Old Exam Questions - Risk and Rates of Return - Solutions Page 1 of 62 Pages

Risk and Rates of Return - Solutions
1. The variance of a portfolio consisting of Securities 1 through 5, with weights W1 through

W5, can be written as:
P2 = W1212 + W2222 + W3232 + W4242+ W5252
+ 2W1W2COV12 + 2W1W3COV13 + 2W1W4COV14 + 2W1W5COV15
+ 2W2W3COV23 + 2W2W4COV24 + 2W2W5COV25 + 2W3W4COV34
+ 2W3W5COV35 + 2W4W5COV45
* A. True
B. False
2. The Efficient Frontier can be defined as consisting of those portfolios that offer the
highest return for a given level of risk, or the least risk for a given level of return.
* A. True
B. False
3. A covariance matrix involving N securities will have [ (N)*(N) ] cells, [ N ] variance terms,
[ (N)*(N-1) / 2 ] covariance terms, and [ (N)*(N-1) / (N-1) ] pairs of covariance terms.
A. True
* B. False
4. Assume that Securities A and B are expected to pay exactly the same dividend stream
over time. However, Security A has a beta of -1.50, while Security B has a beta of
+1.50. Because Security A has less risk than Security B (in fact, because of the negative
beta it has less risk than a risk-free security), its required rate of return will be less and
its price will be more than for Security B.
* A. True
B. False
5. Fannie Mae uses duration to manage its interest rate risk. To do so, it attempts to
maximize the difference between the duration of its assets and the duration of its
liabilities. This help to maximize profits while immunizing or minimizing their exposure to
interest rate risk.
A. True
* B. False
Old Exam Questions - Risk and Rates of Return - Solutions Page 1 of 62 Pages
6. Prices of debt (fixed income) securities are directly related to the required rate of return.
As market interest rates (required rates of return) go up, the price of the security also
goes up.
A. True
* B. False
7. If you constructed a variance/covariance matrix for the S&P 500, you would need to
calculate 500 variances and 124,750 pairs of covariances.
* A. True
B. False
8. The variance of a 4-security portfolio can be calculated as follows:
2P = W1221 + W2222 + W3223 + W4224
+ W1W212COR12 + W1W313COR13 + W1W414COR14
+ W2W323COR23 + W2W424COR24 + W3W434COR34
A. True
* B. False
9. Given a risk-free rate of 5 percent and an expected return on the market of 12 percent (a
market risk premium of 7 percent), a security with a beta of +2.0 will have a required rate
of return of 19 percent, while a security with a beta of -2.0 will have a required rate of
return of -9 percent.
* A. True
B. False
10. The sinking of the PetroBras oil-drilling platform in March of 2001 is an example of
company, or idiosyncratic risk, since the risk was specifically related to PetroBras, and
not the market as a whole. And, as such, it could have been diversified away.
* A. True
B. False
11. Because of flotation costs, the cost to the firm of debt financing, preferred stock, retained
earnings, newly issued equity, etc., will always be greater than the investors’ comparable
required rates of return.
A. True
* B. False
12. One common way of selecting a risk-adjusted discount rate for a project is simply to
make a subjective adjustment to the firms overall cost of capital: increase the rate for
higher-risk projects and decrease the rate for lower-risk projects.
* A. True
B. False
1. Which of the following statements is not (or least) correct?
A. The coefficient of variation is a measure of a distribution’s degree of dispersion

per unit of expected value.
* B. Although the beta of a diversified portfolio represents that risk which cannot be
diversified away, the beta of a single security, since it is not diversified, is a
measure of its total or stand-alone risk.
C. Beta can be defined either as [(COVJM) / (2M)] or as [(CORJM)(J) / (M)]. This
indicates that when comparing securities, a security that has a higher
correlation with the market may not necessarily also have the higher beta.
D. The beta of a portfolio comprised of 100 stocks will not necessarily be less than
the beta of a portfolio comprised of only 50 stocks.
E. The standard deviation (or stand-alone risk) of a portfolio comprised of 100
stocks will not necessarily be less than the standard deviation of a portfolio
comprised of only 50 stocks.
2. Select the statement that is most correct.
* A. Assuming that everyone can lend and borrow at the same risk-free rate,
rational investors will hold a portfolio on the capital market line (i.e., a ray from
the risk-free rate that is tangent to the efficient frontier of risky securities).
B. The Capital Asset Pricing Model is based on the proposition that any stock’s
required rate of return is equal to the risk-free rate plus a risk premium that
compensates investors for diversifiable risk.
C. An investor can eliminate company specific risk simply by increasing a
security’s correlation with the market.
D. The slope of the security market line measures a security’s beta (non-
diversifiable risk) and beta can change whenever there is a change in
investors’ expectations of inflation and/or their degree of risk aversion.
E. A portfolio consisting of two stocks that are perfectly positively correlated will
be exactly as risky (using either standard deviation or beta) as either of the
stocks comprising the portfolio.
3. Stock X has a beta of 0.5 and Stock Y has a beta of 1.5. Which of the following
statements is most correct?
A. Stock Y's actual return this year will be higher than Stock X's return.
B. Stock Y's actual return has a higher standard deviation than Stock X.
* C. If expected inflation increases (but the market risk premium is unchanged), the
required returns on the two stocks will increase by the same amount.
D. If the market risk premium declines (leaving the risk-free rate unchanged),
Stock X will have a larger decline in its required return than will Stock Y.
E. If you invest $50,000 in Stock X and $50,000 in Stock Y, your portfolio will have
a beta less than 1.0, provided the stock returns on the two stocks are not
perfectly correlated.
4. Which of the following statements is most correct?
A. Portfolio diversification reduces the variability of the returns on the individual

stocks held in the portfolio.
B. If an investor buys enough stocks, he or she can, through diversification,
eliminate virtually all of the non-market (or company-specific) risk inherent in
owning stocks. Indeed, if the portfolio contained all publicly traded stocks, it
would be riskless.
C. The required return on a firm’s common stock is determined by its systematic
(or market) risk. If the systematic risk is known, and if that risk is expected to
remain constant, then no other information, including market information, is
required to specify the firm’s required return.
* D. A security’s beta measures its non-diversifiable (systematic, or market) risk
relative to that of the market or an “average stock” within the market.
E. A stock’s beta is less relevant as a measure of risk to an investor with a well-
diversified portfolio than to an investor who holds only that one stock.
5. Which of the following statements is most correct?
* A. Beta measures market risk, but if a firm's stockholders are not well diversified,
beta may not accurately measure stand-alone risk.
B. If the calculated beta underestimates the firm's true investment risk, then the
CAPM method will overestimate ks.
C. The discounted cash flow method of estimating the cost of equity can't be used
unless the growth component, g, is constant during the analysis period.
D. An advantage shared by both the DCF and CAPM methods of estimating the
cost of equity capital, is that they yield precise estimates and require little or no
judgment.
E. All of the statements above are false.
1.
Ex Post Market Security J
Observations Return Return
1 -5% - 8%
2 12% 25%
3 10% 15%
4 20% 20%
5 18% 28%
If the risk-free rate is expected to be 6 percent for the coming period, and if the best
guess of the market’s return is its historical average, then what is the best estimate of
Security J's required rate of return for the coming period?
A. 12.35%
B. 12.88%
C. 12.47%
D. 12.76%
* E. 12.62%
KM = [-.05 + .12 + .10 + .20 + .18]/[5] = .11
KJ = [-.08 + .25 + .15 + .20 + .28]/[5] = .16
COVJM = [-.05-.11][-.08-.16] = .0384

[ .12-.11][ .25-.16] = .0009
[ .10-.11][ .15-.16] = .0001
[ .20-.11][ .20-.16] = .0036
[ .18-.11][ .28-.16] = .0084
.0514/4 = .01285
2M = [(-.05-.11)2 + (.12-.11)2 + (.10-.11)2 + (.20-.11)2 + (.18-.11)2]/[4] = .00970
J = [.01285]/[.00970] = 1.3247423
Alternatively:
Using your calculator you can use regression analysis to also determine that the
average historical returns are 11% and 16% and that the beta is 1.3247423, which
then allows you to determine the required rate of return as:
KJ = .06 + [.11 - .06][1.3247423] = 0.1262371 = 12.62%
2. A security has the following ex ante probability distribution of possible returns:
State Probability Return

1 20% - 5%
2 40% 20%
3 40% 30%
Using the Z-tables at the end of this assignment determine the probability of actually
observing a value between 0.0% and 25.0%.
A. 59.18%
* B. 61.14%
C. 57.15%
D. 63.19%
E. 55.11%
Mean value = 19%
Standard Deviation = .128062
Z1 = (0.00 - 0.19) / (0.128062) = -1.48 => Probability = 43.06%
Z2 = (0.25 - 0.19) / (0.128062) = 0.47 => Probability = 18.08%
Total Probability = 43.06% + 18.08% = 61.14%
3. You are given the following ex ante probability distribution for the returns on Security
A:
State Probability Return

