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Risk Return Solutions
Chapter5
RiskandReturn
Instructors Resources
Overview
Thischapterfocusesonthefundamentalsoftheriskandreturnrelationshipofassetsandtheirvaluation.
Forthesingleassetheldinisolation,riskismeasuredwiththeprobabilitydistributionanditsassociated
statistics:themean,thestandarddeviation,andthecoefficientofvariation.Theconceptofdiversification
isexaminedbymeasuringtheriskofaportfolioofassetsthatareperfectlypositivelycorrelated,perfectly
negativelycorrelated,andthosethatareuncorrelated.Next,thechapterlooksatinternational
diversificationanditseffectonrisk.TheCapitalAssetPricingModel(CAPM)isthenpresentedasa
valuationtoolforsecuritiesandasageneralexplanationoftheriskreturntradeoffinvolvedinalltypesof
financialtransactions.
Study Guide
ThefollowingStudyGuideexamplesaresuggestedforclassroompresentation:
Example
Topic
Riskattitudes
Graphicdeterminationofbeta
12
Impactofmarketchangesonreturn
112Part2ImportantFinancialConcepts
Riskisdefinedasthechanceoffinancialloss,asmeasuredbythevariabilityofexpectedreturns
associatedwithagivenasset.Adecisionmakershouldevaluateaninvestmentbymeasuringthe
chanceofloss,orrisk,andcomparingtheexpectedrisktotheexpectedreturn.Someassetsare
consideredriskfree;themostcommonexamplesareU.S.Treasuryissues.
2.
Thereturnonaninvestment(totalgainorloss)isthechangeinvalueplusanycashdistributionsover
adefinedtimeperiod.Itisexpressedasapercentofthebeginningoftheperiodinvestment.The
formulais:
Return
Realizedreturnrequirestheassettobepurchasedandsoldduringthetimeperiodsthereturnis
measured.Unrealizedreturnisthereturnthatcouldhavebeenrealizediftheassethadbeen
purchasedandsoldduringthetimeperiodthereturnwasmeasured.
3.
(a) Theriskaversefinancialmanagerrequiresanincreaseinreturnforagivenincreaseinrisk.
(b) Theriskindifferentmanagerrequiresnochangeinreturnforanincreaseinrisk.
(c) Theriskseekingmanageracceptsadecreaseinreturnforagivenincreaseinrisk.
Mostfinancialmanagersareriskaverse.
4.
Sensitivityanalysisevaluatesassetriskbyusingmorethanonepossiblesetofreturnstoobtaina
senseofthevariabilityofoutcomes.Therangeisfoundbysubtractingthepessimisticoutcomefrom
theoptimisticoutcome.Thelargertherange,themorevariabilityofriskassociatedwiththeasset.
5.
Thedecisionmakercangetanestimateofprojectriskbyviewingaplotoftheprobability
distribution,whichrelatesprobabilitiestoexpectedreturnsandshowsthedegreeofdispersionof
returns.Themorespreadoutthedistribution,thegreaterthevariabilityorriskassociatedwiththe
returnstream.
6.
Thestandarddeviationofadistributionofassetreturnsisanabsolutemeasureofdispersionofrisk
aboutthemeanorexpectedvalue.Ahigherstandarddeviationindicatesagreaterprojectrisk.Witha
largerstandarddeviation,thedistributionismoredispersedandtheoutcomeshaveahigher
variability,resultinginhigherrisk.
7.
Thecoefficientofvariationisanotherindicatorofassetrisk,measuringrelativedispersion.Itis
calculatedbydividingthestandarddeviationbytheexpectedvalue.Thecoefficientofvariationmay
beabetterbasisthanthestandarddeviationforcomparingriskofassetswithdifferingexpected
returns.
Chapter5RiskandReturn113
8.
Anefficientportfolioisonethatmaximizesreturnforagivenrisklevelorminimizesriskforagiven
levelofreturn.Returnofaportfolioistheweightedaverageofreturnsontheindividualcomponent
assets:
n
k p wj k j
j1
where:
nnumberofassets,
wjweightofindividualassets,
j expectedreturns.
k
Thestandarddeviationofaportfolioisnottheweightedaverageofcomponentstandarddeviations;
theriskoftheportfolioasmeasuredbythestandarddeviationwillbesmaller.Itiscalculatedby
applyingthestandarddeviationformulatotheportfolioassets:
kp
i 1
9.
(ki k)2
(n 1)
Thecorrelationbetweenassetreturnsisimportantwhenevaluatingtheeffectofanewassetonthe
portfoliosoverallrisk.Returnsondifferentassetsmovinginthesamedirectionarepositively
correlated,whilethosemovinginoppositedirectionsarenegativelycorrelated.Assetswithhigh
positivecorrelationincreasethevariabilityofportfolioreturns;assetswithhighnegativecorrelation
reducethevariabilityofportfolioreturns.Whennegativelycorrelatedassetsarebroughttogether
throughdiversification,thevariabilityoftheexpectedreturnfromtheresultingcombinationcanbe
lessthanthevariabilityorriskoftheindividualassets.Whenoneassethashighreturns,theothers
returnsarelowandviceversa.Therefore,theresultofdiversificationistoreduceriskbyprovidinga
patternofstablereturns.
Diversificationofriskintheassetselectionprocessallowstheinvestortoreduceoverallriskby
combiningnegativelycorrelatedassetssothattheriskoftheportfolioislessthantheriskofthe
individualassetsinit.Evenifassetsarenotnegativelycorrelated,thelowerthepositivecorrelation
betweenthem,thelowertheresultingrisk.
10. Theinclusionofforeignassetsinadomesticcompanysportfolioreducesriskfortworeasons.When
returnsfromforeigncurrencydenominatedassetsaretranslatedintodollars,thecorrelationofreturns
oftheportfoliosassetsisreduced.Also,iftheforeignassetsareincountriesthatarelesssensitiveto
theU.S.businesscycle,theportfoliosresponsetomarketmovementsisreduced.
