91% 7.32%

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b.
S&P 500 Wal-Mart Target
Avg Monthly
Return 1.04% -0.91% 0.75%

Std Dev 2.84% 3.64% 5.59%

Note that during this 24-month period that Wal-Mart had a negative average monthly
return—a fairly unusual event for the retailer.

c.1 Wal-Mart monthly returns plotted relative to the S&P 500 Index

0.1
Walmart

0.08

0.06

0.04

0.02

0
-0.08 -0.06 -0.04 -0.02 0 0.02 0.04 0.06 0.08
-0.02
S&P 500
-0.04

-0.06

-0.08

-0.1

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c.2 Target monthly returns plotted relative to the S&P 500 Index

20.0%
Target

15.0%

10.0%

5.0%
S&P 500

0.0%
-8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0%

-5.0%

-10.0%

d. Wal-Mart’s returns are more volatile than the S&P Index returns, at least based
on these two years of return data.
Target’s returns are also more volatile than the S&P Index.
In both cases, however, we see a direct, but not by any means perfect,
relationship between the two firms and the market index. That is to say, we see
both systematic and unsystematic risk.

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e. Monthly returns of a portfolio of equal amounts of Wal-Mart and Target

Wal-mart & Target Combined Returns


1/2 Wal-mart 1/2 Target Average
2004 March
April -2.25% -1.85% -4.11%
May -1.11% 1.53% 0.42%
June -2.90% -2.49% -5.39%
July 0.49% 1.33% 1.82%
August -0.32% 1.12% 0.80%
September 0.50% 0.75% 1.25%
October 0.68% 5.27% 5.95%
November -1.72% 1.20% -0.53%
December 0.73% 0.69% 1.42%
2005 January -0.40% -1.12% -1.51%
February -0.75% 0.05% -0.70%
March -1.45% -0.79% -2.24%
April -2.96% -3.61% -6.57%
May 0.10% 7.85% 7.95%
June 1.03% 0.66% 1.69%
July 1.19% 3.99% 5.18%
August -4.45% -4.26% -8.70%
September -1.27% -1.69% -2.96%
October 3.98% 3.62% 7.60%
November 1.32% -1.96% -0.64%
December -1.81% 1.36% -0.45%
2006 January -0.74% -0.20% -0.94%
February -0.81% -0.32% -1.13%
March 2.07% -2.20% -0.12%
Average -0.08%
Std Dev 0.041

213
f. The Wal-Mart and Target portfolio monthly returns plotted relative to the S&P
500 Index

10.00%
Walmart/Target

8.00%

6.00%

4.00%

2.00%

0.00%
-8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0%
-2.00%
S&P 500

-4.00%

-6.00%

-8.00%

-10.00%

There is less variability about the characteristic line with the two-stock
portfolio.

g. Monthly holding-period returns for long-term government bonds

Annualized Monthly (Rt - R)^2


2004 March
April 4.50% 0.38% 0.001%
May 4.66% 0.39% 0.002%
June 4.62% 0.39% 0.001%
July 4.47% 0.37% 0.001%
August 4.13% 0.34% 0.001%
September 4.12% 0.34% 0.001%
October 4.03% 0.34% 0.001%
November 4.36% 0.36% 0.001%
December 4.22% 0.35% 0.001%

214
2005 January 4.13% 0.34% 0.001%
February 4.36% 0.36% 0.001%
March 4.50% 0.38% 0.001%
April 4.20% 0.35% 0.001%
May 4.01% 0.33% 0.001%
June 3.94% 0.33% 0.001%
July 4.29% 0.36% 0.001%
August 4.02% 0.34% 0.001%
September 4.33% 0.36% 0.001%
October 4.56% 0.38% 0.001%
November 4.50% 0.38% 0.001%
December 4.39% 0.37% 0.001%
2006 January 4.53% 0.38% 0.001%
February 4.55% 0.38% 0.001%
March 4.86% 0.41% 0.002%
8.69%
Average
Monthly
Return
(Sum / 24) 0.36%

Standard
Deviation 0.02%

h. Monthly portfolio returns when portfolio consists of equal amounts invested in


Wal-Mart, Target, and long-term government bonds.