1 30% 5%
2 40% 10%
3 30% 15%
Based on this information, what is the coefficient of variation for Security A?
A. 0.6834
B. 0.2173
* C. 0.3873
D. 0.7372
E. 0.5852
Expected Return = (0.30)(0.05) + (0.40)(0.10) + (0.30)(0.15)
Expected Return = 0.015 + 0.04 + 0.045 = 0.10
Variance = (0.30)(0.05-0.10)2 + (0.40)(0.10-0.10)2 + (0.30)(0.15-0.10)2

Variance = 0.00075 + 0.00000 + 0.00075 = 0.0015
Standard Deviation = (0.0015)1/2 = 0.038729833
Coefficient of Variation = 0.038729833 / 0.10 = 0.3873
4. Assume that you observe the following percentage returns (in decimal form) for the
Market and for Security A. Use regression analysis to determine how the returns for
Security A are related to the returns for the Market. Based on these results, if the risk-
free rate is expected to be 4 percent, and the market risk premium is expected to be 7
percent, then what is the required rate of return for Firm A based on the CAPM?
Year Market Security A

2002 - .10 -.25
2001 .15 .00
2000 .20 .30
1999 .30 .64
1998 .28 .40
A. 18.53%
B. 17.85%
C. 18.37%
D. 17.59%
* E. 18.12%
Do the following on your HP-10BII

.10 +/- Input .25 +/- +
.15 Input .00 +
.20 Input .30 +
.30 Input .64 +
.28 Input .40 +
0  y,m -0.116929791 (intercept)

 SWAP 2.017649341 (slope)
K = .04 + (.07)(2.017649341) = 18.12%
YOU ARE GIVEN THE FOLLOWING DATA FOR PROBLEMS 5 - 7:
Variance/Covariance Matrix
Security A Security B Market
Security A 0.00390625 0.00221875 0.00393250
Security B 0.00221875 0.00504100 0.00514250
Market 0.00393250 0.00514250 0.00302500
5. If the risk-free rate is expected to be 4 percent, and the market risk premium is
expected to be 7 percent, then what is the required rate of return for Security A based
on the CAPM?
* A. 13.10%
B. 13.50%
C. 13.40%
D. 13.20%
E. 13.30%
BetaA = 0.00393250 / 0.00302500 = 1.3
KA = .04 + (.07)(1.3) = 13.10%
6. Assume that you put half of your money into Security A and half of your money into
Security B. What is the standard deviation of the resulting portfolio? (Note: you may
wish to take all calculations out to 8-9 decimal places before rounding at the end of the
problem.)
A. 5.22%
B. 5.49%
* C. 5.78%
D. 4.93%
E. 5.31%
P2 = (.5)2(.00390625) + (.5)2(.00504100) + (2)(.5)(.5)(.00221875)

P2 = .000976563 + .00126025 + .001109375 = .003346188
P = [.003346188]1/2 = 0.057846244 = 5.78%
7. If the expected return for Security B is 10%, then what is the probability that you will
observe an actual value between 5.03 percent and 14.97 percent? (Note: a Z-table
may be found on Page 15 of the exam handout packet.)
* A. 51.60%
B. 54.12%
C. 48.64%
D. 57.80%
E. 46.36%
B = [.00504100]1/2 = 0.0710
Z1 = (.0503 - .10) / .071 = -.70

Z2 = (.1497 - .10) / .071 = .70
Prob1 = 25.80%
Prob2 = 25.80%
Total Probability = 25.80% + 25.80% = 51.60%
8. You are given the following returns on the Market and on Security A. Assume that
over the coming year the risk-free rate is expected to be 5 percent and the risk
premium on the market is expected to be 4 percent. Using regression analysis and the
CAPM, determine the required rate of return for Security A over the coming year.

2002 - .10 -.25
2001 .15 .00
2000 .20 .30
1999 .30 .64
1998 .28 .40
A. 12.78%
* B. 13.07%
C. 14.24%
D. 13.59%
E. 13.82%
Do the following on your HP-10BII
.10 +/- Input .25 +/- +
.15 Input .00 +
.20 Input .30 +
.30 Input .64 +
.28 Input .40 +
0  y,m -0.116929791 (intercept)

 SWAP 2.017649341 (slope)
K = .05 + (.04)(2.017649341) = 13.07%
9. You are analyzing two normal distributions of return. Distribution A has a mean value
of 10.85%, while Distribution B has a mean value of 10.50%. You find that there is a
1.50 percent probability that Distribution A will have a return less than zero, while there
is a 4.01 percent probability that Distribution B will have a value less than zero. Using
Z-tables or t-Tables (see the exam handout), determine what the covariance will be
between the two securities if their correlation is 0.75.
A. 0.00195
B. 0.00335
* C. 0.00225
D. 0.00285
E. 0.00245
From table, Probability of 1.50%  ZA = 2.17
A = 0.1085 / 2.17 = 0.05
From table, Probability of 4.01%  ZB = 1.75
B = 0.105 / 1.75 = 0.06
COVAB = (CORAB)(A)(B) = (.75)(0.05)(0.06) = 0.00225
10. You note that Security J has a required rate of return of 13 percent using the CAPM.
Assume that the risk-free rate is 5%, the risk premium for the market is 5%, and the
covariance of Security J with the Market is 0.00340. Given this data, determine the
standard deviation of the Market?
A. 4.75%
B. 4.48%
C. 4.32%
D. 4.20%
* E. 4.61%
0.13 = 0.05 + (0.05)(BetaJ)
BetaJ = 1.60 = COVJM / 2M
2M = COVJM / BetaJ = 0.00340 / 1.60 = 0.002125
M = [.002125]1/2 = 0.046097722 = 4.61%
11. You note that Security J has a standard deviation of 0.045, a covariance with the
market of 0.00108, and a correlation with the market of 0.80. Assume that the risk-free
rate is 5%, and the risk premium for the market is 5%. Given this data, and using the
CAPM, determine the required rate of return for Security J.
A. 10.75%
B. 10.58%
C. 11.23%
* D. 11.00%
E. 10.31%
M = 0.00108 / (0.8)(0.045) = 0.03
2M = (0.03)2 = 0.0009
BetaJ = 0.00108 / 0.0009 = 1.20
KJ = 0.05 + (0.05)(1.2) = 0.11 = 11.0%
12. Company A's stock has an estimated beta of 1.4, and its required rate of return is 13
percent. Company B’s stock has a beta of 0.8, and the risk-free rate is 6 percent.
Determine the required rate of return on Company B’s stock.
* A. 10.0%
B. 9.8%
C. 10.4%
D. 10.2%
E. 10.6%
Calculate the market risk premium (kM - kRF) using the information for Company A:
13.0% = 6.0% + (kM - kRF)(1.4)
kM - kRF = 5.0%.
Now calculate the required return for Company B:
KS = 6% + (5%)(0.8) = 10.0%
13. Historical rates of return for the market and for Stock A are given below:
Year Market Stock A
1 6.0% 8.0%
2 -8.0 3.0
3 -8.0 -2.0
4 18.0 12.0
Assume that the required return on the market is 11 percent and the risk-free rate is 6
percent. Determine the required return on Stock A (use regression analysis to
determine beta and then apply CAPM/SML theory).
A. 8.03%
B. 7.67%
C. 7.45%
* D. 8.27%
E. 7.89%
kA = 6.0% + (11.0% - 6.0%)A.
Calculate A as follows using a financial calculator:
6 Input 8 +
-8 Input 3 +
-8 Input -2 +
18 Input 12 +
0  y,m Interecept = 4.34322
 swap A = 0.453389831.
kA = 6.0% + (11.0% - 6.0%)(0.453389831) = 8.2669492% = 8.27%
14. Assume that you currently manage a $500,000 portfolio. You are expecting to receive
an additional $250,000 from a new client. The existing portfolio has a required return
of 10.75 percent. The risk-free rate is 4 percent and the return on the market is 9
percent. If you want the required return on the new portfolio to be 11.5 percent,
determine what the average beta will have to be for the new stocks added to the
portfolio.
A. 1.53
B. 1.95
C. 1.67
D. 1.38
* E. 1.80
Find the beta of the original portfolio (Old) as
10.75% = 4% + (9% - 4%)Old or Old = 1.35.
To achieve an expected return of 11.5%, the new portfolio must have a beta (New) of
11.5% = 4% + (9% - 4%)(New) or (New) = 1.5.
To construct a portfolio with a New = 1.5, the added stocks must have an average beta
(Avg) such that:
1.5 = ($250,000/$750,000) )Avg + ($500,000/$750,000)(1.35)
1.5 = 0.333)Avg + 0.90
Avg = 0.6 / 0.333 = 1.80
15. Company A's stock has an estimated beta of 1.3, and its required rate of return is 11.8
percent. Company B’s stock has a required rate of return of 13.0 percent. If the
expected return on the market is 10 percent, then determine the beta of Company B’s
stock.
A. 1.35
* B. 1.50
C. 1.45
D. 1.55
E. 1.40
Calculate the risk-free rate (kRF) using the information for Company A:
0.118 = kRF + (0.10 - kRF)(1.3) = 0.13 - (0.3)(kRF)
kRF = (0.118 - 0.13) / 0.3 = 0.04
Now calculate the beta for Company B:
KB = 0.13 = 0.04 + (0.10 - 0.04)()
 = (0.13 - 0.04) / 0.06 = 1.5
16. Assume that Company A has a beta of 1.5, while Company B has a beta is 0.8. The
risk-free rate is 8 percent, and the required rate of return on an “average” stock is 12
percent. Now assume that the expected rate of inflation built into KRF rises by 1
percentage point, the real risk-free rate remains constant, the required return on the
market rises to 15 percent, and betas remain constant. Determine by how much the
required return on Company A will exceed that on Company B after all of these
changes have been reflected in the data.
A. 5.48%
B. 4.86%
C. 5.23%
* D. 4.20%
E. 4.61%
A = 1.5; B = 0.8; KRF = 8%; KM = 12%
Inflation increases by 1%, but K* remains constant
KRF increases by 1% to 9%; KM rises to 15%
Before inflation change:

KA = 8% + (12% - 8%)(1.5) = 14%
KB = 8% + (12% - 8%)(0.8) = 11.2%
After inflation change:

KA = 9% + (15% - 9%)1.5 = 18.0%
KB = 9% + (15% - 9%)0.8 = 13.8%
KA - KB = 18.0% - 13.8% = 4.20%
YOU ARE GIVEN THE FOLLOWING INFORMATION FOR PROBLEMS 17 - 18:
Here are the expected returns on two stocks:
Returns
State Probability
Stock A Stock B
1 0.1 - 20% 10%
2 0.8 20 15
3 0.1 40 20
17. Assume that the variance of Stock A is 0.0196. Determine the probability that Stock A
will have a return less than 10 percent. (Hint: Z-tables and t-tables are included
towards the end of the exam handout.)
A. 32.76%
B. 41.29%
C. 35.94%
* D. 28.43%
E. 38.18%
KA = (.1)(-20%) + (.8)(20%) + (.1)(40%) = 18%
A2 = (.1)(-.20-.18)2 + (.8)(20-.18)2 + (.1)(.40-.18)2 = .0196
A = (.0196)1/2 = .14
ZA = (.10 - .18) / .14 = .57
Probability (.57) = 21.57%

Probability = .50 - .2157 = 28.43%
18. Assume that you form an equal-weighted (50-50) portfolio of the two stocks.
Determine the standard deviation of the resulting portfolio.
A. 6.84%
B. 7.71%
* C. 8.08%
D. 7.45%
E. 7.16%
Returns
State Probability
Stock A Stock B Portfolio
1 0.1 - 20% 10% -5%
2 0.8 20 15 17.5
3 0.1 40 20 30
KP = (.1)(-5%) + (.8)(17.5%) + (.1)(30%) = 16.5%
P2 = (.1)(-.05-.165)2 + (.8)(.175-.165)2 + (.1)(.30-.165)2 = .006625
P = (.006525)1/2 = .080777472 = 8.08%
19. You are given the ex ante probability distribution listed below. Based on this
distribution, calculate the coefficient of variation for Security J.
State
of Probability Security J Security K Market
Nature
1 0.2 - 10% - 5% - 6%
2 0.4 15% 11% 8%
3 0.4 25% 18% 13%
* A. 0.9147
B. 0.9483
C. 0.9716
D. 1.0000
E. 1.2379
Answer: A 0.9147

KJ = [(.2)(-.10) + (.4)(.15) + (.4)(.25)] = .14
J = [(.2)(-.10 - .14)2 + (.4)(.15 - .14)2 + (.4)(.25 - .14)2]1/2
J = [.01152 + .00004 + .00484]1/2 = [.0164]1/2 = .128062485
CV = .128062485 / .14 = 0.9147
20. You are given the ex post distribution of historical returns listed below. You should be
able to use regression analysis to determine the beta for Security J. Given an
expected risk-free rate of 4% and an expected return on the market of 8%, you should
now be able to determine the investor’s required rate of return for Security J. If
Security J is an issue of preferred stock that pays a constant annual dividend of $15
per year, then how much should an investor be willing to pay for this stock?
Year Security J Security K Market

1 2% 16% 6%
2 10% 14% 2%
3 16% 22% 12%
4 24% 2% 15%
5 8% 6% 5%
A. $150.70
B. $155.70
C. $160.70
* D. $165.70
E. $170.70
Answer: D $165.70
.06 Input .02 +

.02 Input .10 +
.12 Input .16 +
.15 Input .24 +
.05 Input .08 +
Solve for slope = BetaJ = 1.263157895
Alternatively:
_
KJ = [.02 + .10 + .16 + .24 + .08] / 5 = 12%
_
KM = [.06 + .02 + .12 + .15 + .05] / 5 = 8%
COVJM = [(.02-.12)(.06-.08) + (.10-.12)(.02-.08) + (.16-.12)(.12-.08) +
(.24-.12)(.15-.08) + (.08-.12)(.05-.08)] / [5-1]
COVJM = [.0144] / [4] = 0.0036
2M = [ (.06-.08)2 + (.02-.08)2 + (.12-.08)2 + (.15-.08)2 + (.05-.08)2] / [5-1]
2M = [.0114] / [4] = 0.00285
BetaJ = [0.0036] / [0.00285] = 1.263157895
K = 0.04 + (0.08 – 0.04)(1.263157895) = 0.090526316
Price = $15 / 0.090526316 = $165.70
21. Given a standard normal probability distribution with a mean of 10% and a standard
deviation of 4%, what is the probability of observing a value between 2% and 14%?
You may use the Z-score table in the handout packet for this exam.
A. 84.32%
* B. 81.86%
C. 78.21%
D. 75.38%
E. 71.19%
Answer: B 81.86%
Z1 = (.02 - .10) / .04 = -2.0
Probability (Z1) = 0.4773
Z2 = (.14 - .10) / .04 = 1.0
Probability = 0.4773 + 0.3413 = 0.8186 = 81.86%
22. Assume that a security has a required rate of return, based on the CAPM, of 10.25%.
If the variance of the market portfolio is 0.28, the covariance between this security and
the market is 0.35, and the expected return on the market is 9%, then what is the risk-
free rate?
A. 3.60%
B. 3.80%
* C. 4.00%
D. 4.20%
E. 4.40%
Beta = 0.35 / 0.28 = 1.25
10.25% = KRF + (9.00% - KRF)(1.25)
10.25% = KRF + 11.25% – 1.25 KRF
.25 KRF = 1.00% => KRF = 4.00%
23. Assume that you are given the following historical levels of sales and inventory.
Determine what inventory should be if sales are expected to be $8,300 in 2005
Year Sales Inventory

2000 $4,000 $1,400
2001 $4,800 $1,445
2002 $5,100 $1,700
2003 $4,800 $1,720
2004 $7,400 $3,200
2005 $8,300 ???
A. $3,587
B. $3,746
C. $3,691
D. $3,803
* E. $3,634
4,000 Input 1,400 +

4,800 Input 1,445 +
5,100 Input 1,700 +
4,800 Input 1,720 +
7,400 Input 3,200 +
0  y,m = -1,057 = Intercept
 SWAP = .5652 = Slope Coefficient
Predicted Value = Y = a + (b)(X) = -$1,057 + (.5652)($8,300) = $3,634
Alternatively,
8,300  y,m = $3,634
24. As discussed in class, we can use regression analysis and the historical returns on the
market and a firm (Firm J in this example) to determine what the return on Firm J is
predicted to be next year, given an expected return on the market, as well as what
return is required to compensate investors for risk, as measured by the Capital Asset
Pricing Model (CAPM) and the Security Market Line (SML). Assuming that the market
is expected to have a 12 percent rate of return in 2005, and assuming that the risk-free
rate will be 4 percent in 2005, determine the difference between the predicted and the
required rate of return for Firm J.
Year Market Firm J

2000 -15% 5%
2001 5% -10%
2002 25% 25%
2003 15% 40%
2004 10% 20%
2005 12% ???
A. 5.0%
* B. 9.0%
C. 7.0%
D. 8.0%
E. 6.0%
.15 +/- Input .05 +