Whenthedollarappreciatesrelativetoothercurrencies,thedollarvalueofaforeigncurrency
denominatedportfoliodeclinesandresultsinlowerreturnsindollarterms.Ifthisappreciationisdue
tobetterperformanceoftheU.S.economy,foreigncurrencydenominatedportfoliosgenerallyhave
lowerreturnsinlocalcurrencyaswell,furthercontributingtoreducedreturns.
Politicalrisksresultfrompossibleactionsbythehostgovernmentthatareharmfultoforeign
investorsorpossiblepoliticalinstabilitythatcouldendangerforeignassets.Thisformofriskis
particularlyhighindevelopingcountries.Companiesdiversifyinginternationallymayhaveassets
seizedorthereturnofprofitsblocked.
114Part2ImportantFinancialConcepts
11. Thetotalriskofasecurityisthecombinationofnondiversifiableriskanddiversifiablerisk.
Diversifiableriskreferstotheportionofanassetsriskattributabletofirmspecific,randomevents
(strikes,litigation,lossofkeycontracts,etc.)thatcanbeeliminatedbydiversification.
Nondiversifiableriskisattributabletomarketfactorsaffectingallfirms(war,inflation,political
events,etc.).Somearguethatnondiversifiableriskistheonlyrelevantriskbecausediversifiablerisk
canbeeliminatedbycreatingaportfolioofassetswhicharenotperfectlypositivelycorrelated.
12. Betameasuresnondiversifiablerisk.Itisanindexofthedegreeofmovementofanassetsreturnin
responsetoachangeinthemarketreturn.Thebetacoefficientforanassetcanbefoundbyplotting
theassetshistoricalreturnsrelativetothereturnsforthemarket.Byusingstatisticaltechniques,the
characteristiclineisfittothedatapoints.Theslopeofthislineisbeta.Betacoefficientsfor
activelytradedstocksarepublishedinValueLineInvestmentSurveyandinbrokeragereports.The
betaofaportfolioiscalculatedbyfindingtheweightedaverageofthebetasoftheindividual
componentassets.
13. TheequationfortheCapitalAssetPricingModelis:
kjRF[bj(kmRF)],
where:
kj
RF
bj
km
therequired(orexpected)returnonassetj.
therateofreturnrequiredonariskfreesecurity(aU.S.Treasurybill)
thebetacoefficientorindexofnondiversifiable(relevant)riskforassetj
therequiredreturnonthemarketportfolioofassets(themarketreturn)
Thesecuritymarketline(SML)isagraphicalpresentationoftherelationshipbetweentheamountof
systematicriskassociatedwithanassetandtherequiredreturn.Systematicriskismeasuredbybeta
andisonthehorizontalaxiswhiletherequiredreturnisontheverticalaxis.
14. (a) Ifthereisanincreaseininflationaryexpectations,thesecuritymarketlinewillshowaparallel
shiftupwardinanamountequaltotheexpectedincreaseininflation.Therequiredreturnfora
givenlevelofriskwillalsorise.
(b) TheslopeoftheSML(thebetacoefficient)willbelesssteepifinvestorsbecomelessrisk
averse,andalowerlevelofreturnwillberequiredforeachlevelofrisk.
15. TheCAPMprovidesfinancialmanagerswithalinkbetweenriskandreturn.Becauseitwas
developedtoexplainthebehaviorofsecuritiespricesinefficientmarketsanduseshistoricaldatato
estimaterequiredreturns,itmaynotreflectfuturevariabilityofreturns.Whilestudieshavesupported
theCAPMwhenappliedinactivesecuritiesmarkets,ithasnotbeenfoundtobegenerallyapplicable
torealcorporateassets.However,theCAPMcanbeusedasaconceptualframeworktoevaluatethe
relationshipbetweenriskandreturn.
Chapter5RiskandReturn115
TotalAnnualReturn
Answer:
K1
20%
P0
$10, 000, 000
Logistics,Inc.doubledtheannualrateofreturnpredictedbytheanalyst.Thenegativenet
incomeisirrelevanttotheproblem.
116Part2ImportantFinancialConcepts
E52.
ExpectedReturn
Answer:
E53.
Analyst
Probability
Return
WeightedValue
0.35
5%
1.75%
0.05
5%
0.25%
0.20
10%
2.0%
0.40
3%
1.2%
Total
1.00
ExpectedReturn
4.70%
ComparingtheRiskofTwoInvestments
Answer: CV10.100.150.6667
CV20.050.120.4167
Basedsolelyonstandarddeviations,investment2haslowerriskthaninvestment1.Basedon
coefficientsofvariation,investment2isstilllessriskythaninvestment1.Sincethetwo
investmentshavedifferentexpectedreturns,usingthecoefficientofvariationtoassessriskis
betterthansimplycomparingstandarddeviationsbecausethecoefficientofvariationconsiders
therelativesizeoftheexpectedreturnsofeachinvestment.
E54.
ComputingtheExpectedReturnofaPortfolio
Answer:
K p (0.45 0.038) (0.40 0.124) (0.15 0.175)
(0.0171) (0.0496) (0.02625)
0.09295 9.295%
Theportfolioisexpectedtohaveareturnofapproximately9.3%.
E55.
CalculatingaPortfolioBeta
Answer:
Beta 0.20 1.15) (0.10 0.85) (0.15 1.60) (0.20 1.35) (0.35 1.85)
0.2300 0.0850 0.2400 0.2700 0.6475 1.3875
Solutions to Problems
P51.
LG1:RateofReturn: kt
(Pt Pt1 Ct )
Pt1
Basic
(a) InvestmentX:Return
Chapter5RiskandReturn117
P52.
LG1:ReturnCalculations: kt
(Pt Pt1 Ct )
Pt1
Basic
Investment
P53.
Calculation
kt(%)
($1,100$800$100)$800
25.00
($118,000$120,000$15,000)$120,000
10.83
($48,000$45,000$7,000)$45,000
22.22
($500$600$80)$600
3.33
($12,400$12,500$1,500)$12,500
11.20
LG1:RiskPreferences
Intermediate
(a) TheriskindifferentmanagerwouldacceptInvestmentsXandYbecausethesehavehigher
returnsthanthe12%requiredreturnandtheriskdoesntmatter.