Wal-mart, Target & Bonds Combined Return


1/3 Wal-mart 1/3 Target 1/3 Bonds Sum (Rt - R)^2
2004 March
April -1.50% -1.24% 0.13% -2.61% 0.0683%
May -0.74% 1.02% 0.13% 0.41% 0.0017%
June -1.93% -1.66% 0.13% -3.47% 0.1202%
July 0.32% 0.89% 0.12% 1.33% 0.0178%
August -0.21% 0.75% 0.11% 0.65% 0.0042%
September 0.34% 0.50% 0.11% 0.95% 0.0090%
October 0.45% 3.51% 0.11% 4.08% 0.1662%
November -1.15% 0.80% 0.12% -0.23% 0.0005%
December 0.49% 0.46% 0.12% 1.07% 0.0114%
2005 January -0.27% -0.74% 0.11% -0.89% 0.0080%
February -0.50% 0.03% 0.12% -0.35% 0.0012%

215
March -0.97% -0.52% 0.13% -1.37% 0.0187%
April -1.98% -2.41% 0.12% -4.26% 0.1819%
May 0.06% 5.24% 0.11% 5.41% 0.2928%
June 0.68% 0.44% 0.11% 1.23% 0.0152%
July 0.80% 2.66% 0.12% 3.57% 0.1277%
August -2.97% -2.84% 0.11% -5.69% 0.3238%
September -0.85% -1.13% 0.12% -1.85% 0.0344%
October 2.65% 2.41% 0.13% 5.19% 0.2699%
November 0.88% -1.30% 0.13% -0.30% 0.0009%
December -1.21% 0.91% 0.12% -0.18% 0.0003%
2006 January -0.49% -0.13% 0.13% -0.50% 0.0025%
February -0.54% -0.21% 0.13% -0.63% 0.0040%
March 1.38% -1.46% 0.14% 0.05% 0.0000%
1.62%
Average
Monthly
Return
(Sum / 24) 0.07%

Standard
Deviation 2.70%

i. Comparison of average returns and standard deviations

Avg Returns Std Deviation


Government Security 0.36% 0.02%
Wal-mart, Target, & govt. security 0.07% 2.70%
S&P 500 Index 1.04% 2.84%
Wal-mart -0.91% 3.64%
Target 0.75% 5.59%
Walmart & Target -0.08% 4.05%

From the findings above, we see that with the exception of Wal-Mart, higher average
returns are associated with higher standard deviations. Also, the effects of
diversification are obvious. As we diversify, the portfolio average returns are a
proportionate reflection of the average returns of the individual securities. But the
standard deviations for the portfolios are not an average of the standard deviations for
the individual stocks--the result of the individual stocks not being perfectly correlated
with each other and the market.

216
j. Based on the standard deviations, Target has more risk than Wal-Mart, 5.59
percent versus 3.64 percent, respectively. Also, when we only consider
systematic risk, Wal-Mart is again considered less risky--Wal-Mart's beta is .58
compared to Target's beta of 1.02. (The betas given here for Wal-Mart and
Target come from financial services that calculate firms' betas. These are not
consistent with the graphs above--the result of using only 24 months of returns
in our calculations.)

Required
Risk-Free
k. Rate of = + (Market Return - Risk-Free Rate) X Beta
Rate
Return

Market return = 1.04% average monthly return X 12 months


= 12.52%.

Wal-Mart: 9.15% = 4.5% + ( 12.52% - 4.5%) X .58

TARGET: 12.68% = 4.5% + ( 12.52% - 4.5%) X 1.02

Note: We are computing required rates of return using a market return for a relatively
short period, which also provided unusually high historical market returns.
Hardly any investor would require such high returns to justify an investment in
these two firms.

217
ALTERNATIVE PROBLEMS WITH SOLUTIONS

ALTERNATIVE PROBLEMS

6-1A. (Expected Rate of Return and Risk) B. J. Gautney Enterprises is evaluating a


security. One-year Treasury bills are currently paying 8.9 percent. Calculate the
investment’s expected return and its standard deviation. Should Gautney invest in
this security?

Probability Return
.15 6%
.30 5%
.40 11%
.15 14%

6-2A. (Expected Rate of Return and Risk) Kelly B. Stites, Inc., is considering an investment
in one of two common stocks. Given the information that follows, which
investment is better, based on risk (as measured by the standard deviation) and
return?

Common Stock A Common Stock B


Probability Return Probability Return
.15 6%
.20 10% .30 8%
.60 13% .40 15%
.20 20% .15 19%

6-3A. (Expected Rate of Return and Risk) Clevenger Manufacturing, Inc., has prepared the
following information regarding two investments under consideration. Which
investment should be accepted?

Security A Security B
Probability Return Probability Return
.20 –2% .10 5%
.50 19% .30 7%
.30 25% .40 12%
.20 14%

6-4A. a. (Required Rate of Return Using CAPM) Compute a fair rate of return for Apple
common stock, which has a 1.5 beta. The risk-free rate is 8 percent and the
market portfolio (New York Stock Exchange stocks) has an expected return of
16 percent.
b. Why is the rate you computed a fair rate?