.05 Input .10 +/- +
.25 Input .25 +
.15 Input .40 +
.10 Input .20 +
0  y,m = .10 = Intercept
 SWAP = .75 = Slope Coefficient = Beta
Predicted Value = Y = a + (b)(X) = .10 + (.75)(.12) = .19 = 19%
Alternatively,
.12  y,m = .19 = 19%
CAPM / SML = Required Return:
KJ = KRF + (KM - KRF)(BetaJ) = .04 + (.12 - .04)(.75) = .10
Difference = 19% - 10% = 9.0%
Therefore, this would be an excellent security to buy, since the predicted return far
exceeds what is required based on its risk.
25.
Returns
Probability
Company A Company B
0.1 -20% 10%
0.8 20% 15%
0.1 40% 20%
Assume that you form a 50-50 portfolio of the two stocks. Determine the standard
deviation of the resulting portfolio.
* A. 8.1%
B. 12.4%
C. 10.7%
D. 14.3%
E. 16.5%
Determine the possible and expected return on the portfolio:
Returns Portfolio Weighted
Probability
Company A Company B Return Product
0.1 -20% 10% -5.00% -0.50%
0.8 20% 15% 17.50% 14.00%
0.1 40% 20% 30.00% 3.00%
Expected 16.50%
2 = [(.1)(-.05 - .165)2 + (.8)(.175 - .165)2 + (.1)(.30 - .165)2]
2 = [(.0046225) + (.00008) + (.0018225)] = .006525
 = [2]1/2 = [.006525]1/2 = .0808 = 8.1%
26. Historical rates of return for the market and for the stock of Company A are given
below:
Year Market Company A
1 6% 8%
2 -8% 3%
3 -8% -2%
4 18% 12%
Now assume that the expected required rate of return on the market is 11 percent and
that the expected risk-free rate is 6 percent. Determine the required return on the
stock of Company A using regression analysis and CAPM/SML theory.
A. 7.68%
B. 6.92%
C. 7.96%
D. 7.31%
* E. 8.27%
Calculate beta (slope coefficient) using your financial calculator:
6 Input 8 +
-8 Input 3 +
-8 Input -2 +
18 Input 12 +
0  y,m = 4.3432 (intercept)
 swap = 0.4534 (slope)
KS = 6% + (11% - 6%)(.4534) = 8.27%
27. Given the following probability distribution, determine the probability that the actual
return you observe for Security J will be less than 10 percent.
State Pi KJ
1 0.25 8%
2 0.50 12%
3 0.25 16%
* A. 23.89%
B. 21.05%
C. 25.11%
D. 26.74%
E. 28.28%
KJ = (.25)(8%) + (.50)(12%) + (.25)(16%) = 12%
J2 = (.25)(.08-.12)2 + (.50)(.12-.12)2 + (.25)(.16-.12)2 = .0004 + 0 + .0004 = .0008
J = (.0008)½ = 0.0282842
Z-score = (.10 - .12) / .0282842 = -0.71
Z(-0.71) = Z(0.71) = 26.11%
Probability of a Return Less than 10% = 50.00% - 26.11% = 23.89%
Alternatively, using a t-table,
t(-0.71) = 23.89%
YOU ARE GIVEN THE FOLLOWINGINFORMATION FOR PROBLEMS 28 - 30:
Return Return Return

State Probability
Security J Security K Market
1 0.20 0.10 0.10 0.15
2 0.30 0.30 0.20 0.10
3 0.30 0.30 0.10 0.10
4 0.20 0.15 0.20 0.05
Expected Return 0.23 0.15 0.10
28. Determine the variance for Security K. (Hint: do not round your answer until the end.)
A. 0.0050
B. 0.0100
* C. 0.0025
D. 0.0075
E. 0.0125
2 = (.2)(.10-.15)2 + (.3)(.20-.15)2 + (.3)(.10-.15)2 + (.2)(.20-.15)2
2 = 0.0005 + 0.00075 + 0.00075 + 0.0005 = 0.0025
29. Determine the covariance between Security J and the Market. (Hint: do not round your
answer until the end.)
A. -0.0004
B. -0.0006
C. -0.0003
D. -0.0002
* E. -0.0005
COVJM = (.2)(.10-.23)(.15-.10) + (.3)(.30-.23)(.10-.10) + (.3)(.30-.23)(.10-.10)
+ (.2)(.15-.23)(.05-.10)
COVJM = - 0.0013 + 0.00 + 0.00 + 0.0008 = - 0.0005
30. Assume that the variance for Security J is 0.0076. Determine the probability that you will
actually observe a return in the range between 0.00% and 15.00%.
A. 16.73%
B. 18.32%
C. 20.96%
* D. 17.47%
E. 19.53%
J = (2J)1/2 = (0.0076)1/2 = 0.0872
Z1 = (0.00 - 0.23) / 0.0872 = - 2.64
Z2 = (0.15 - 0.23) / 0.0872 = - 0.92
Using Z-Tables:
Probability = 0.4959 - 0.3212 = 0.1747 = 17.47%
Using t-Tables
Probability = 0.1788 - 0.0041 = 0.1747 = 17.47%
Covariance
Matrix
Security J 0.028561 Left Blank Left Blank
Security K 0.015818 0.054756 Left Blank
Market 0.013790 0.014321 Left Blank
Correlation
Matrix
Security J 1.00 0.40 0.80
Security K 0.40 1.00 0.60
Market 0.80 0.60 1.00
31. Assume that you are given the covariance and correlation matrices above, with some
cells intentionally left blank. Based on this information, determine the variance of the
market. (Hint: do not round your answer until the end.)
A. 0.0092
B. 0.0129
C. 0.0115
* D. 0.0104
E. 0.0123
Covariance
Matrix
Security J (0.169)2 0.015818 0.013790
Security K 0.015818 (0.234)2 0.014321
Market 0.013790 0.014321 (0.102)2
CORJM = 0.80 = COVJM / JM = 0.013790 / JM
J = (0.028561)1/2 = 0.169
CORJM = 0.80 = 0.013790 / (0.169)(M)
M = 0.013790 / (0.169)(0.80) = 0.102
2M = (0.102)2 = 0.0104
32. Assume that you invest 40 percent of your funds in Security J, and 60 percent of your
funds in Security K. Based on this information, and the tables above, determine the
standard deviation of the resulting portfolio. (Hint: do not round your answer until the
end.)
* A. 17.85%
B. 16.22%
C. 18.82%
D. 15.58%
E. 17.07%
2P = (WJ)2(2J) + (WK)2(2K) + 2(WJ)(WK)(COVJK)
2P = (.40)2(0.028561) + (.60)2(0.054756) + (2)(.40)(.60)(0.015818)
2P = 0.0045697 + 0.0197121 + 0.0075926 = 0.03187
P = (0.03187)1/2 = 0.1785 = 17.85%
33. You are given the following historical returns for Project A and the Market. Using
regression analysis, and assuming that the expected market return for the coming year
is 10%, while the expected risk-free rate is 4%, you should be able to determine the
required rate of return for Project A. Now assume that you are at Year 0 and this project
is expected to produce cash flows of $10,000 each year for 16 years, starting today
(Years 0-15). Determine the value of these cash flows as of Year 0. (Hint: remember
that the Market is the independent variable and is entered first on the HP10BII. Also,
remember to reset calculator to END of period if you set it to BEGIN of period.)
Year Project A Market

-5 0.10 0.05
-4 - 0.20 - 0.10
-3 0.15 0.05
-2 0.30 0.20
-1 0.05 0.10
A. $72.598.30
B. $75,853.43
C. $74.784.83
D. $71,504.57
* E. $73,366.26
Run regression on HP10BII to determine beta:
.05 Input .10 +

.10 +/- Input .20 +/- +
.05 Input .15 +
.20 Input .30 +
.10 Input .05 +
0  y,m = -0.01383 = Intercept (not needed for this problem)
 SWAP = 1.5638 = Slope Coefficient = Beta
KA = 4% + (10% - 4%)(1.5638) = 13.3828%
Since looking for the value as of the first cash flow, set calculator to BEGIN of period:
N = 16; I/YR = 13.3828; PMT = 10,000; Solve for PV = $73,366.26
Alternatively,
CFj = 10,000
CFj = 10,000
Nj = 15
I/YR = 13.3828
Solve for NPV = $73,366.26
34. Given the following probability distribution, determine the probability that the actual
return you observe for Security J will be less than 8 percent.
State Pi KJ
1 0.35 8%
2 0.40 12%
3 0.25 16%
A. 11.30%
B. 12.50%
C. 11.70%
* D. 12.10%
E. 10.90%
KJ = (.35)(8%) + (.40)(12%) + (.25)(16%) = 11.6%
J2 = (.35)(.08-.116)2 + (.40)(.12-.116)2 + (.25)(.16-.116)2
J2 = .0004536 + .0000064 + .000484 = .000944
J = (.000944)½ = 0.030724583
Z-score = (.08 - .116) / .030724583 = -1.17
Z(-1.17) = Z(1.17) = 37.90%
Probability of a Return Less than 10% = 50.00% - 37.90% = 12.10%
Alternatively, using a t-table,
t(-1.17) = 12.10%
36. Assume that you have determined that the probability distribution of returns for
Security J has a mean value of 10.0% and a standard deviation of 4.0%. Based on
this information, determine the probability of actually observing a return between 0.0%
and 5.0%.
A. 10.01%
B. 9.87%
C. 10.08%
* D. 9.94%
E. 10.15%
Using Z-table:
Z1 = (0.0% - 10.0%) / (4.0%) = - 2.50 (+ 2.50 for Z-table)
Probability of Z1(2.50) using Z-table = 49.38%
Z2 = (5.0% - 10.0%) / (4.0%) = - 1.25 (+ 1.25 for Z-table)
Probability of Z2(1.25) using Z-table = 39.44%
Probability of observing between 0.0% to 5.0% = 49.38% - 39.44% = 9.94%
Alternatively, using t-table:
Z1 = (0.0% - 10.0%) / (4.0%) = - 2.50
Probability of Z1(- 2.50) using t-table = 0.62%
Z2 = (5.0% - 10.0%) / (4.0%) = - 1.25
Probability of Z2(- 1.25) using t-table = 10.56%
Probability of observing between 0.0% to 5.0% = 10.56% - 0.62% = 9.94%
37. You are given the probability distribution shown below. As you can calculate, the
expected return for Security J is 14 percent, the standard deviation for Security J is
7.3485 percent, the expected return for the Market is 11 percent, and the standard
deviation for the Market is 3.7417 percent. Based on this information, determine the
beta of Security J.
State
of Probability Security J Market
Nature
1 20.00% 0.00% 5.00%
2 40.00% 15.00% 10.00%
3 40.00% 20.00% 15.00%
A. 1.93
B. 1.72
* C. 1.86
D. 1.79
E. 1.65
^
KJ = (.20)*(.00) + (.40)*(.15) + (.40)*(.20) = 14.0%
^
KM = (.20)*(.05) + (.40)*(.10) + (.40)*(.15) = 11.0%
COVJM = (.2)(.00-.14)(.05-.11) + (.4)(.15-.14)(.10-.11) + (.4)(.20-.14)(.15-.11)
COVJM = 0.00168 - 0.00004 + .00096 = 0.0026
M2 = (0.037417)2 = .0014
J = .0026 / .0014 = 1.86
38. You are given the correlation matrix shown below. You are also given the following
data:
Standard Deviation of Security J 2.84%

