Chapters 12&13 Practice Problems

SOLUTION

Problem 1:

(a) E(RA)= E ( R )   R j  Pj = (0.2)(0.2) + (0.3)(0.1) + (0.3)(0) + (0.2)(-0.1) = 0.05 = 5%

j

E(RB)= E ( R)   R j  Pj = (0.2)(0.07) + (0.3)(0.05) + (0.3)(0.02) + (0.2)(-0.05) = 0.025 = 2.5%

j

(b)     R j  E ( R )   Pj
2 2

 2A  0.2(20 – 5)2 + 0.3(10 – 5)2 + 0.3(0 – 5)2 + 0.2(-10 – 5)2 = 105

Standard Deviation   A  105  10.25%

 2B  0.2(7 – 2.5)2 + 0.3(5 – 2.5)2 + 0.3(2 – 2.5)2 + 0.2(-5 – 2.5)2

= 17.25

Standard Deviation   B  17.25  4.15%

(c) COVAB  
j
Pj ( RAj  E ( RA ))( RBj  E ( RB ))

=0.2(20 – 5)(7 – 2.5) + 0.3(10 -5)(5 – 2.5) + 0.3(0 – 5)(2 – 2.5) + 0.2(-10 – 5)(-5 – 2.5) = 40.50

COVAB 40.50
CORR AB   AB    0.95
AB (10.25)(4.15)

(d)

7500
wA   0.75
10000
2500
wB   0.25
10000

E ( RP )  W1  E ( R1 )  W2  E ( R2 )  ...  Wn  E ( Rn )

= 0.75(5%) + 0.25(2.5%) = 4.375%

 P2  WA2 A2  WB2 B2  2WAWBCOVAB

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  (0.75) 2 (10.25) 2  (0.25) 2 (4.15) 2  2(0.75)(0.25)(40.50)
 2 p  75.36
p  75.36
 8.68%

Problem 2:

a)
E ( R )   R j  Pj
j

Equity Fund

E ( R)  30%(.25)  20%(.25)  10%(.25)  (30%)(.25)

E ( R )  7.5%  5.00%  2.5%  7.5%  7.50%

b) Calculate the standard deviation for the equity fund.

Variance:     R j  E ( R )   Pj
2 2

Equity Fund

2
σ = (30% − 7.50%)2 .25 + (20% − 7.50%) 2 .25 + (10% − 7.50%)2 .25 + (−30% − 7.50%)2 .25

2
 126.5625  39.0625  1.5625  351.5625  518.7500

Standard Deviation =    2  518.75  22.77608395  22.78 %

€ c) Calculate the expected rate of return for the bond fund.

Expected Return

E(Rj)= E ( R )   R j  Pj
j

Bond Fund

E ( R )  10%(.25)  5%(.25)  10%(.25)  15%(.25)

E ( R )  2.5%  1.25%  2.5%  3.75%  5%

d) Calculate the standard deviation for the bond fund.

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Variance:     R j  E ( R )   Pj
2 2

Bond Fund


2
 (10%  5%) 2 .25  (5%  5%) 2 .25  (10%  5%) 25 .25  (15%  5%) 2 .25


2
 56.25  0  6.25  25  87.5

   2  87.5  9.354143467  9.3541 %

e) Calculate the correlation of the returns of the two funds.

Correlation of Returns

COVAB   Pj ( RAj  E ( RA ))( RBj  E ( RB ))

j

COVAB
CORR AB   AB 
AB

COVAB  (30%  7.50%)(10%  5%)(.25)  (25%  7.50%)(5%  5%)(.25)

 (10%  7.50%)(10%  5%)(.25)  (30%  7.50%)(15%  5%)(.25)

COVAB  84.375  0  3.125  93.750  175

COVAB  175.0000  175.0000

CORR AB   AB     0.821400508
AB (22.7761)(9.3541) 213.0507569

f) An investor puts 50 percent of their wealth in the equity fund and 50 percent in the bond fund.
Calculate the expected return and standard deviation of the investor’s portfolio.