218
6-5A. (Estimating Beta) From the graph below relating the holding-period returns for Bram,
Inc. to the S&P 500 Index, estimate the firm’s beta.

k
Bram
8

4 8 k
S&P

6-6A. (Capital Asset Pricing Model) Bobbi Manufacturing, Inc., is considering several
investments. The rate on Treasury bills is currently 6.75 percent, and the expected
return for the market is 12 percent. What should be the required rates of return for
each investment (using the CAPM)?

Security Beta
A 1.40
B .75
C .80
D 1.20

6-7A. (Capital Asset Pricing Model) Breckenridge, Inc., has a beta of .85. If the expected
market return is 10.5 percent and the risk-free rate is 7.5 percent, what is the
appropriate required return of Breckenridge (using the CAPM)?
6-8A. (Capital Asset Pricing Model) The expected return for the general market is 12.8
percent, and the risk premium in the market is 4.3 percent. Dupree, Yofota, and
MacGrill have betas of .82, .57, and .68, respectively. What are the corresponding
required rates of return for the three securities?
6-9A. (Computing Holding-Period Returns) From the price data below, compute the holding-
period returns for O’Toole and Baltimore for periods 2 through 4.

Time O’Toole Baltimore


1 $22 $45
2 24 50
3 20 48
4 25 52

How would you interpret the meaning of a holding-period return?

219
6-10A. (Measuring Risk and Rates of Return)
a. Given the holding-period returns shown below, compute the average returns and
the standard deviations for the Sugita Corporation and for the market.

Month Sugita Corp. Market


1 1.8% 1.5%
2 –0.5 1.0
3 2.0 0.0
4 –2.0 –2.0
5 5.0 4.0
6 5.0 3.0

b. If Sugita’s beta is 1.18 and the risk-free rate is 8 percent, what would be an
appropriate required return for an investor owning Sugita? (Note: Because the
above returns are based on monthly data, you will need to annualize the returns
to make them compatible with the risk-free rate. For simplicity, you can convert
from monthly to yearly returns by multiplying the average monthly returns by
12.)
c. How does Sugita’s historical average return compare with the return you believe
to be a fair return, given the firm’s systematic risk?
6-11A. (Portfolio Beta and Security Market Line) You own a portfolio consisting of the
following stocks:

Percentage Expected
Stock of Portfolio Beta Return
1 10% 1.00 12%
2 25 0.75 11
3 15 1.30 15
4 30 0.60 9
5 20 1.20 14

The risk-free rate is 8 percent. Also, the expected return on the market portfolio is 11.6
percent.
a. Calculate the expected return of your portfolio. (Hint: The expected return of a
portfolio equals the weighted average of the individual stock’s expected return,
where the weights are the percentage invested in each stock.)
b. Calculate the portfolio beta.
c. Given the information above, plot the security market line on paper. Plot the
stocks from your portfolio on your graph.
d. From your plot in part (c), which stocks appear to be your winners and which
ones appear to be losers?
e. Why should you consider your conclusion in part (d) to be less than certain?

220
SOLUTIONS TO ALTERNATIVE PROBLEMS

6-1A.
(A) (B) (A) x (B) Weighted
Probability Return Expected Return Deviation

P(ki) (ki) k (ki - k )2P(ki)

.15 6% 0.90% 1.26


.30 5 1.50 4.56
.40 11 4.40 1.76
.15 14 2.10 3.90
_
k = 8.9% σ2 = 11.48%
σ = 3.39%
No, Gautney should not invest in the security. The level of risk is excessive for a
return which equals the rate offered on treasury bills.

6-2A. Investment A:

(A) (B) (A) x (B) Weighted


Probability Return Expected Return Deviation

P(ki) (ki) k (ki - k )2P(ki)

0.2 10% 2.0% 2.89%


0.6 13 7.8 0.38
0.2 20 4.0 7.69
k = 13.8% σ2 = 10.96%
σ = 3.31%

Investment B

(A) (B) (A) x (B) Weighted


Probability Return Expected Return Deviation
_ _
P(ki) (ki) k (ki - k )2P(ki)

0.15 6% 0.90% 5.67%


0.30 8 2.40 5.17
0.40 15 6.00 3.25
0.15 19 2.85 7.04
_
k = 12.15% σ2 = 21.13%
σ = 4.60%
Investment A is better. It has a higher expected return with less risk.