Required Return for Security J Using CAPM/SML 13.60%
Risk-Free Rate 4.00%
Expected Return on the Market 10.00%
Based on this data, determine the variance of the market’s return. (Hint: you should
be able to work backwards and get beta from the information above, then remember
that beta can be expressed either as (CORJM)*(J / M), or as COVJK / M2.)
Security
Correlation J Security K Market
Security J 1.0 0.6 0.8
Security K 0.6 1.0 0.4
Market 0.8 0.4 1.0
A. 0.020247%
B. 0.020413%
C. 0.020330%
D. 0.020496%
* E. 0.020164%
KJ = 13.60% = 4.0% + (10.0% - 4.0%)(J)
J = (13.60% - 4.00%) / (10.0% - 4.0%) = 9.6% / 6.0% = 1.60
J = 1.60 = (CORJM)*(J / M) = (0.8)*(2.84% / M)
M = (0.8)*(2.84%) / (1.60) = 1.42%
M2 = (0.0142)2 = .00020164 = 0.020164%
39. As discussed in class, Jensen’s Alpha is a measure of superior or inferior

performance. Assume that a regression is run on the “raw” returns (not the excess
returns above and beyond the risk-free rate) of an investment portfolio and you get:
Intercept = .039903
Slope = 1.31068
Assuming that the risk-free rate is 4 percent, you should be able to determine what the
“theoretical” intercept should have been (Hint: think about the CAPM/SML equation).
Based on this, determine by how much the portfolio outperformed the market.
A. 5.47%
B. 5.31%
C. 5.55%
* D. 5.23%
E. 5.39%
As shown in class:
KJ = KRF + (KM - KRF)*(J)
Which can be rearranged into:
KJ = (1 - J)*(KRF) + (KM)*(J)
Given an equation of the form y = a + xb
Theoretical Intercept = (1 - J)*(KRF) = (1 - 1.31068)*(.04) = -0.0124272
Superior Performance = 0.039903 - (-0.0124272) = .0523302 = 5.23%
40. You are given the historical returns for Security J (average return of 10%) and Security
K (average return of 12%) below. You may assume that the standard deviation for
Security J is 5.000 percent, while the standard deviation for Security K is 8.426
percent. Given this information, determine the correlation between Securities J and K.
Year Security J Security K

1 5.0% 8.0%
2 13.0% 9.0%
3 17.0% 25.0%
4 9.0% 15.0%
5 6.0% 3.0%
A. 1.051
B. 0.551
C. 1.301
* D. 0.801
E. 1.551
KJ = (.05 + .13 + .17 + .09 + .06) / 5 = .10
KK = (.08 + .09 + .25 + .15 + .03) / 5 = .12
2J = [(.05-.10)2 + (.13-.10)2 + (.17-.10)2 + (.09-.10)2 + (.06-.10)2] / [5 - 1] = 0.0025
J = (0.0025)1/2 = 0.05000
2K = [(.08-.12)2 + (.09-.12)2 + (.25-.12)2 + (.15-.12)2 + (.03-.12)2] / [5 - 1] = 0.0071
K = (0.0071)1/2 = 0.08426
COVJK = [(.05-.10)(.08-.12) + (.13-.10)(.09-.12) + (.17-.10)(.25-.12)
+ (.09-.10)(.15-.12) + (.06-.10)(.03-.12)] / [5 - 1] = .003375
CORJK = .003375 / (.05)(.08426) = 0.801
41. You are given the following information based on the CAPM/SML:
Required Return on Security J = 12%

Risk-Free Rate = 6%
Expected Market Return = 10%
Variance of the Market = 7.5%
Based on this information, determine the covariance between the Market and Security
J. (Hint: you can use the data above to determine beta)
A. 0.1775
B. 0.3075
* C. 0.1125
D. 0.2425
E. 0.3725
KJ = 12% = 6% + (10% - 6%)(J)
J = 6% / 4% = 1.50
J = COVJM / 2M = COVJM / 0.075
COVJM = (J)*(2M) = (1.5)*(0.075) = 0.1125
42. You have determined that the distribution for Security A will have an expected return of
14 percent and a standard deviation of 6.5 percent. Given this information, determine
the probability that the actual return will be greater than 20 percent.
A. 18.02%
B. 17.74%
C. 17.46%
* D. 17.88%
E. 17.60%
There is a 50% probability of observing a return greater than 14%. To determine the
probability of observing a value between 14% and 20%, calculate the corresponding Z-
score:
Z-score = (.20 - .14) / .065 = 0.92
Using a Z-table we would get
Probability of Z(0.92) = 32.12%
Therefore,
P = 50.00% - 32.12% = 17.88%
Alternatively, using a t-table (cumulative probability)
Probability of t(0.92) = 81.12%
Therefore,
P = 100.00% - 81.12% = 17.88%
43. You are given the following information concerning the market and Firm A.
Year Market Firm A

1 0.05 -0.15
2 0.10 0.08
3 0.20 0.27
4 0.03 0.18
Assume that for the coming year, the risk-free rate is expected to be 4 percent, while
the return on the market is expected to be 10 percent. Using regression analysis, and
the concept of the Capital Asset Pricing Model (CAPM) as discussed in class,
determine the required rate of return for Firm A.
A. 10.35%
B. 12.85%
C. 11.65%
* D. 12.25%
E. 10.95%
Run a regression on the HP10BII to determine beta:
.05 Input .15 +/- +

.10 Input .08 +
.20 Input .27 +
.03 Input .18 +
0  y,m = -0.0357 = Intercept (not needed for this problem)
KA = KRF + (KM - KRF)(βA) = 0.04 + (0.10 – 0.04)(1.3757) = 12.25%
44. Assume that you are given the following historical returns for Security J and the
Market.
Year Market Security J

1 0.10 0.15
2 0.05 - 0.05
3 0.07 0.09
4 0.12 0.14
5 0.04 0.18
Now assume that for the coming year you expect the market to have a return of 10%
percent and the risk-free rate to be 6 percent. Using regression analysis, determine
the difference between the expected return for Security J next year and its required
rate of return.
A. 2.93%
B. 3.41%
C. 3.09%
* D. 2.77%
E. 3.25%
Run regression on HP10BII to determine beta:
.10 Input .15 +
.05 Input .05 +/- +
.07 Input .09 +
.12 Input .14 +
.04 Input .18 +
0  y,m = 0.03407 = Intercept (the expected return when the market return is 0%)
Calculate the expected return for the coming year:
0.10  y,m = .1235 = 12.35% (the expected return when the market return is 10%)
Calculate the required rate of return:
KJ = 6% + (10% - 6%)(0.8938) = 9.58%
Difference = 12.35% - 9.58% = 2.77%
45. A project with a 3-year life has the following probability distributions for possible end-
of-year cash flows in each of the next three years:
Year 1 Year 2 Year 3

Probability Cash Flow Probability Cash Flow Probability Cash Flow
0.30 $300 0.15 $100 0.25 $200
0.40 $500 0.35 $200 0.75 $800
0.30 $700 0.35 $600
0.15 $900
Using an interest rate of 8 percent, determine the expected present value of these
uncertain cash flows. (Hint: Find the expected cash flow in each year, then evaluate
the expected cash flows.)
A. $1,294.95
B. $1,435.42
C. $1,391.21
D. $1,473.07
* E. $1,347.61
Expected Cash Flows:
Year 1 = (.3)($300) + (.4)($500) + (.3)(700) = $500
Year 1 = $90 + $200 + $210 = $500
Year 2 = (.15)($100) + (.35)($200) + (.35)($600) + (.15)($900)
Year 2 = $15 + $70 + $210 + $135 = $430
Year 3 = (.25)($200) + (.75)($800)
Year 3 = $50 + $600 = $650
And,
PV = $500 / 1.081 + $430 / 1.082 + $650 / 1.082
PV = $462.95 + $368.64 + $515.97 = $1,347.56
Alternatively:
CF0 = 0
CF1 = 500
CF2 = 430
CF3 = 650
I/YR = 8
46. A project with a 3-year life has the following probability distributions for possible end-
of-year cash flows in each of the next three years:
Year 1 Year 2 Year 3