Porfolio

E ( RP )  W1  E ( R1 )  W2  E ( R2 )  ...  Wn  E ( Rn )

Expected Return - Portfolio

ER p  (.50)(7.50%)  (.50)(5%)

ER p  3.75%  2.5%  6.25%

Risk - Portfolio

 P2  WA2 A2  WB2 B2  2WAWBCOVAB

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 COVAB
CORR AB   AB 
AB

 p2  (.50) 2 (22.7761) 2  (.50) 2 (9.3541) 2  2(.50)(.50)(22.7761)(9.3541)(0.821400508)

 p2  (.25)(518.75)  (.25)(87.5)  2(.50)(.50)(22.7761)(9.3541)(0.821400508)

 2p  129.6875  21.875  87.49965503  64.06284497

p   p2  64.06284497  8.003926847  8.00 %

Problem 3:

Step 1: Calculate the Beta of the stock :

CoviM (−0.2)(0.35)(.20)
i  = = −0.35
 M2 (0.2) 2

Step 2  Calculate the required rate of return  based on CAPM :

€i )  R f   E ( RM )  R f   i
E(R

 3%  ( 0.35)(5.5%)
 1.075%

Step 3: Calculate the current market price:

Dt 1 $0.08
Pt    $106.67
r  g .01075  .01

Problem 4:

E ( R )   R j  Pj
a) j

E(RA ) = 10%(.30) + 7%(.50) + −8%(.20) = 3.0% + 3.5% + −1.6% = 4.90%

E(RB ) = 35%(.30) +15%(.50) + −25%(.20) =10.5% + 7.5% − 5.0% =13.0%
E(RC ) = −8%(.30) + 5%(.50) +15%(.20) = −2.4% + 2.5% + 3.0% = 3.10%
€ E(RM ) =18%(.30) +10%(.50) + −10%(.20) = 5.4% + 5% − 2.0% = 8.40%
€
€
b.     R j  E ( R )   Pj
2 2
€ j

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 A2  (10%  4.90%) 2 (.30)  (7%  4.90%) 2 (.50)  (8%  4.90%) 2 (.20)

 A2  7.803  2.205  33.282  43.290

Standard Deviation :  A   A2  43.290  6.579514  6.58%

 B2  (35%  13.0%) 2 (.30)  (15%  13.0%) 2 (.50)  (25%  13.0%) 2 (.20)

 B2  145.2  2.0  288.80  436.0

Standard Deviation   B   B2  436.0  20.88061  20.88%
 C2  (8%  3.10%) 2 (.30)  (5%  3.10%) 2 (.50)  (15%  3.10%) 2 (.20)

 C2  36.963  1.805  28.322  67.090

Standard Deviation   C   C2  67.090  8.190849  8.19%

 M2  (18%  840%) 2 (.30)  (10%  8.40%) 2 (.50)  (10%  8.40%) 2 (.20)

 M2  27.648  1.28  67.712  96.640

Standard Deviation 

 M   M2  96.640  9.830565  9.83%

c. COVAB   Pj ( RAj  E ( RA ))( RBj  E ( RB ))

j

COVAB
CORR AB   AB 
AB

A and M

Cov AM  10%  4.90%)(18%  8.40%  (.30)  (7%  4.90%)(10%  8.40%)(.50)

( 8%  4.90%)(10%  8.40%)(.20)

 14.688  1.68  47.472  63.84

Cov AM 63.84 63.84

CorrAM   AM     0.986991623  0.9870
 A M (6.58)(9.83) 64.6814

B and M

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Cov BM   35%  13%)(18%  8.40%  (.30)  (15%  13.0%)(10%  8.40%)(.50)
( 25%  13%)(10%  8.40%)(.20)

 63.36  1.6  139.84  204.80

CovBM 204.80 204.80

CorrBM   BM     0.997805607  0.9978
 B M (20.88)(9.83) 205.2504

C and M

Cov CM    8%  3.10%)(18%  8.40%  (.30)  (5%  3.10%)(10%  8.40%)(.50)

(15%  3.1%)(10%  8.40%)(.20)

 31.968  1.52  43.792  74.24

CovcM  74.24  74.24

CorrCM   cM     0.922147819  0.9221
 c M (8.19)(9.83) 80.5077

CoviM
d)  i 
 M2

Stock A:

Cov AM 63.84
A    0.660596026  0.6606
M2
96.640

Stock B:

Cov BM 204.80
B    2.119205298  2.119
 M2 96.640

Stock C:

Cov CM  74.24
C    0.76821192  0.7682
 M2 96.640

Problem 5:

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 a) Assuming the stocks pay the same future dividends, the stock with the higher price today should be
the stock with the lower return. The stock with the lower expected return is the stock with the lower
risk. The relevant measure of risk is the beta, therefore the stock with the lower beta should have the
lower expected return. Since Stock A has a lower beta, it should have a lower expected return, and
higher price.