(b) TheriskaversemanagerwouldacceptInvestmentXbecauseitprovidesthehighestreturn
andhasthelowestamountofrisk.InvestmentXoffersanincreaseinreturnfortakingon
moreriskthanwhatthefirmcurrentlyearns.
(c) TheriskseekingmanagerwouldacceptInvestmentsYandZbecauseheorsheiswillingto
takegreaterriskwithoutanincreaseinreturn.
(d) Traditionally,financialmanagersareriskaverseandwouldchooseInvestmentX,sinceit
providestherequiredincreaseinreturnforanincreaseinrisk.
P54.
LG2:RiskAnalysis
Intermediate
(a)
Expansion
Range
24%16%8%
30%10%20%
(b) ProjectAislessrisky,sincetherangeofoutcomesforAissmallerthantherangefor
ProjectB.
(c) Sincethemostlikelyreturnforbothprojectsis20%andtheinitialinvestmentsareequal,the
answerdependsonyourriskpreference.
(d) Theanswerisnolongerclear,sinceitnowinvolvesariskreturntradeoff.ProjectBhasa
slightlyhigherreturnbutmorerisk,whileAhasbothlowerreturnandlowerrisk.
P55.
LG2:RiskandProbability
Intermediate
(a)
Camera
Range
30%20%10%
35%15%20%
118Part2ImportantFinancialConcepts
(b)
CameraR
CameraS
Possible
Outcomes
Probability
Pri
ExpectedReturn
ki
Weighted
Value(%)(kiPri)
Pessimistic
0.25
20
5.00
Mostlikely
0.50
25
12.50
Optimistic
0.25
30
7.50
1.00
ExpectedReturn
25.00
Pessimistic
0.20
15
3.00
Mostlikely
0.55
25
13.75
Optimistic
0.25
35
8.75
1.00
ExpectedReturn
25.50
(c) CameraSisconsideredmoreriskythanCameraRbecauseithasamuchbroaderrangeof
outcomes.TheriskreturntradeoffispresentbecauseCameraSismoreriskyandalso
providesahigherreturnthanCameraR.
P56.
LG2:BarChartsandRisk
Intermediate
(a)
BarChartLineJ
0.6
Probability
0.5
0.4
0.3
0.2
0.1
0
0.75
1.25
8.5
ExpectedReturn(%)
14.75
16.25
Chapter5RiskandReturn119
BarChartLineK
0.7
0.6
0.5
Probability
0.4
0.3
0.2
0.1
0
1
2.5
13.5
15
ExpectedReturn(%)
(b)
Probability
Pri
ExpectedReturn
ki
Weighted
Value
(kiPri)
VeryPoor
0.05
0.0075
0.000375
Poor
0.15
0.0125
0.001875
Average
0.60
0.0850
0.051000
Good
0.15
0.1475
0.022125
Excellent
0.05
0.1625
0.008125
1.00
ExpectedReturn
0.083500
VeryPoor
0.05
0.010
0.000500
Poor
0.15
0.025
0.003750
Average
0.60
0.080
0.048000
Good
0.15
0.135
0.020250
Excellent
0.05
0.150
0.007500
1.00
ExpectedReturn
0.080000
Market
Acceptance
LineJ
LineK
(c) LineKappearslessriskyduetoaslightlytighterdistributionthanlineJ,indicatingalower
rangeofoutcomes.
120Part2ImportantFinancialConcepts
P57.
LG2:CoefficientofVariation: CV
k
k
Basic
7%
0.3500
20%
9.5%
B CVB
0.4318
22%
6%
C CVC
0.3158
19%
5.5%
D CVD
0.3438
16%
(b) AssetChasthelowestcoefficientofvariationandistheleastriskyrelativetotheother
choices.
(a) A CVA
P58.
LG2:StandardDeviationversusCoefficientofVariationasMeasuresofRisk
Basic
(a) ProjectAisleastriskybasedonrangewithavalueof0.04.
(b) ProjectAisleastriskybasedonstandarddeviationwithavalueof0.029.Standarddeviation
isnottheappropriatemeasureofrisksincetheprojectshavedifferentreturns.
0.029
(c) A CVA
0.2417
0.12
0.032
B CVB
0.2560
0.125
0.035
C CVC
0.2692
0.13
0.030
D CVD
0.2344
0.128
InthiscaseprojectDisthebestalternativesinceitprovidestheleastamountofriskforeach
percentofreturnearned.Coefficientofvariationisprobablythebestmeasureinthisinstance
sinceitprovidesastandardizedmethodofmeasuringtherisk/returntradeoffforinvestments
withdifferingreturns.
Chapter5RiskandReturn121
P59.
