Practice Week 2:

Risk, Return, and Modern Portfolio Analysis

1. Identify each of the following risks as most likely to be systematic risk or diversifiable
risk:
a. The risk that your main production plant is shut down due to a tornado.
b. The risk that the economy slows, decreasing demand for your firm’s products.
c. The risk that your best employees will be hired away.
d. The risk that the new product you expect your R&D division to produce will not
materialize.

2. Using the data in the following table, estimate (a) the average return and volatility
for each stock, (b) the covariance between the stocks, and (c) the correlation
between these two stocks.

3. The figure below shows the one-year return distribution for RCS stock. Calculate:

a. The expected return.

b. The standard deviation of the return.
4. You have been asked for your advice in selecting a portfolio of assets and have
been given the following data:

Expected Return
Year Asset A Asset B Asset C
2013 12% 16% 12%
2014 14 14% 14
2015 16 12 16

You have been told that you can create two portfolios—one consisting of assets A
and B and the other consisting of assets A and C—by investing equal proportions
(50%) in each of the two component assets.

a. What is the expected return for each asset over the 3-year period?
b. What is the standard deviation for each asset’s return?
c. What is the expected return for each of the two portfolios?
d. How would you characterize the correlations of returns of the two assets
making up each of the two portfolios identified in part c?
e. What is the standard deviation for each portfolio?
f. Which portfolio do you recommend? Why?

5. Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate
three prospective investments: X, Y, and Z. Sharon will evaluate each of these
investments to decide whether they are superior to investments that her company
already has in place, which have an expected return of 12% and a standard
deviation of 6%. The expected returns and standard deviations of the investments
are as follows:

Investment Expected Return Standard Deviation

2013 12% 16%
2014 14 14%
2015 16 12

a. If Sharon were risk neutral, which investments would she select? Explain why.
b. If she were risk averse, which investments would she select? Why?
c. If she were risk seeking, which investments would she select? Why?
d. Given the traditional risk preference behavior exhibited by financial managers,
which investment would be preferred? Why?