Probability Cash Flow Probabilitiy Cash Flow Probability Cash Flow
0.3 $300 0.2 $100 0.25 $200
0.4 $600 0.3 $350 0.75 $800
0.3 $900 0.3 $650
0.2 $900
Using an interest rate of 8 percent, determine how much you should be willing to pay
at Year 0 for this project. (Hint: Find the expected cash flow in each year, and then
evaluate those cash flows.)
A. $1,450.20
B. $1,600.26
C. $1,550.24
D. $1,650.28
* E. $1,500.22
Calculate the expected cash flow for each year:
Year 1 = (.3)($300) + (.4)(600) + (.3)($900)
Year 1 = $90 + 240 + $270 = $600
Year 2 = (.2)($100) + (.3)(350) + (.3)($650) + (.2)($900)
Year 2 = $20 + 105 + $195 + $180 = $500
Year 3 = (.25)($200) + (.75)(800)
Year 3 = $50 + 600 = $650
Now calculate the expected present value of those cash flows:
PV = $600 / (1.08)1 + $500 / (1.08)2 + $650 / (1.08)3
PV = $555.56 + $428.67 + $515.99 = $1,500.22
Alternatively:
CFj = 0
CFj = $600
CFj = $500
CFj = $650
I/YR = 8
47. Assume that you are given the following historical relationship between the returns on
Security J and the Market:

1 0.05 0.10
2 0.05 0.00
3 0.12 0.30
4 0.10 0.20
5 0.08 0.20
Also assume that the risk-free rate is expected to be 3 percent over the coming year,
while the return on the market is expected to be 10 percent. Based on this data, and
using CAPM/SML, determine the required rate of return over the coming year for
Security J.
A. 24.60%
B. 17.55%
* C. 26.95%
D. 22.25%
E. 19.90%
0.05 Input 0.10 +

0.05 Input 0.00 +
0.12 Input 0.30 +
0.10 Input 0.20 +
0.08 Input 0.20 +
0  y,m = -.1137 = Intercept
KJ = .03 + (.10 - .03)*(3.421) = 26.95%
48. Assume that a stock has an expected return of 12.25 percent. Also assume that the
beta of the stock is 1.15 and the risk-free rate is 5 percent. Determine the market risk
premium.
A. 6.00%
B. 6.40%
C. 6.20%
* D. 6.30%
E. 6.10%
According to CAPM:
KS = KRF + (KM - KRF)
RPM = (KM - KRF)
KS = KRF + (RPM)
12.25% = 5% + (RPM)(1.15)
7.25% = (RPM)(1.15)
RPM = 7.25% / 1.15 = 6.30%
49. Assume that your company has a beta coefficient of 0.7, a required rate of return of 15
percent, and that the market risk premium is currently 5 percent. Now assume that the
inflation premium increases by 2 percentage points and that your company acquires
new assets which increase its beta by 50 percent. Determine the new required rate of
return for your company.
A. 19.25%
B. 18.25%
* C. 18.75%
D. 17.25%
E. 17.75%
Original Situation:
KS = 15% = KRF + (5%)(.7)
KRF = 15% - (5%)(.7) = 11.5%
New Situation:
KRF = 11.5% + 2% = 13.5%
Since KM would also go up by 2%, RPM stays the same at 5%
 = (.7)(1.5) = 1.05
KS = 13.5% + (5%)(1.05) = 13.5% + 5.25% = 18.75%
50. Assume that your company has a beta of 1.6, and that its realized rate of return has
averaged 15 percent over the last 5 years. Now assume that investors expect, next
year, inflation to be 5.0%, the real risk-free rate to be 3.0%, and the market risk
premium to be 6.0%. Given this information, determine the rate of return that investors
should require next year based upon the risk of your company.
A. 16.9%
B. 15.0%
C. 15.8%
* D. 17.6%
E. 18.3%
KRF = 3.0% + 5.0% = 8.0%
K = 8.0% + (6.0%)(1.6) = 17.6%
51. Assume that your company has a beta coefficient of 0.8 and a required rate of return of
9.5 percent. Also assume that the current market risk premium is 5 percent. Determine
what the new required rate of return will be if the inflation premium increases by 2
percentage points, the market risk premium increases to 6 percent, and your company
acquires new assets that increase its beta by 50 percent.
A. 11.1%
B. 15.3%
* C. 14.7%
D. 13.5%
E. 12.9%
Currently,
K = 9.5% = KRF + (5%)(.8) = KRF + 4.0%
 KRF = 9.5% - 4.0% = 5.5%
After inflation premium increases,
KRF = 5.5% + 2.0% = 7.5%
Beta = (0.80)(1.5) = 1.20
K = 7.5% + (6.0%)(1.20) = 14.7%
52. Assume that you have forecasted four possible states of nature for the coming year
with probabilities and returns for Security A as shown below for each state of nature.
Given this information, determine the standard deviation of Security A.
State of Return
Probability
Nature Security A
1 0.2 10.00%
2 0.3 15.00%
3 0.3 25.00%
4 0.2 30.00%
A. 7.89%
B. 6.46%
* C. 7.42%
D. 8.37%
E. 6.95%
^
rA = (.2)*(.10) + (.3)*(.15) + (.3)*(.25) + (.2)*(.30) = 20.0%
A2 = (.2)(.10-.20)2 + (.3)*(.15-.20)2 + (.3)*(.25-.20)2 + (.2)*(.30-.20)2
A2 = 0.002 + 0.00075 + 0.00075 + 0.002 = 0.0055
A = (0.0055)1/2 = 0.074161985 = 7.42%
53. Assume that Security B has an expected return of 8.50 percent and a standard
deviation of 3.84 percent. Based on this information, determine the probability of
observing a return greater than 10.75 percent.
A. 30.23%
B. 21.65%
* C. 27.76%
D. 24.92%
E. 18.14%
Z = (0.1075 - 0.0850) / (0.0384) = 0.59
Z(0.59) = 0.2224 (Probability of Observing a Value Between 8.50% and 10.75%)
Probability = 0.50 - 0.2224 = 0.2776 = 27.76%
54. Assume that you are given the following covariance matrix for Securities J, K, and L.
Also assume that you form a portfolio by putting 40 percent of your funds in Security J
and 60 percent of your funds in Security L. Based on this information, determine the
standard deviation of the resulting portfolio.
Covariance Security J Security K Security L

Security J 0.0012532 0.0010344 0.0019711
Security K 0.0010344 0.0023717 0.0013558
Security L 0.0019711 0.0013558 0.0048442
* A. 5.38%
B. 5.70%
C. 5.54%
D. 5.86%
E. 6.02%
P2 = (0.4)2(0.0012532) + (0.6)2(0.0048442) + 2(0.4)(0.6)(0.0019711)
P2 = 0.000200512 + 0.00174312 + 0.000946128
P2 = 0.002889760
P = (0.002889760)1/2 = 0.053756488 = 5.38%
55. Assume that you are given the following historical returns on the Market and on
Security J. As you can calculate, the average return on the Market has been 3.6
percent, while the average return on Security J has been 7.20 percent. Now assume
that over the coming year the risk-free rate is expected to be 4.0 percent, while the risk
premium on the market is expected to be 3.50 percent. Given this information, and
using regression analysis and the concept of CAPM/SML, determine the return that
investors should require for Security J during the coming year.