LG2:AssessingReturnandRisk
Challenge
(a) Project257
(1) Range:1.00(.10)1.10
n
ExpectedReturn
RateofReturn
ki
Probability
Pr i
WeightedValue
ki Pr i
.10
0.01
0.001
0.10
0.04
0.004
0.20
0.05
0.010
0.30
0.10
0.030
0.40
0.15
0.060
0.45
0.30
0.135
0.50
0.15
0.075
0.60
0.10
0.060
0.70
0.05
0.035
0.80
0.04
0.032
1.00
0.01
0.010
1.00
3. StandardDeviation:
i=1
0.450
(k k)
i
k k i Pr i
Pri
i=1
ki
ki k
(ki k) 2
Pr i
(ki k) 2Pr i
0.10
0.450
0.550
0.3025
0.01
0.003025
0.10
0.450
0.350
0.1225
0.04
0.004900
0.20
0.450
0.250
0.0625
0.05
0.003125
0.30
0.450
0.150
0.0225
0.10
0.002250
0.40
0.450
0.050
0.0025
0.15
0.000375
0.45
0.450
0.000
0.0000
0.30
0.000000
0.50
0.450
0.050
0.0025
0.15
0.000375
0.60
0.450
0.150
0.0225
0.10
0.002250
0.70
0.450
0.250
0.0625
0.05
0.003125
0.80
0.450
0.350
0.1225
0.04
0.004900
1.00
0.450
0.550
0.3025
0.01
0.003025
0.027350
122Part2ImportantFinancialConcepts
0.165378
0.3675
0.450
Project432
CV
(1) Range:0.500.100.40
n
(2) Expectedreturn: k k i Pr i
i 1
ExpectedReturn
RateofReturn
ki
Probability
Pr i
WeightedValue
ki Pri
0.10
0.05
0.0050
0.15
0.10
0.0150
0.20
0.10
0.0200
0.25
0.15
0.0375
0.30
0.20
0.0600
0.35
0.15
0.0525
0.40
0.10
0.0400
0.45
0.10
0.0450
0.50
0.05
0.0250
k k i Pr i
i 1
1.00
0.300
(k k)
(3) StandardDeviation:
Pri
i 1
ki
ki k
(ki k) 2
Pri
(ki k) 2Pri
0.10
0.300
0.20
0.0400
0.05
0.002000
0.15
0.300
0.15
0.0225
0.10
0.002250
0.20
0.300
0.10
0.0100
0.10
0.001000
0.25
0.300
0.05
0.0025
0.15
0.000375
0.30
0.300
0.00
0.0000
0.20
0.000000
0.35
0.300
0.05
0.0025
0.15
0.000375
0.40
0.300
0.10
0.0100
0.10
0.001000
0.45
0.300
0.15
0.0225
0.10
0.002250
0.50
0.300
0.20
0.0400
0.05
0.002000
0.011250
0.106066
0.3536
0.300
Chapter5RiskandReturn123
(b) BarCharts
Project257
0.35
0.3
0.25
Probability
0.2
0.15
0.1
0.05
0
-10%
10%
20%
30%
40%
45%
50%
60%
70%
80%
100%
RateofReturn
Project432
0.3
0.25
0.2
Probability
0.15
0.1
0.05
0
10%
15%
20%
25%
30%
RateofReturn
35%
40%
45%
50%
124Part2ImportantFinancialConcepts
(c) SummaryStatistics
Project257
Project432
Range
1.100
0.400
ExpectedReturn( k )
StandardDeviation( k )
0.450
0.300
0.165
0.106
CoefficientofVariation(CV)
0.3675
0.3536
SinceProjects257and432havedifferingexpectedvalues,thecoefficientofvariationshould
bethecriterionbywhichtheriskoftheassetisjudged.SinceProject432hasasmallerCV,it
istheopportunitywithlowerrisk.
P510. LG2:IntegrativeExpectedReturn,StandardDeviation,andCoefficientofVariation
Challenge
n
ExpectedReturn
AssetF
RateofReturn
ki
Probability
Pri
WeightedValue
kiPri
0.40
0.10
0.04
0.10
0.20
0.02
0.00
0.40
0.00
0.05
0.20
0.01
0.10
0.10
0.01
k k i Pri
i 1
0.04
AssetG
0.35
0.40
0.14
0.10
0.30
0.03
0.20
0.30
0.06
0.11
AssetH
0.40
0.10
0.04
0.20
0.20
0.04
0.10
0.40
0.04
0.00
0.20
0.00
0.20
0.10
0.02
0.10
AssetGprovidesthelargestexpectedreturn.
Chapter5RiskandReturn125
(b) StandardDeviation: k
(k k)
i
Pri
i 1
(ki k) 2
Pri
0.1296
0.10
0.01296
0.0036
0.20
0.00072
0.00 0.040.04
0.0016
0.40
0.00064
0.05 0.040.09
0.0081
0.20
0.00162
0.10 0.040.14
0.0196
0.10
0.00196
(ki k)
AssetF
0.01790
AssetG
0.0576
0.40
0.02304
0.10 0.110.01
0.0001
0.30
0.00003
0.20 0.110.31
0.0961
0.30
0.02883
0.05190
AssetH
0.0900
0.10
0.009
0.0100
0.20
0.002
0.0000
0.40
0.000
0.00 0.100.10
0.0100
0.20
0.002
0.20 0.100.30
0.0900
0.10
0.009
0.022
0.1338
0.2278
0.1483
Basedonstandarddeviation,AssetGappearstohavethegreatestrisk,butitmustbe
measuredagainstitsexpectedreturnwiththestatisticalmeasurecoefficientofvariation,since
thethreeassetshavedifferingexpectedvalues.Anincorrectconclusionabouttheriskofthe
assetscouldbedrawnusingonlythestandarddeviation.
(c) CoefficientofVariation=
standarddeviation()
expectedvalue
0.1338
3.345
0.04
0.2278
AssetG: CV
2.071
0.11
0.1483
AssetH: CV
1.483
0.10
Asmeasuredbythecoefficientofvariation,AssetFhasthelargestrelativerisk.
AssetF: CV
126Part2ImportantFinancialConcepts
P511. LG2:NormalProbabilityDistribution
Challenge
(a) Coefficientofvariation:CV k k
Solvingforstandarddeviation: 0.75 k0.189
k 0.750.1890.14175
(b) (1) 68%oftheoutcomeswillliebetween1standarddeviationfromtheexpectedvalue:
1 0.189 0.14175 0.33075
1 0.189 0.14175 0.04725
(2) 95%oftheoutcomeswillliebetween2standarddeviationsfromtheexpectedvalue:
2 0.189 (2 0.14175) 0.4725
2 0.189 (2 0.14175) 0.0945
(3) 99%oftheoutcomeswillliebetween3standarddeviationsfromtheexpectedvalue:
3 0.189 (3 0.14175) 0.61425
3 0.189 (3 0.14175) 0.23625
(c)
ProbabilityDistribution
60
50
40
Probability
30
20
10
0
-0.236
-0.094
0.047
0.189
Return
0.331
0.473
0.614
Chapter5RiskandReturn127
P512. LG3:PortfolioReturnandStandardDeviation
Challenge
(a) ExpectedPortfolioReturnforEachYear:kp(wLkL)(wMkM)
Expected
PortfolioReturn
AssetL
AssetM
Year
(wLkL)
(wMkM)
kp
2004
(14%0.405.6%)
(20%0.6012.0%)
17.6%
2005
(14%0.405.6%)
(18%0.6010.8%)
16.4%
2006
(16%0.406.4%)
(16%0.609.6%)
16.0%
2007
(17%0.406.8%)
(14%0.608.4%)
15.2%
2008
(17%0.406.8%)
(12%0.607.2%)
14.0%
2009
(19%0.407.6%)
(10%0.606.0%)
13.6%
(b) PortfolioReturn:
w k
j
kp
kp
j1
n
17.6 16.4 16.0 15.2 14.0 13.6
15.467 15.5%
6
(c) StandardDeviation: kp
(ki k)2
i 1 (n 1)
n
kp
6 1
(2.1%)2 (0.9%)2 (0.5%)2
kp
5
kp
11.42
2.284 1.51129
5
(d) Theassetsarenegativelycorrelated.
