SOLUTIONS FOR RISK AND RETURN

1
YEAR

X
1
2
3
4
5

AM
VAR
STDEV

8
21
17
-16
9
7.8
206.7
14.377065

2
ORIGINAL PRICE OF BOND
PRICE OF BOND TODAY
SETTLEMENT DATE
MATURITY DATE
COUPON RATE
YIELD
REDEMPTION
PRICE
FREQUENCY
PRICE
PRICE
NOMINAL RETURN

NOMINAL RATE OF RETURN IS

ACCORDING TO FISHER EQUATION
1+N=(1+R)(1+i)
1.0948=(1+R)(1.042)
1.0948/1.042=1+R
0.0506718
so the real rate of return R=5.07%

YEAR

RETURNS
1
2
3
4
5
6

3
38
21
-15
29
-13

AM

10.5

CALCULATION OF GEOMETRIC MEAN

1+R

1.03
1.38
1.21
0.85
1.29
0.87
0.086021096
GEOMETRIC AVERAGE MEAN RETURN IS 8.60%
REMEMBER , THE GEOMETRIC AVERAGE RETURN WILL ALWAYS BE LESS THAN T

YEAR

PRICE
1
2
3
4
5
6

60.18
73.66
94.18
89.35
78.49
95.05

THE ARITHMETIC AVERAGE IS 11.83%

CALCULATION OF GEOMETRIC MEAN
YEAR

1+R
2
3
4

1.233964772
1.287265816
0.956360161

5
6
GM

0.887409065
1.226270863
0.105759168
THE GEOMETRIC MEAN IS 10.58%

RISK RETURN AND SECURITY MARKET LINE

1 STATE OF ECONOMY
RECESSION
NORMAL
BOOM

The expected return of the asset is :

The variance can be calculated as follows

VARIANCE CALCULATION
STOCK A
RETURNS(X)
AVG
0.05
0.08
0.13

(X-AVG)^2
0.0855 0.0012603
0.0855 3.025E-05
0.0855 0.0019803

1
STOCK B
RETURNS (Y)

AVG
-0.17
0.12
0.29

(Y-AVG)^2
0.1105 0.0786803
0.1105 9.025E-05
0.1105 0.0322203

2
WEIGHTS

Q
R
S
T

0.25
0.2
0.15
0.4

0.84
1.17
1.11
1.36

0.21
0.234
0.1665
0.544

PORTFOLIO BETA

1.1545

3
E(Ri)=Rf+[E(Rm)-Rf]i
Rf
Rm

0.052
0.11
1.05

E(Ri)

0.1129
EXPECTED RETURN =11.29%

4
a

BOOM
A
B
C

STATE
BOOM
NORMAL
BUST

PROB

0.24
0.17
0

RETURN OF THE PORTFOLIO IN EACH STATE OF ECONOMY

WEIGHTS
RETURNS
0.4
0.24
0.096
0.4
0.36
0.144
0.2
0.55
0.11
EXPECTED RETURNS
0.35

NORMAL WEIGHTS
RETURNS
A
0.4
B
0.4
C
0.2
EXPECTED RETURNS
BUST
A
B

A
0.35
0.5
0.15

WEIGHTS

0.17
0.13
0.09

0.068
0.052
0.018
0.138

0
-0.28

0
-0.112

RETURNS
0.4
0.4

0.2

-0.45

EXPECTED RETURNS

-0.09
-0.202

EXPECTED RETURN OF THE PORTFOLIO

STATE
BOOM
NORMAL
BUST

PROB

RETURNS
0.35
0.35
0.5
0.138
0.15
-0.202
SUM

EXPECTED RETURN OF THE PORTFOLIO IS 16.12%

CALCULATION OF VARIANCE
STATE
BOOM
NORMAL
BUST

RETURNS (X)
EXPECTED RETURNS(R)
0.35
0.1612
0.138
0.1612
-0.202
0.1612

STANDARD DEVIATION IS 18.04%

THE RISK PREMIUM IS THE RETURN OF A RISK ASSET ,MINUS THE RISK FREE RAT
RISK PREMIUM RPI

0.1612-0.0380
0.1232

The aproximate expected real return is the expected nominal return minus the
0.1612-0.035
0.1262 or 12.62%
EXACT REAL RETURN USING FISHER EQUATION
1+N=(1+i)(1+R)
1.1612=1.035*(1+R)
R

0.121932367

EXACT REAL RETURN IS 12.19%

Y
16
38
14
-21
26
14.6
486.8
22.06354459

1030
COUPON

80

1/1/2000
1/1/2006
0.08
0.07
100
??
1
104.7665397
1047.665
(1047.665-1030)+80/1030
0.094820388

F RETURN IS

1.0948=(1+R)(1.042)

1.0948/1.042=1+R

R
so the real rate of return R=5.07%

9.48%

80 IS THE ANNUAL COUPON PAYMENT

ARITHMETIC AVERAGE RETURN =10.50%

GEOMETRIC MEAN

RAGE MEAN RETURN IS 8.60%

ETURN WILL ALWAYS BE LESS THAN THE ARITHMETIC AVERAGE RETURN IS THE RETURNS HAVE ANY VARIATION

DIVIDEND

RETURNS
0.6
0.64
0.72
0.8
1.2

AM

AVERAGE IS 11.83%

GEOMETRIC MEAN

0.233964772
0.287265816
-0.04363984
-0.11259093
0.226270863
0.118254136

MEAN IS 10.58%

PROBABILITY
0.15
0.65
0.2
E(Ra)

urn of the asset is :

E(Ra)
E(Rb)

RATE OF RETURN IF STATE OCCURS

STOCK A STOCK B
0.05
-0.17
0.08
0.12
0.13
0.29
0.0855
0.1105

8.55
11.05

(0.05-0.0855)^2*0.15+(0.08-0.0855)^2*0.65+(0.13-0.0855)^2*0.2

3 4=2*3
PROB

VAR
STDEV

0.15 0.000189038
0.65 1.96625E-05
0.2 0.00039605
0.00060475
0.024591665
2.46%
3 4=2*3

PROB

VAR
STDEV

0.15 0.011802038
0.65 5.86625E-05
0.2 0.00644405
0.01830475
0.135295048
13.53%

TE OF ECONOMY

C
0.36
0.13
-0.28

0.55
0.09
-0.45

0.1225
0.069
-0.0303
0.1612

EXPECTED RETURNS(R)

(X-R)^2
PROB
0.03564544
0.35 0.012476
0.00053824
0.5 0.000269
0.13191424
0.15 0.019787
VARIANCE
0.032532
STDEV
0.180367

ISK ASSET ,MINUS THE RISK FREE RATE . T BILLS ARE OFTEN USED AS THE RISK FREE RATE SO

12.32%

expected nominal return minus the inflation rate so