b) E ( RP )  W1  E ( R1 )  W2  E ( R2 )  ...  Wn  E ( Rn )

w A = .5 w B = .5
E(R p ) = (.5)0.12 + (.5)0.13
= 12.5%

C) σ 2p = w A2 σ A2 + w B2 σ B2 + 2w A w B COVAB
= (.5) 2 (.021) 2 + (.5) 2 (.029) 2 + 2(.5)(.5)(.6)(.021)(.029)
σ 2 p = .0005032
σ p = .0224 or 2.24%

d) Yes, there are benefits to holding a portfolio of stocks A and B since the correlation is less than +1.
€ t
e)  p   Wi  i W A  A  WB  B  ...Wt  t = .5(1.10)  .5(1.20)  1.15
i 1

f) E ( Ri )  R f   E ( RM )  R f   i

0.125  0.08  1.15( E ( R M )  0.08)

E ( R M )  11 .91%

Problem 6:

Dt P  Pt 1 45.20  40
Current expected return = r   t = 0+  13%
Pt 1 Pt 1 40

According to CAPM, currently we have: E ( Ri )  R f   E ( RM )  R f   i

0.13  0.07  (0.08)

  0.75

Winter 2016 7
 Cov iM
Since βi = , if the covariance doubles then beta will double.
σ M2

Thus, the new beta will be 2(0.75) = 1.5

€ Therefore, E ( Ri )  R f   E ( RM )  R f   i

 0.07  1.5(0.08)
 0.19

Dt P  Pt 1
Current expected return = r   t
Pt 1 Pt 1

45.20  today ' s price

0.19  0 
today ' s price
today ' s price  $37.98

Problem 7:

Cov iM
βi =
σ M2

0.6(.35)
  1.4
(0.15)
€
E ( Ri )  R f   E ( RM )  R f   i

= 4.5% + 1.4(8.5%) = 16.4%

Using formulae for growing annuity and growing perpetuity in a two stage growth model:

D1 ⎡ ⎛1+ g ⎞ ⎤
9
D10 ⎛ 1 ⎞
9

price = ⎢1 − ⎜ ⎟ ⎥+ ⎜ ⎟
r − g ⎣ ⎝1+ r ⎠ ⎦ rs − g2 ⎝1+ rs ⎠

1.50 ⎡ ⎛ 1.25 ⎞9 ⎤ 1.50(1.25) 8 (1.08) ⎛ 1 ⎞9

= ⎢1 − ⎜ ⎟ ⎥+ ⎜ ⎟
.164 − 0.25 ⎣ ⎝1.164 ⎠ ⎦ 0.164 − 0.08 ⎝1.164 ⎠
= $44.99

€ Problem 8:

Winter 2016 8
 CoviM 0.25(0.12)(0.08)
i    0.375
M
2
(0.08) 2

E ( Ri )  R f   E ( RM )  R f   i

= 5% + 0.375(9%) = 8.375%

D1 1.50
Value of stock = P0  =  $400
rs  g 0.08375  0.08

Problem 9:

Windex = 10,000/16,000 = .625

WRF = 6,000/16, 000 = .375

index = 1 (since it closely parallels the market)

RF = 0 (Government of Canada T’Bills have 0 risk...risk free rate)

t
 p   Wi  i W A  A  WB  B  ...Wt  t = (.625)(1) + (.375)(0) = .625
i 1

Problem 10:

False, the risk premium will be twice as large, but not the expected return.

Problem 11:

(a) E ( Ri )  R f   E ( RM )  R f   i

= 8% + 0.75(14% - 8%) = 12.5%

D1 D2 D  Pt
(b) P0    ... t
(1  r ) 1
(1  r ) 2
(1  r ) t

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 1.25  P0
P0 
1.125
P0  $10

Problem 12:

(a) E ( R p )  W1  E ( R1 )  W2  E ( R2 )  ...  Wn  E ( Rn )

= 0.6(0.12) + 0.4(0.10) = 11.2%

 P2  WA2 A2  WB2 B2  2WAWBCOVAB

 [(0.6) 2 (0.04) 2  (0.4) 2 (0.10) 2  2(0.6)(0.4)( 1)(0.04)(0.10)]

 0.000256

p  0.000256
 0.016  1.6%

(b)

Yes, the answer changes. The expected return stays the same, however the risk changes.

