Chapters 12 & 13 Practice Problems

1) Two stocks, A and B, have returns over the next year that depends on the state of the economy.
There are four possible outcomes, depending on the economy:

Economy Probability Return on Stock A Return on Stock B

Boom 0.2 20% 7%
Above Average 0.3 10% 5%
Below Average 0.3 0% 2%
Recession 0.2 -10% -5%

(a) Calculate the expected returns for each stock.

(b) Calculate the standard deviation of each stock’s returns.
(c) Calculate the correlation between the returns of the stocks.
(d) Assume you have a portfolio with $7500 invested in A and $2500 invested in B. Calculate the
expected return and standard deviation of returns for this portfolio.

2) Two investment funds use differing investment strategies have provided the following
expectations for the next year. One of the funds is an equity fund and the second fund is a bond
fund.
Proba bility
Sta te of of Sta te of Equity Bond
Na ture Na ture Fund Fund
Boom 0 .25 30 % -10 %
Growth 0 .25 20 % 5%
Norma l 0 .25 10 % 10 %
Recession 0 .25 -30 % 15%
a. Calculate the expected rate of return for the equity fund.
b. Calculate the standard deviation for the equity fund.
c. Calculate the expected rate of return for the bond fund.
d. Calculate the standard deviation for the bond fund.
e. Calculate the correlation of the returns of the two funds.
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.

3) A stock is expected to pay a dividend in one year of $0.08. Dividends are expected to grow after
that at a rate of 1%, forever. The stock has a correlation with the overall market of -0.2. The
standard deviation of the stock’s returns is 0.35 and the standard deviation of the overall
market’s returns is 0.2. If the yield on Treasury Bills (i.e. the risk free rate of interest) is 3%, and
the market is expected to return 5.5% more than Treasury Bills (i.e. the risk premium on the
market is 5.5%), what should be the price of the stock assuming that the Capital Asset Pricing
model is true?

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 4) A well noted financial forecaster has provided the following expected returns and probability
information for three stocks and the market.
Associated
Rate
of Return
State of the Probability of Stock Stock Stock Stock Market
Economy State A B C M
Occurring
Boom .30 10% 35% -8% 18%
Normal .50 7% 15% 5% 10%
Recession .20 -8% -25% 15% -10%

a. Calculate the expected rate of return for stock A, stock B, stock C and the market portfolio.
b. Calculate the standard deviation for stock A, stock B, stock C and the market portfolio.
c. Calculate the correlation coefficient for stock A, stock B, stock C and the market portfolio.
d. Calculate the beta for stock A, stock B, and stock C.

5) Suppose you invest your money in equal proportions in the two securities A and B, whose
properties are shown below:
Stock A Stock B
Expected Return .12 .13
Standard deviation .021 .029
Beta 1.10 1.20
The variance of the market portfolio is .0002 and the correlation coefficient between the returns to stocks
A and B is 0.60.
a) Assuming both stocks are expected to pay the same future dividends which stock should have the
higher price today?
b) What is the expected return on your portfolio?
c) What is the portfolio standard deviation?
d) Are there any benefits to combining stocks A and B into a portfolio?
e) What is the portfolio beta?
f) If returns behave in accordance with CAPM, and the risk free rate is 8%, then what must the
expected return on the market portfolio be?

6) Assume that there is a security that currently pays no dividends. The current price of the security
is $40. The price is expected to be $45.20 next period. The risk free rate of interest is 7% and
the risk premium on the market is 8%. What will be the security’s current price if the expected
future price remains the same but the covariance of its returns with the returns to the market
doubles?

7) A stock is expected to have a dividend next year of $1.50 per share. Dividends are expected to
grow at a rate of 25% per year for the next 8 years. They are then expected to slow down to an
industry average rate of 8%. Based on past returns, this stock’s returns have a standard
deviation of 0.35. This stock has a correlation of 0.6 with returns to the overall market. The
overall market has a standard deviation of 0.15. Historically, the market has returned 8.5% more
than T-bills in an average year. The current yield on T-Bills is 4.5%.
What is your estimate of the value of per share of this stock?

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 8) A stock is expected to pay a dividend of $1.50 per share in one year. After that, dividends are
expected to grow at a rate of 8% per year. The stock has a correlation with the market portfolio
of 0.25. It has a standard deviation of 0.12. The market portfolio has a standard deviation of 0.08
and is expected to return 9% above the risk free rate. The risk free rate of interest is 5%. What
is the value of the stock?

9) An investor purchases $10,000 worth of shares in an index fund whose returns closely parallel
those of the overall market. She also invests $6,000 in Government of Canada T-Bills. What is
the beta of her investment?

10) “The expected return of a stock with a beta of 2 is twice that of a stock with a beta of 1.”
Is this true or false? Explain.

11) You are analyzing a stock that has a beta of 0.75. The risk free rate for the coming year is
8%. The expected return on the market portfolio is 14%.
(a) What is the expected return on the stock?
(b) Suppose this stock is expected to pay a dividend of $1.25 one year from now and the stock
price is not expected to change over the year. At what price should this stock trade today?

12) You are given the following information about two shares, A and B:
r A = 12%, r B = 10%
σA= 4% , σB= 10%
CORRAB= -1

(a) What is the expected return and standard deviation of returns of a portfolio that consists of
60% A and 40% B?
(b) If the correlation between the stocks was 0 (instead of -1), would your answer to (a) change?
If so, recomputed the standard deviation and expected return.

13) If the expected return of a firm’s shares is 16%, the expected market return is 12%, and
the risk free rate of return is 6%, what should the beta of the stock be?

14) You observe the following shares in the market and have calculated their returns and
Betas.
Expected
Stock Return Beta
A 16.00% 1.5
B 13.50% 0.7
C 15.50% 1.3
D 11.00% 0.9

If the risk free rate is currently 4% and the return on the market portfolio is 12%. Which shares should
you immediately sell and which shares should you immediately buy? Why? Show your work.

15) You can borrow or lend at the risk free rate of 9%. The market portfolio has an
expected return of 15% and a standard deviation of 0.21. What are the expected returns
and standard deviations of portfolios where:
a) you lend all of your wealth out at the risk free rate.
b) you lend out one-third of your wealth and invest two thirds in the market portfolio.

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 c) you invest all of your wealth in the market portfolio. Furthermore, you borrow an
amount equal to one-third of your wealth to invest in the market portfolio.

16) You are an investment advisor who believes that the Capital Asset Pricing Model
will hold in the long run for all stocks. That is, the expected return on a stock does not
always have to be the same as CAPM says, but eventually the price of a stock will
adjust so that the CAPM does hold.
You currently have holdings of two stocks, A and B, with the following characteristics:
Expected Return Beta
A 14% 1.2
B 18% 2.9
The current risk free rate is 4% and the expected return on the market is 10%.
Both of these stocks are mispriced according to CAPM (i.e. they do not lie on the
Security Market Line). If these stocks will eventually move back to the SML, how would you
change your holdings of the two stocks (i.e. for each, would you sell, or buy more)?

17) (a) Can the risk–free rate be 10% and the expected return on the market be 5%?
(b) For a particular year, can the risk free rate be 10% and the actual return on
the market be 5%?

18) If IBM stocks returns have the same variance as the market portfolio and the
correlation between the two is 0.7, what is IBM’s beta?

19) Discuss the relationship between risk and return.

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