(e) Combiningthesetwonegativelycorrelatedassetsreducesoverallportfoliorisk.
kp
128Part2ImportantFinancialConcepts
P513. LG3:PortfolioAnalysis
Challenge
(a) Expectedportfolioreturn:
Alternative1:100%AssetF
kp
Alternative2:50%AssetF50%AssetG
AssetF
(wFkF)
Year
AssetG
(wGkG)
PortfolioReturn
kp
2007
(16%0.508.0%)
(17%0.508.5%)
16.5%
2008
(17%0.508.5%)
(16%0.508.0%)
16.5%
2009
(18%0.509.0%)
(15%0.507.5%)
16.5%
2010
(19%0.509.5%)
(14%0.507.0%)
16.5%
66
16.5%
4
Alternative3:50%AssetF50%AssetH
kp
Year
AssetF
(wFkF)
AssetH
(wHkH)
PortfolioReturn
kp
2007
(16%0.508.0%)
(14%0.507.0%)
15.0%
2008
(17%0.508.5%)
(15%0.507.5%)
16.0%
2009
(18%0.509.0%)
(16%0.508.0%)
17.0%
2010
(19%0.509.5%)
(17%0.508.5%)
18.0%
kp
66
16.5%
4
(b) StandardDeviation: kp
i 1
(ki k)2
(n 1)
(1)
F
5
1.667 1.291
3
Chapter5RiskandReturn129
(2)
FG
FG
FG 0
(3)
FH
FH
FH
FH
5
1.667 1.291
3
(c) Coefficientofvariation:CV k k
1.291
0.0738
17.5%
0
CVFG
0
16.5%
1.291
CVFH
0.0782
16.5%
(d) Summary:
CVF
kp:ExpectedValue
ofPortfolio
kp
CVp
Alternative1(F)
17.5%
1.291
0.0738
Alternative2(FG)
16.5%
Alternative3(FH)
16.5%
1.291
0.0
0.0782
Sincetheassetshavedifferentexpectedreturns,thecoefficientofvariationshouldbeusedto
determinethebestportfolio.Alternative3,withpositivelycorrelatedassets,hasthehighest
coefficientofvariationandthereforeistheriskiest.Alternative2isthebestchoice;itis
perfectlynegativelycorrelatedandthereforehasthelowestcoefficientofvariation.
130Part2ImportantFinancialConcepts
P514. LG4:Correlation,Risk,andReturn
Intermediate
(a) (1) Rangeofexpectedreturn:between8%and13%
(2) Rangeoftherisk:between5%and10%
(b) (1) Rangeofexpectedreturn:between8%and13%
(2) Rangeoftherisk:0risk10%
(c) (1) Rangeofexpectedreturn:between8%and13%
(2) Rangeoftherisk:0risk10%
P515. LG1,4:InternationalInvestmentReturns
Intermediate
(a) Returnpesos
0.20732 20.73%
20, 500
20, 500
(b) Purchaseprice
Salesprice
Priceinpesos
20.50
Priceinpesos
24.75
(c) Returnpesos
2, 512.69 2, 225.84
286.85
0.12887 12.89%
2, 225.84
2, 225.84
(d) Thetworeturnsdifferduetothechangeintheexchangeratebetweenthepesoandthedollar.
Thepesohaddepreciation(andthusthedollarappreciated)betweenthepurchasedateandthe
saledate,causingadecreaseintotalreturn.Theanswerinpart(c)isthemoreimportantof
thetworeturnsforJoe.Aninvestorinforeignsecuritieswillcarryexchangeraterisk.
Chapter5RiskandReturn131
P516. LG5:Total,Nondiversifiable,andDiversifiableRisk
132Part2ImportantFinancialConcepts
Intermediate
(a)and(b)
16
14
12
Portfolio
Risk
(kp)
(%)
10
Diversifiable
8
6
4
Nondiversifiable
2
0
0
10
15
20
25
NumberofSecurities
(c) Onlynondiversifiableriskisrelevantbecause,asshownbythegraph,diversifiableriskcan
bevirtuallyeliminatedthroughholdingaportfolioofatleast20securitieswhicharenot
positivelycorrelated.DavidTalbotsportfolio,assumingdiversifiableriskcouldnolongerbe
reducedbyadditionstotheportfolio,has6.47%relevantrisk.
P517. LG5:GraphicDerivationofBeta
Intermediate
(a)
DerivationofBeta
Asset Return %
32
Asset B
28
b = slope = 1.33
24
20
Asset A
16
12
b = slope = .75
8
4
0
-16
-12
-8
-4
-4 0
12
16
Market
20 Return
-8
-12
Rise Y
Run X
Chapter5RiskandReturn133
Takingthepointsshownonthegraph:
BetaA
Y 12 9 3
0.75
X 8 4 4
Y 26 22 4
1.33
X 13 10 3
Afinancialcalculatorwithstatisticalfunctionscanbeusedtoperformlinearregression
analysis.Thebeta(slope)oflineAis0.79;oflineB,1.379.