1 5.00% 11.00%
2 -3.00% -7.00%
3 2.00% 2.00%
4 8.00% 10.00%
5 6.00% 20.00%
A. 11.80%
B. 9.36%
C. 10.58%
* D. 11.19%
E. 9.97%
0.05 Input 0.11 +
- 0.03 Input - 0.07 +
0.02 Input 0.02 +
0.08 Input 0.10 +
0.06 Input 0.20 +
0  y,m = -0.001967 = Intercept (Not Needed)
rJ = 0.04 + (0.035)*(2.0546448) = 11.19%
56. Assume that you are given the following historical returns for Security J. As you can
calculate, the average rate of return earned by Security J over this time period was
10.0 percent. Now assume that over this same time period, a regression on the raw
returns on the market versus the raw returns on Security J, gave an intercept of
0.0012797 and a slope of 1.3711152. Also assume that over this time period, the risk-
free rate was 4.0 percent, and the return on the Market was 7.20 percent. Given this
information, determine the value of Jensen’s Alpha.
Security
Year J
1 10.00%
2 -8.00%
3 15.00%
4 18.00%
5 15.00%
A. 2.51%
B. 5.21%
C. 4.31%
D. 3.41%
* E. 1.61%
Calculate Required Return:
rJ = 0.04 + (0.072 - 0.04)*(1.3711152) = 8.39%
Jensen’s Alpha = Average Return - Required Return
Jensen’s Alpha = 10.00% - 8.39% = 1.61%
Alternatively,
Theoretical Intercept = (rRF)*(1 - βJ) = (0.04)*(1 - 1.3711152) = -0.014845080
Jensen’s Alpha = Actual Intercept - Theoretical Intercept
Jensen’s Alpha = 0.0012797 - (-0.014845080) = 1.61%
57. Assume that you are given the following ex ante return information for Securities 1-4
with given possible States of Nature 1-4:
State of Nature Probability Security 1 Security 2 Security 3 Security 4

1 0.20 10.00% 0.00% 40.00% 20.00%
2 0.30 20.00% 10.00% 30.00% 10.00%
3 0.30 20.00% 20.00% 20.00% 10.00%
4 0.20 30.00% 10.00% 10.00% 20.00%
Now assume that you construct a portfolio by investing an equal amount (25%) into
each of the four securities. Given this information, determine the variance of the
resulting portfolio.
A. 8.88%
B. 4.44%
* C. 0.00%
D. 6.66%
E. 2.22%
The resulting portfolio will have a return of 17.50% in each state of nature. Therefore,
its expected rate of return is also 17.50% and there is zero deviation from the expected
value. Given that the deviation is zero, the squared deviation is also zero, and the
variance is zero:
2P = 0.00%
58. Assume that you are given the following historical return information for Security J:
Year Security J
1 12.00%
2 19.00%
3 34.00%
4 10.00%
5 12.00%
Given this data, and assuming a normal distribution, determine the probability of
observing a return less than 17.40 percent (Z-tables are provided in the Exam
Handout).
* A. 50.00%
B. 45.00%
C. 40.00%.
D. 35.00%
E. 30.00%
The average return is equal to:
_
r = [.12 + .19 + .34 + .10 + .12] / [5] = 17.4%
Since normal distributions are symmetrical, there is a 50.0% probability of observing a

value less than the mean/average and a 50.0% probability of observing a value greater
than the mean/average.
59. You are given the following historical returns for security J and the Market:

1 0.060 0.136
2 0.120 0.202
3 0.080 0.158
4 0.140 0.224
5 0.050 0.125
Assume that next year the market’s rate of return is expected to be 12 percent, while
the risk-free rate is expected to be 4.0 percent. Given this information, and using
regression analysis, determine the difference between the expected rate of return on
Security J and the required rate of return on Security J.
A. 8.30%
B. 7.70%
C. 8.60%
D. 8.00%
* E. 7.40%
0.060 Input 0.136 +

0.120 Input 0.202 +
0.080 Input 0.158 +
0.140 Input 0.224 +
0.050 Input 0.125 +
0  y,m = 0.07 = Intercept
Expected = 0.07 + (0.12)*(1.10) = 20.20%
Required = 0.04 + (0.12 - 0.04)*(1.10) = 12.80%
Difference = 20.20% - 12.80% = 7.40%
60. Assume that you are given the variance/covariance matrix listed below for Securities J
and K and the Market. Now assume that you construct a portfolio by investing 35
percent of your funds in Security J and 65 percent of your funds in Security K. Finally,
assume that the risk-free rate is 3 percent and that the risk premium on the market is 4
percent. Based on this information, and using the CAPM/SML, determine the required
rate of return on this portfolio.
Security J K Market
J 0.058569 0.054531 0.029808
K 0.054531 0.068643 0.046368
Market 0.029808 0.046368 0.033120
A. 7.60%
B. 7.70%
C. 7.80%
* D. 7.90%
E. 8.00%
Calculate betas:
J = 0.029808 / 0.033120 = 0.90
K = 0.046368 / 0.033120 = 1.40
P = (0.90)*(.35) + (1.40)*(.65)
P = 0.315 + 0.910 = 1.225
KP = 0.03 + (0.04)(1.225) = 7.90%
Alternatively,
KJ = 0.03 + (0.04)( 0.90) = 6.6%
KK = 0.03 + (0.04)( 1.40) = 8.6%
KP = (6.6%)*(0.35) + (8.6)*(0.65) = 2.31% + 5.59% = 7.90%
61. Assume that you are given the historical return data for Security J and the Market
listed below. Given this information, and assuming that the risk-free rate was 3
percent and constant over this period, calculate the value of Jensen’s Alpha.

1 4.00% 9.00%
2 6.00% 16.00%
3 10.00% 14.00%
4 12.00% 18.00%
5 15.00% 28.00%
A. 6.63%
* B. 5.19%
C. 4.47%
D. 5.91%
E. 3.75%
First Method:
Calculate Beta and Intercept using the data above:
0.04 Input 0.09 +

0.06 Input 0.16 +
0.10 Input 0.14 +
0.12 Input 0.18 +
0.15 Input 0.28 +
0  y,m = 0.040631313 = Intercept
Theoretical Intercept = (KRF)*(1 - J) = (0.03)*(1 - 1.376262626) = -0.011287879
Now Calculate Jensen’s Alpha:
Jensen’s Alpha = 0.040631313 - (-0.011287879) = 5.19%
Second Method:
Calculate Beta and Intercept using the excess return data derived from the data
above:
0.01 Input 0.06 +

0.03 Input 0.13 +
0.07 Input 0.11 +
0.09 Input 0.15 +
0.12 Input 0.25 +
0  y,m = 0.051919192 = Intercept = 5.19% = Jensen’s Alpha
Third Method:
Calculate average rates of return over the last five years.

_
KJ = [0.09 + 0.16 + 0.14 + 0.18 + 0.28] / 5 = 0.17
_
KM = [0.04 + 0.06 + 0.10 + 0.12 + 0.15] / 5 = 0.094
Given the beta for Security J calculated above, calculate the required rate of return for
Security J.
KJ = 0.03 + (0.094 - 0.03)*(1.376262626) = 0.118080808
Jensen’s Alpha = 0.17 - 0.118080808 = 5.19%
62. You are given the following information concerning the possible returns on Security A
for the coming year:
State of
Probability Return
Nature
1 30.0% 10.0%
2 40.0% 12.0%
3 30.0% 14.0%
As you can calculate, the expected return is 12.0%. Based on this data, determine the
probability that the actual return on Security A will be between 9.0% and 12.0%.
A. 46.01%
B. 50.12%
* C. 47.38%
D. 51.49%
E. 48.75%
2A = (.30)*(.10-.12)2 + (.40)*(.12-.12)2 + (.30)*(.14-.12)2
2A = 0.00012 + 0.00000 + 0.00012 = 0.00024
A = (0.00024)1/2 = .015494933
Z = (0.09 - .12) / 0.15494933 = -1.94
Z(-1.94) = Z(1.94) = 47.38%
63. Assume that you are given the following historical returns for the market and Security
A.
1 0.05 0.01
2 0.10 0.20
3 0.08 0.22
4 0.15 0.28
5 0.12 0.15
Now assume that over the coming year the risk-free rate is expected to be 4.0 percent
and the market risk premium is expected to be 6.0 percent. Given this information,
and using regression analysis and the concept of CAPM/SML, determine the required
rate of return for Security A for the coming year.
A. 15.78%
B. 15.04%
C. 16.15%
D. 15.41%
* E. 16.52%
0.05 Input 0.01 +

0.10 Input 0.20 +
0.08 Input 0.22 +
0.15 Input 0.28 +
0.12 Input 0.15 +
0  y,m = -0.03662069 = Intercept (not needed)
rA = 0.04 + (0.06)*(2.086207) = 16.52%
64. You are given the historical data below concerning your firm’s sales and inventory
levels. Using regression analysis, determine the firm’s level of safety stocks.

1 $3,875.24 $3,566.77
2 $4,172.83 $3,772.65
3 $4,783.29 $4,194.98
4 $5,893.67 $4,963.16
5 $7,231.91 $5,888.99
A. $925.79
B. $805.79
* C. $885.79
D. $845.79
E. $765.79
3,875.24 Input 3,566.77 +

4,172.83 Input 3,772.65 +
4,783.29 Input 4,194.98 +
5,893.67 Input 4,963.16 +
7,231.91 Input 5,888.99 +
0  y,m = $885.79 = Intercept = Safety Stocks
 SWAP = 0.6918208 = Slope Coefficient (Not needed for this problem)
65. You are given the historical data below concerning your firm’s sales and inventory
levels. Using regression analysis, determine the firm’s level of safety stocks.

1 $3,875.24 $3,446.77
2 $4,172.83 $3,652.65
3 $4,783.29 $4,074.98
4 $5,893.67 $4,843.16
5 $7,231.91 $5,768.99
A. $925.79
B. $805.79
C. $885.79
D. $845.79
* E. $765.79
3,875.24 Input 3,446.77 +

4,172.83 Input 3,652.65 +
4,783.29 Input 4,074.98 +
5,893.67 Input 4,843.16 +
7,231.91 Input 5,768.99 +
0  y,m = $765.79 = Intercept = Safety Stocks
 SWAP = 0.6918208 = Slope Coefficient (Not needed for this problem)
66. Assume that your firm had the following sales/inventory values over the last five years.
Given this information, determine how much inventory safety stock (dollar value) the
firm appears, on average, to have been carrying over this time period.