 P2  WA2 A2  WB2 B2  2WAWBCOVAB

 [(0.6) 2 (0.04) 2  (0.4) 2 (0.10) 2  2(0.6)(0.4)(0)(0.04)(0.10)]0.5

 [(0.6) 2 (0.04) 2  (0.4) 2 (0.10) 2  0]  .002176

p  .002176  0.0466  4.66%

The expected return does not change. Therefore, with negative correlation the expected return is the
same but risk is lower.

Problem 13:


CAPM  SML  E ( Ri )  R f  E  RM )  R f    i 
0.16 = 0.06 + (0.12 – 0.06)  = 1.67

Problem 14:

Expected return in the market

E ( Ri )  R f   E ( RM )  R f   i

Winter 2016 10
 Stock A

E(Ri ) = 4% +1.5(12% − 4%) =16.0%

According to CAPM, this stock should be earning a return of 16.0%. Since this stock is earning its return
of 16.0%, the stock is properly priced in the market; therefore, you are indifferent as to buying or
€ selling of the stock.

Stock B

E(Ri ) = 4% + 0.7(12% − 4%) = 9.6%

According to CAPM, this stock should be earning a return of 9.6%. For this stock to earn a return of 9.6%
rather than the current expected return of 13.5%, the price of the share will increase as investors bid the
€ price up; therefore, buy the stock. Since the expected return> required return, the stock is underpriced,
therefore, you should purchase.

Stock C

E(Ri ) = 4% +1.3(12% − 4%) =14.4%

According to CAPM, this stock should be earning a return of 14.4%. For this stock to earn a return of
14.4% rather than the current expected return of 15.5%, the price of the share will increase as investors
€ bid the price up; therefore, buy the stock. Since the expected return> required return, the stock is
underpriced, therefore, you should purchase.

Stock D

E(Ri ) = 4% + 0.9(12% − 4%) = 11.2%

According to CAPM, this stock should be earning a return of 11.2%. For this stock to earn a return of
11.2% rather than the current expected return of 11%, the price of the share must drop; therefore, sell
€ the stock. Since the expected return< the required return, the stock is over-priced, therefore, you should
sell the stock.

Problem 15:

(a) E ( R p )  W1  E ( R1 )  W2  E ( R2 )  ...  Wn  E ( Rn )

E[Rp] = 100% (9%) + 0 = 9%

p = 0 since the standard deviation of the risk free rate = 0

(b)

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 wf  1 wM  2
3 3
   
E[ R p ]  1 0.09  2 0.15
3 3
 13%
 p2  w 2f  2f  wM2  M2  2w f wM Cov[ R f , RM ]
 0  wM2  M2  0
 p  wM  M
 
 2 (0.21)
3
 0.14

(c) Since we are borrowing at the risk free rate and investing these extra funds in the market:

wf   1 wM  4
3 3
   
E[ R p ]   1 0.09  4 0.15  17%
3 3
 
 p  wM  M  4 (0.21)  0.28
3
Problem 16: According to E (Ri ) = R f + [ E ( RM ) − R f )] × βi

Stock A: Required Return: E[RA] = 4% + 1.2(10% - 4%) = 11.2%

€
Expected Return: 14% (given)

Stock A’s expected return is higher than CAPM says it should be, the stock is undervalued and
you should buy.

Stock B: Required Return: E[R B] = 4% + 2.9(10% - 4%) = 21.4%

Expected Return: 18% (given)

Stock B’s expected return is lower than CAPM says it should be, therefore it is overvalued and
you should sell.

Problem 17:

(a) No. In a well functioning market, investors must expect to be compensated for taking risks.
Otherwise, everyone would invest in the riskless asset.

(b) Yes. The expected return on the market must exceed the risk free rate, but in any given year
the realized return (i.e. the actual outcome) may be very low or even negative

Problem 18:

Winter 2016 12
 Cov iM COVAB
βi = CORR AB   AB 
σ M2 AB

Since the standard deviation of IBM and the market are equal and the CORR IBM,M = 0.7 :

0.7 i
€ i 
M

The Beta of IBM = .7

Problem 19:
In order for investors to be willing to purchase an asset, the expected return must be adequate to
compensate for the risk of the asset. The larger the risk (market risk, as measured by beta), the larger
the expected return.

Winter 2016 13