(c) Withahigherbetaof1.33,AssetBismorerisky.Itsreturnwillmove1.33timesforeachone
pointthemarketmoves.AssetAsreturnwillmoveatalowerrate,asindicatedbyitsbeta
coefficientof0.75.
BetaB
P518. LG5:InterpretingBeta
Basic
Effectofchangeinmarketreturnonassetwithbetaof1.20:
(a) 1.20(15%)
18.0%increase
(b) 1.20(8%)
9.6%decrease
(c) 1.20(0%)
nochange
(d) Theassetismoreriskythanthemarketportfolio,whichhasabetaof1.Thehigherbeta
makesthereturnmovemorethanthemarket.
P519. LG5:Betas
Basic
(a)and(b)
Asset
Beta
Increasein
MarketReturn
ExpectedImpact
onAssetReturn
Decreasein
MarketReturn
Impacton
AssetReturn
0.50
0.10
0.05
0.10
0.05
1.60
0.10
0.16
0.10
0.16
0.20
0.10
0.02
0.10
0.02
0.90
0.10
0.09
0.10
0.09
(c) AssetBshouldbechosenbecauseitwillhavethehighestincreaseinreturn.
(d) AssetCwouldbetheappropriatechoicebecauseitisadefensiveasset,movinginopposition
tothemarket.Inaneconomicdownturn,AssetCsreturnisincreasing.
134Part2ImportantFinancialConcepts
P520. LG5:BetasandRiskRankings
Intermediate
(a)
Stock
Beta
1.40
0.80
0.30
Mostrisky
Leastrisky
(b)and(c)
Increasein
ExpectedImpact
Decreasein
Impacton
Asset
Beta
MarketReturn
onAssetReturn
MarketReturn
AssetReturn
0.80
0.12
0.096
0.05
0.04
1.40
0.12
0.168
0.05
0.07
0.30
0.12
0.036
0.05
0.015
(d) Inadecliningmarket,aninvestorwouldchoosethedefensivestock,stockC.Whilethe
marketdeclines,thereturnonCincreases.
(e) Inarisingmarket,aninvestorwouldchoosestockB,theaggressivestock.Asthemarket
risesonepoint,stockBrises1.40points.
n
P521. LG5:PortfolioBetas:bp
w b
j
j1
Intermediate
(a)
Beta
PortfolioA
wA
wAbA
1.30
0.10
0.130
0.30
0.39
0.70
0.30
0.210
0.10
0.07
1.25
0.10
0.125
0.20
0.25
1.10
0.10
0.110
0.20
0.22
0.90
0.40
0.360
0.20
0.18
Asset
bA
0.935
PortfolioB
wB
wBbB
bB
1.11
(b) PortfolioAisslightlylessriskythanthemarket(averagerisk),whilePortfolioBismore
riskythanthemarket.PortfolioBsreturnwillmovemorethanPortfolioAsforagiven
increaseordecreaseinmarketreturn.PortfolioBisthemorerisky.
Chapter5RiskandReturn135
P522. LG6:CapitalAssetPricingModel(CAPM):kjRF[bj(kmRF)]
Basic
Case
kj
8.9%
5% [1.30(8%5%)]
12.5%
8% [0.90(13%8%)]
8.4%
9% [0.20(12%9%)]
15.0%
10% [1.00(15%10%)]
8.4%
6% [0.60(10%6%)]
RF[bj(kmRF)]
P523. LG5,6:BetaCoefficientsandtheCapitalAssetPricingModel
Intermediate
TosolvethisproblemyoumusttaketheCAPMandsolveforbeta.Theresultingmodelis:
k RF
km RF
10% 5% 5%
Beta
0.4545
16% 5% 11%
15% 5% 10%
Beta
0.9091
16% 5% 11%
18% 5% 13%
Beta
1.1818
16% 5% 11%
20% 5% 15%
Beta
1.3636
16% 5% 11%
IfKatherineiswillingtotakeamaximumofaverageriskthenshewillbeabletohavean
expectedreturnofonly16%.(k5%1.0(16%5%)16%.)
Beta
(a)
(b)
(c)
(d)
(e)
P524. LG6:ManipulatingCAPM:kjRF[bj(kmRF)]
Intermediate
(a) kj 8%[0.90(12%8%)]
kj 11.6%
(b) 15% RF[1.25(14%RF)]
RF 10%
(c) 16% 9%[1.10(km9%)]
km 15.36%
(d) 15% 10%[bj(12.5%10%)
bj
2
136Part2ImportantFinancialConcepts
P525. LG1,3,5,6:PortfolioReturnandBeta
Challenge
(a) bp(0.20)(0.80)(0.35)(0.95)(0.30)(1.50)(0.15)(1.25)
0.160.33250.450.18751.13
(b) kA
8%
$20, 000
$20, 000
kB
6.86%
$35, 000
$35, 000
kC
15%
$30, 000
$30, 000
kD
12.5%
$15, 000
$15, 000
(c) kP
10.375%
$100, 000
$100, 000
(d) kA4%[0.80(10%4%)]8.8%
kB4%[0.95(10%4%)]9.7%
kC4%[1.50(10%4%)]13.0%
kD4%[1.25(10%4%)]11.5%
(e) Ofthefourinvestments,onlyChadanactualreturnwhichexceededtheCAPMexpected
return(15%versus13%).Theunderperformancecouldbeduetoanyunsystematicfactor
whichwouldhavecausedthefirmnotdoaswellasexpected.Anotherpossibilityisthatthe
firmscharacteristicsmayhavechangedsuchthatthebetaatthetimeofthepurchase
overstatedthetruevalueofbetathatexistedduringthatyear.Athirdexplanationisthatbeta,
asasinglemeasure,maynotcaptureallofthesystematicfactorsthatcausetheexpected
return.Inotherwords,thereiserrorinthebetaestimate.
