Chapter 8 Risk and Return

STUDY PROBLEMS

8-5 Portofolio Expected rate of return

Penny Francis inherited a $100,000 portfolio of investment from her grandparents when she turned 21
years of the age. The portfolio is comprised of the following three investments:

Expected Return $ Value

Treasury Bills 4.5% 40,000
Ford (F) 8.0% 30,000
Harley Davidson (HOG) 12.0% 30,000

The following figure shows the expected rate of returns for each investment in Penny’s portfolio:

14.00%

12.00%

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12.00%

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10.00%
Expected Return (%)

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8.00%
8.00%
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6.00%
4.50%
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4.00%
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2.00%

0.00%
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Treasury Bills Ford (F) Harley Davidson (HOG)

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a. Based on the current portfolio composition and the expected rates of return given above, the
expected rate of return for Penny’s portfolio is:
is

Expected Return $ Value Weight

Treasury Bills 4.5% 40,000 0.40 (40,000/100,000)
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Ford (F) 8.0% 30,000 0.30 (30,000/100,000)

Harley Davidson (HOG) 12.0% 30,000 0.30 (30,000/100,000
sh

E(rportfolio) = [w1 x E(r1)] + [w2 x E(r2)] + ….. + [wn x E(rn)]

= (0.40 x 4.5%) + (0.3 x 8%) + (0.12 x 12%)
= 1.8% + 2.4% + 3.6%
= 7.8%

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 b. If Penny moves all her money out of Treasury Bills and split it evenly between the two stocks, her
expected rate of return for her portfolio is:

Expected Return $ Value Weight

Treasury Bills 4.5% 0 0
Ford (F) 8.0% 50,000 0.50 (50,000/100,000)
Harley Davidson (HOG) 12.0% 50,000 0.50 (50,000/100,000)

E(rportfolio) = [w1 x E(r1)] + [w2 x E(r2)] + ….. + [wn x E(rn)]

= (0.50 x 8%) + (0.50 x 12%)
= 4% + 6%
= 10%

c. If Penny does move money out of Treasury Bills and into the two stocks she will reap a higher
expected portfolio return, so why would anyone want to hold Treasury Bills in their portfolio?
Although Treasury Bills have a lower expected rate of return then stocks, they are risk free
compared to other securities. Therefore many people include Treasury Bills in their portfolio to

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lower the risk of their portfolios.

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8-23 Portfolio beta and CAPM

o.
You are putting together a portfolio made up of four different stocks. However, you are considering
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two possible weightings:
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Portfolio Weightings
Assets Beta First Portfolio Second Portfolio
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A 2.5 10% 40%

B 1.0 10% 40%
aC s

C 0.5 40% 10%

vi y re

D -1.5 40% 10%

a. The Beta (β) for each portfolio is :

ed d

βportfolio = [W1 x β1] + [W2 x β2] + …. + [Wn x βn]

ar stu

β first portfolio = [W1 x β1] + [W2 x β2] + …. + [Wn x βn]

= (10% x 2.5) + (10% x 1.0) + (40% x 0.5) + (40% x -1.5)
= 0.25 + 0.1 + 0.2 – 0.6
= -0.05
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β first portfolio = [W1 x β1] + [W2 x β2] + …. + [Wn x βn]

Th

= (40% x 2.5) + (40% x 1.0) + (10% x 0.5) + (10% x -1.5)

= 1.0 + 0.4 + 0.05 – 0.15
= 1.30
sh

b. Which portfolio is riskier?

The Second portfolio is riskier because the beta is higher.

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 c. If the risk-free of interest were 4% and the market risk premium were 5%, what rate of return
would you expect to earn of the portfolios?

CAPM formula
E(rasset j) = rrisk-free + βasset j (E(rmarket) – rrisk-free)

Market risk premium

E(rfirst portfolio) = rrisk-free + βfirst portfolio (E(rmarket) – rrisk-free)

= 4% + (-0.05)5%
= 4% - 0.25%
= 3.75%

E(rsecond portfolio) = rrisk-free + βfirst portfolio (E(rmarket) – rrisk-free)

= 4% + (1.3)5%
= 4% + 6.5%

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= 10.5%

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If the risk-free rate of interest were 4% and the market risk premium were 5%, then the rate of
return on the first portfolio is expected to be 3.75%.

o.
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If the risk-free rate of interest were 4% and the market risk premium were 5%, then the rate of
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return on the second portfolio is expected to be 10.5%.
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ar stu
is
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