221
6-3A.
Security A:
(A) (B) (A) x (B) Weighted
Probability Return Expected Return Deviation
_ _
P(ki) (ki) k (ki - k )2P(ki)

0.2 - 2% 0.4% 69.19%


0.5 19 9.5 2.88
0.3 25 7.5 21.17
_
k = 16.6% σ2 = 93.24%
σ = 9.66%
Security B:

(A) (B) (A) x (B) Weighted


Probability Return Expected Return Deviation
_ _
P(ki) (ki) k (ki - k )2P(ki)

0.1 5% 0.5% 2.704%


0.3 7 2.1 3.072
0.4 12 4.8 1.296
0.2 14 2.8 2.888
_
k = 10.2% σ2 = 9.96%
σ = 3.16%

Security A Security B
k = 16.6% k = 10.2%
σ = 9.66% σ = 3.16%

We cannot say which investment is "better." It would depend on the investor's attitude
toward the risk-return tradeoff.

Required rate Risk-free Market Risk


6-4A. a.  of return  =  rate  + Beta Premium 
     

= 8 % + 1.5 (16% - 8%)

= 20%

b. The 20 percent "fair rate" compensates the investor for the time value of money
and for assuming risk. However, only nondiversifiable risk is being considered,
which is appropriate.

222
6-5A. Eye-balling the characteristic line for the problem, the rise relative to the run is about
1.75. That is, when the S & P 500 return is four percent Bram's expected return would
be about seven percent. Thus, the beta is also approximately 1.75 (7 ÷ 4).

6-6A.
Required
Risk-Free Expected Market Risk-Free
+  - Rate  x Beta = Rate of
Rate  Return 
Return
A 6.75% + (12% - 6.75%) x 1.40 = 14.10%
B 6.75% + (12% - 6.75%) x 0.75 = 10.69%
C 6.75% + (12% - 6.75%) x 0.80 = 10.95%
D 6.75% + (12% - 6.75%) x 1.20 = 13.05%

6-7A.
Required
Risk-Free
Rate of = + (Market Return - Risk-Free Rate) X Beta
Rate
Return

= 7.5% + (10.5% - 7.5%) x 0.85

= 10.05%

6-8A.

If the expected market return is 12.8 percent and the risk premium is 4.3
percent, the riskless rate of return is 8.5 percent (12.8% - 4.3%). Therefore;

Dupree = 8.5% + (12.8% - 8.5%) x 0.82 = 12.03%


Yofota = 8.5% + (12.8% - 8.5%) x 0.57 = 10.95%
MacGrill = 8.5% + (12.8% - 8.5%) x 0.68 = 11.42%

6-9A.
O'Toole Baltimore
Time Price Return Price Return
1 22 45
2 24 9.09% 50 11.11%
3 20 -16.67% 48 -4.00%
4 25 25.00% 52 8.33%

A holding-period return indicates the rate of return you would earn if you bought a
security at the beginning of a time period and sold it at the end of the period, such as
the end of the month or year,

223
6-10A. a. Sugita Market
_ _
Month kt (kt -k )2 kt (kt - k )2

1 1.80% 0.01% 1.50% 0.06%


2 -0.50 5.66 1.00 0.06
3 2.00 0.01 0.00 1.56
4 -2.00 15.05 -2.00 10.56
5 5.00 9.73 4.00 7.56
6 5.00 9.73 3.00 3.06
Sum 11.30 40.19 7.50 22.86

Average
monthly 1.88% 1.25%
return
(Sum ÷ 6)
Annualized
average 22.60% 15.00%
returns
Variance 8.04% 4.58%
(Sum ÷ 5)
Standard
2.84% 2.14%
deviation
Required
Risk-Free
b. Rate of = + (Market Return - Risk-Free Rate) X Beta
Rate
Return
= 8% + [(15% - 8%) X 1.18] = 16.26%
c. Sugita's historical return of 22.6 percent exceeds what we would consider a fair
return of 16.26 percent, given the stock's systematic risk.
6-11A a. The portfolio expected return, k p, equals a weighted average of the individual
stock's expected returns.
kp = (0.10)(12%) + (0.25)(11%) + (0.15)(15%) + (0.30)(9%) +
(0.20)(14%)
= 11.7%
b. The portfolio beta, ßp, equals a weighted average of the individual stock betas
ßp = (0.10)(1.00) + (0.25)(0.75) + (0.15)(1.30) + (0.30)(0.60) +
(0.20)(1.20)
= 0.90

224
c. Plot the security market line and the individual stocks

16.00
3
14.00
5
P 1
12.00 2
M
10.00
8.00 4

6.00
4.00
2.00
0.00
0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40
Beta

d. A "winner" may be defined as a stock that falls above the security market line,
which means these stocks are expected to earn a return exceeding what should
be expected given their beta or systematic risk. In the above graph, these stocks
include 1, 2, 3, and 5. "Losers" would be those stocks falling below the
security market line, that being stock 4.

e. Our results are less than certain because we have problems estimating the
security market line with certainty. For instance, we have difficulty in
specifying the market portfolio.

225