Chapter5RiskandReturn137
P526. LG6:SecurityMarketLine,SML
Intermediate
(a),(b),and(d)
SecurityMarketLine
16
B
Km
14
SML
12
MarketRisk
RequiredRateof
Return%
Risk premium
10
Risk-free
Rate
8
6
4
2
0
0
0.2
0.4
0.6
0.8
1.2
1.4
NondiversifiableRisk(Beta)
(c) kjRF[bj(kmRF)]
AssetA
kj0.09[0.80(0.130.09)]
kj0.122
AssetB
kj0.09[1.30(0.130.09)]
kj0.142
(d) AssetAhasasmallerrequiredreturnthanAssetBbecauseitislessrisky,basedonthebeta
of0.80forAssetAversus1.30forAssetB.ThemarketriskpremiumforAssetAis3.2%
(12.2%9%),whichislowerthanAssetBs(14.2%9%5.2%).
138Part2ImportantFinancialConcepts
P527. LG6:ShiftsintheSecurityMarketLine
Challenge
(a),(b),(c),(d)
SecurityMarketLines
20
SMLd
SMLa
SMLc
Asset A
18
16
14
Required
Return(%)
12
10
8
6
4
Asset A
2
0
0
0.2
0.4
0.6
0.8
1.2
1.4
NondiversifiableRisk(Beta)
1.6
1.8
(b) kjRF[bj(kmRF)]
kA8%[1.1(12%8%)]
kA8%4.4%
kA12.4%
(c) kA6%[1.1(10%6%)]
kA6%4.4%
kA10.4%
(d) kA8%[1.1(13%8%)]
kA8%5.5%
kA13.5%
(e) (1) Adecreaseininflationaryexpectationsreducestherequiredreturnasshowninthe
paralleldownwardshiftoftheSML.
(2) Increasedriskaversionresultsinasteeperslope,sinceahigherreturnwouldberequired
foreachlevelofriskasmeasuredbybeta.
Chapter5RiskandReturn139
P528. LG6:IntegrativeRisk,Return,andCAPM
Challenge
(a)
Project
kj
RF[bj(kmRF)]
kj
9%[1.5(14%9%)]
16.5%
kj
9%[0.75(14%9%)]
12.75%
kj
9%[2.0(14%9%)]
19.0%
kj
9%[0(14%9%)]
9.0%
kj
9%[(0.5)(14%9%)]
6.5%
(b)and(d)
SecurityMarketLine
20
SMLb
18
SMLd
16
14
Required
Rateof
Return(%)
12
10
8
6
4
2
0
-1
-0.5
0.5
1.5
2.5
NondiversifiableRisk(Beta)
(c) ProjectAis150%asresponsiveasthemarket.
ProjectBis75%asresponsiveasthemarket.
ProjectCistwiceasresponsiveasthemarket.
ProjectDisunaffectedbymarketmovement.
ProjectEisonlyhalfasresponsiveasthemarket,butmovesintheoppositedirectionasthe
market.
140Part2ImportantFinancialConcepts
(d) SeegraphfornewSML.
kA9%[1.5(12%9%)]
13.50%
kB9%[0.75(12%9%)]
11.25%
kC9%[2.0(12%9%)]
15.00%
kD9%[0(12%9%)]
9.00%
kE9%[0.5(12%9%)]
7.50%
(e) ThesteeperslopeofSMLbindicatesahigherriskpremiumthanSMLdforthesemarket
conditions.Wheninvestorriskaversiondeclines,investorsrequirelowerreturnsforany
givenrisklevel(beta).
P529. EthicsProblem
Intermediate
Onewayistoaskhowthecandidatewouldhandleahypotheticalsituation.Onemaygaininsight
intothemoral/ethicalframeworkwithinwhichdecisionsaremade.Anotherapproachistousea
pencilandpaperhonestytestthesearesurprisinglyaccurate,despitetheobviousnotionthatthe
jobcandidatemayattempttogametheexambygivingtherightversustheindividuallyaccurate
responses.Beforeevenadministeringthesituationalinterviewquestionorthetest,askthe
candidatetolistthepreferredattributesofthetypeofcompanyheorsheaspirestoworkfor,and
seeifcharacterandethicstermsemergeinthedescription.Somecompaniesdocredithistory
checks,aftergainingthecandidatesapprovaltodoso.Usingallfourofthesetechniquesallows
onetotriangulatetowardavalidanddefensibleappraisalofacandidateshonestyandintegrity.
Case
Analyzing Risk and Return on Chargers Products Investments
Thiscaserequiresstudentstoreviewandapplytheconceptoftheriskreturntradeoffbyanalyzingtwo
possibleassetinvestmentsusingstandarddeviation,coefficientofvariation,andCAPM.
(a) Expectedrateofreturn: kt
(Pt Pt1 Ct )
Pt1
AssetX:
Year
Cash
Flow(Ct)
Ending
Value(Pt)
Beginning
Value(Pt1)
Gain/
Loss
AnnualRate
ofReturn
1997
$1,000
$22,000
$20,000
$2,000
15.00%
1998
1,500
21,000
22,000
1,000
2.27
1999
1,400
24,000
21,000
3,000
20.95
2000
1,700
22,000
24,000
2,000
1.25
2001
1,900
23,000
22,000
1,000
13.18
2002
1,600
26,000
23,000
3,000
20.00
2003
1,700
25,000
26,000
1,000
2.69
2004
2,000
24,000
25,000
1,000
4.00
2005
2,100
27,000
24,000
3,000
21.25
2006
2,200
30,000
27,000
3,000
19.26
Chapter5RiskandReturn141
AverageexpectedreturnforAssetX11.74%
AssetY:
Beginning
Value(Pt1)
Year
Cash
Flow(Ct)
Ending
Value(Pt)
Gain/
Loss
AnnualRate
ofReturn
1997
$1,500
$20,000
$20,000
$0
1998
1,600
20,000
20,000
8.00
1999
1,700
21,000
20,000
1,000
13.50
2000
1,800
21,000
21,000
8.57
2001
1,900
22,000
21,000
1,000
13.81
2002
2,000
23,000
22,000
1,000
13.64
2003
2,100
23,000
23,000
9.13
2004
2,200
24,000
23,000
1,000
13.91
2005
2,300
25,000
24,000
1,000
13.75
2006
2,400
25,000
25,000
9.60
7.50%
AverageexpectedreturnforAssetY11.14%
(b) k
(k k)
i
(n 1)
i 1
AssetX:
Year
Return
ki
Average
Return,k
(ki k)
(ki k) 2
1997
15.00%
11.74%
3.26%
10.63%
1998
2.27
11.74
9.47
89.68
1999
20.95
11.74
9.21
84.82
2000
1.25
11.74
12.99
168.74
2001
13.18
11.74
1.44
2.07
2002
20.00
11.74
8.26
68.23
2003
2.69
11.74
9.05
81.90
2004
4.00
11.74
7.74
59.91
2005
21.25
11.74
9.51
90.44
2006
19.26
11.74
7.52
56.55
712.97
x
CV
712.97
79.22 8.90%
10 1
8.90
0.76
11.74%
142Part2ImportantFinancialConcepts
AssetY:
Year
Return
ki
Average
Return,k
(k i k)
(k i k)2
1997
7.50%
11.14%
3.64%
13.25%
1998
8.00
11.14
3.14
9.86
1999
13.50
11.14
2.36
5.57
2000
8.57
11.14
2.57
6.60
2001
13.81
11.14
2.67
7.13
2002
13.64
11.14
2.50
6.25
2003
9.13
11.14
2.01
4.04
2004
13.91
11.14
2.77
7.67
2005
13.75
11.14
2.61
6.81
2006
9.60
11.14
1.54
2.37
69.55
69.55
7.73 2.78%
10 1
2.78
CV
0.25
11.14%
Y
(c) SummaryStatistics:
AssetX
AssetY
11.74%
11.14%
StandardDeviation
8.90%
2.78%
CoefficientofVariation
0.76
0.25
ExpectedReturn
Comparingtheexpectedreturnscalculatedinpart(a),AssetXprovidesareturnof11.74percent,
onlyslightlyabovethereturnof11.14percentexpectedfromAssetY.Thehigherstandard
deviationandcoefficientofvariationofInvestmentXindicatesgreaterrisk.Withjustthis
information,itisdifficulttodeterminewhetherthe0.60percentdifferenceinreturnisadequate
compensationforthedifferenceinrisk.Basedonthisinformation,however,AssetYappearsto
bethebetterchoice.
(d) Usingthecapitalassetpricingmodel,therequiredreturnoneachassetisasfollows:
CapitalAssetPricingModel:kjRF[bj(kmRF)]
Asset
RF[bj(kmRF)]
kj
7%[1.6(10%7%)]
11.8%
7%[1.1(10%7%)]
10.3%
Chapter5RiskandReturn143
Fromthecalculationsinpart(a),theexpectedreturnforAssetXis11.74%,comparedtoits
requiredreturnof11.8%.Ontheotherhand,AssetYhasanexpectedreturnof11.14%anda
requiredreturnofonly10.8%.ThismakesAssetYthebetterchoice.
(e) Inpart(c),weconcludedthatitwouldbedifficulttomakeachoicebetweenXandYbecausethe
additionalreturnonXmayormaynotprovidetheneededcompensationfortheextrarisk.In
part(d),bycalculatingarequiredrateofreturn,itwaseasytorejectXandselectY.Therequired
returnonAssetXis11.8%,butitsexpectedreturn(11.74%)islower;thereforeAssetXis
unattractive.ForAssetYthereverseistrue,anditisagoodinvestmentvehicle.
Clearly,ChargerProductsisbetteroffusingthestandarddeviationandcoefficientofvariation,
ratherthanastrictlysubjectiveapproach,toassessinvestmentrisk.BetaandCAPM,however,
providealinkbetweenriskandreturn.Theyquantifyriskandconvertitintoarequiredreturn
thatcanbecomparedtotheexpectedreturntodrawadefinitiveconclusionaboutinvestment
acceptability.Contrastingtheconclusionsintheresponsestoquestions(c)and(d)aboveshould
clearlydemonstratewhyJuniorisbetteroffusingbetatoassessrisk.
(f) (1) Increaseinriskfreerateto8%andmarketreturnto11%:
Asset
RF[bj(kmRF)]
8%[1.6(11%8%)]
12.8%
8%[1.1(11%8%)]
11.3%
kj
(2) Decreaseinmarketreturnto9%:
Asset
RF[bj(kmRF)]
kj
7%[1.6(9%7%)]
10.2%
7%[1.1(9%7%)]
9.2%
Insituation(1),therequiredreturnrisesforbothassets,andneitherhasanexpectedreturn
abovethefirmsrequiredreturn.
Withsituation(2),thedropinmarketratecausestherequiredreturntodecreasesothatthe
expectedreturnsofbothassetsareabovetherequiredreturn.However,AssetYprovidesa
largerreturncomparedtoitsrequiredreturn(11.149.201.94),anditdoessowithless
riskthanAssetX.
Group Exercises
Thisexerciseusescurrentinformationfromseveralwebsitesregardingtherecentperformanceofeach
groupsshadowfirm.Thisinformationisthencomparedtoarelevantindex.Thetimeperiodsfor
comparisonare1and5years.Calculatedannualreturnsandbasicgraphicalanalysisbegintheprocessof
comparison.Correlationbetweenthefirmandthemarketisinvestigatedfurtherthroughtheuseofthe
firmsbeta,andtheriskfreerateasrepresentedbythe3monthTreasuryrate.Lastly,thegroupisaskedto
graphthefirmsSMLusingthedatatheycalculated.
Accurateandtimelyinformationisthefirstmessageofthisassignment.Studentsareencouragedtolookat
severalsitesandalsotosearchforothers.Theinformationcontentofthedifferentsitescanthenbe
compared.Thisinformationisthenusedtogetstudentstoseehowbasicstockmarketanalysisisdone.As
always,partsofthisexercisecanbemodifiedordroppedattheadoptersdiscretion.Onesuggestionisto
addothercorporationstothecomparison(s).Also,someofthemorecomplexcalculationscouldbe
eliminated.
144Part2ImportantFinancialConcepts