1 $4,956.94 $4,520.06
2 $4,172.83 $3,586.21
3 $3,783.92 $3,504.28
4 $4,398.76 $3,848.17
5 $7,132.19 $5,618.85
A. $ 819.08
B. $1,116.93
C. $ 918.03
* D. $1,017.98
E. $ 720.13
Using your calculator, you can use the following steps to perform your regression:
4,956.94 Input 4,520.06 +

4,172.83 Input 3,586.21 +
3,783.92 Input 3,504.28 +
4,398.76 Input 3,848.17 +
7,132.19 Input 5,618.85 +
Solve for Intercept = $1,017.98 (Equals average safety stock)
Solve for Slope = 0.654035 (Not needed for this problem)
YOU ARE GIVEN THE FOLLOWING INFORMATION FOR PROBLEMS 67 – 68:
You are given the following information concerning the possible returns for the Market
and Security A for the coming year:
State of Nature Probability Market Security A

1 30.00% 5.00% 10.00%
2 40.00% 7.00% 20.00%
3 30.00% 9.00% 18.00%
67. As you can calculate, the Market has an expected return of 7.00 percent and a
standard deviation of 1.5491933 percent, while Security A has an expected return of
16.40 percent and a standard deviation of 4.2708313 percent. Given this data,
determine the correlation between the Market and Security A.
A. 0.5237
B. 0.8264
C. 0.4228
* D. 0.7255
E. 0.6202
rM = (.30)*(.05) + (.40)*(.07) + (.30)*(.09) = 7.0%
rA = (.30)*(.10) + (.40)*(.20) + (.30)*(.18) = 16.4%
2M = (.30)*(.05-.07)2 + (.40)*(.07-.07)2 + (.30)*(.09-.07)2
2M = 0.00012 + 0.00000 + 0.00012 = 0.00024
M = (0.00024)1/2 = 0.015491933
2A = (.30)*(.10-.164)2 + (.40)*(.20-.164)2 + (.30)*(.18-.164)2
2A = 0.0012288 + 0.0005184 + 0.0000768 = 0.001824
A = (0.001824)1/2 = .042708313
COVMA = (.30)*(.05-.07)*(.10-.164) + (.40)*(.07-.07)*(.20-.164)
+ (.30)*(.09-.07)*(.18-.164)
COVMA = 0.000384 + 0.000 + 0.000096 = 0.00048
CORMA = 0.00048 / ((0.015491933)*(0.042708313)
CORMA = 0.00048 / 0.000661634 = 0.72547625 = 0.7255
68. As you can calculate, Security A has an expected return of 16.40 percent and a
standard deviation of 4.2708313 percent. Given this data, determine the probability
that the return on Security A will be between 15.0% and 20.0%.
A. 73.09%
B. 56.82%
C. 37.17%
D. 68.23%
* E. 42.88%
rA = (.30)*(.10) + (.40)*(.20) + (.30)*(.18) = 16.4%
2A = (.30)*(.10-.164)2 + (.40)*(.20-.164)2 + (.30)*(.18-.164)2
2A = 0.0012288 + 0.0005184 + 0.0000768 = 0.001824
A = (0.001824)1/2 = .042708313
Calculate Probability between 15.0% and 16.4%:
Z1 = (0.15 - .164) / 0.042708313 = -0.33
Z1(-0.33) = Z1(0.33) = 12.93%
Z2 = (0.20 - .164) / 0.042708313 = 0.84
Z2(0.84) = 29.95%
Total probability = 12.93% + 29.95% = 42.88%
69. Assume that the covariance of Security J with the Market is 0.000875, the standard
deviation of the Market is 0.025, the risk-free rate over the coming year is expected to
be 4.50%, and the risk premium on the market is expected to be 6.20%. Given this
information, determine the required rate of return for the coming year using
CAPM/SML.
* A. 13.18%
B. 12.56%
C. 11.94%
D. 11.32%
E. 10.70%
2M = (0.025)2 = 0.000625
J = 0.000875 / 0.000625 = 1.40
rJ = 0.045 + (0.062)*(1.40) = 13.18%
70. You are given the following historical data for the Market and Security J. Assume now
that the expected risk-free rate for the coming year is 5.25%, and the expected return
on the market is 11.00%. Using regression analysis and the concept of CAPM/SML,
determine the required rate of return for Security J for the coming year.

1 5.00% 9.00%
2 10.00% 7.00%
3 8.00% 6.00%
4 6.00% 14.00%
5 12.00% 22.00%
A. 9.92%
B. 10.67%
* C. 11.46%
D. 12.25%
E. 13.03%
0.05 Input 0.09 +

0.10 Input 0.07 +
0.08 Input 0.06 +
0.06 Input 0.14 +
0.12 Input 0.22 +
^
0  y,m = 0.0275 Intercept (not needed for this problem)
 SWAP = 1.079268293 (Slope = Beta)
rJ = 0.0525 + (0.11 - 0.0525)*(1.07926829) = 0.0525 + 0.0621 = 0.1146 =

11.46%
YOU ARE GIVEN THE FOLLOWING INFORMATION FOR PROBLEMS 71 – 72:
You are given the following information concerning the possible returns for the Market
and Security A for the coming year:
State of Nature Probability Market Security A

1 30.00% 5.00% 14.00%
2 40.00% 7.00% 20.00%
3 30.00% 9.00% 18.00%
71. As you can calculate, the Market has an expected return of 7.00 percent and a
standard deviation of 1.5491933 percent, while Security A has an expected return of
17.60 percent and a standard deviation of 2.497992 percent. Given this data,
determine the correlation between the Market and Security A.
A. 0.5237
B. 0.8264
C. 0.4228
D. 0.7255
* E. 0.6202
rM = (.30)*(.05) + (.40)*(.07) + (.30)*(.09) = 7.0%
rA = (.30)*(.14) + (.40)*(.20) + (.30)*(.18) = 17.6%
2M = (.30)*(.05-.07)2 + (.40)*(.07-.07)2 + (.30)*(.09-.07)2
2M = 0.00012 + 0.00000 + 0.00012 = 0.00024
M = (0.00024)1/2 = 0.015491933
2A = (.30)*(.14-.176)2 + (.40)*(.20-.176)2 + (.30)*(.18-.176)2
2A = 0.0003888 + 0.0002304 + 0.0000048 = 0.000624
A = (0.000624)1/2 = .024979992
COVMA = (.30)*(.05-.07)*(.14-.176) + (.40)*(.07-.07)*(.20-.176)
+ (.30)*(.09-.07)*(.18-.176)
COVMA = 0.000216 + 0.000 + 0.000024 = 0.00024
CORMA = 0.00024 / ((0.015491933)*(0.024979992)
CORMA = 0.00024 / 0.000386988 = 0.620173688 = 0.6202
72. As you can calculate, Security A has an expected return of 17.60 percent and a
standard deviation of 2.4979992 percent. Given this data, determine the probability
that the return on Security A will be between 15.0% and 20.0%.
A. 73.09%
B. 56.82%
C. 37.17%
* D. 68.23%
E. 42.88%
rA = (.30)*(.14) + (.40)*(.20) + (.30)*(.18) = 17.6%
2A = (.30)*(.14-.176)2 + (.40)*(.20-.176)2 + (.30)*(.18-.176)2
2A = 0.0003888 + 0.0002304 + 0.0000048 = 0.000624
A = (0.000624)1/2 = .024979992
Z1 = (0.15 - .176) / 0.024979992 = -1.04
Z1(-1.04) = Z1(1.04) = 35.08%
Z2 = (0.20 - .176) / 0.024979992 = 0.96
Z2(0.96) = 33.15%
Total probability = 35.08% + 33.15% = 68.23%
73. Assume that the covariance of Security J with the Market is 0.00075, the standard
deviation of the Market is 0.025, the risk-free rate over the coming year is expected to
be 4.50%, and the risk premium on the market is expected to be 6.20%. Given this
information, determine the required rate of return for the coming year using
CAPM/SML.
A. 13.18%
B. 12.56%
* C. 11.94%
D. 11.32%
E. 10.70%
2M = (0.025)2 = 0.000625
J = 0.00075 / 0.000625 = 1.20
rJ = 0.045 + (0.062)*(1.20) = 11.94%
on the market is 11.00%. Using regression analysis and the concept of CAPM/SML,
determine the required rate of return for Security J for the coming year.

1 5.00% 6.00%
2 10.00% 7.00%
3 8.00% 9.00%
4 6.00% 14.00%
5 12.00% 22.00%
A. 9.92%
B. 10.67%
C. 11.46%
D. 12.25%
* E. 13.03%
0.05 Input 0.06 +

0.10 Input 0.07 +
0.08 Input 0.09 +
0.06 Input 0.14 +
0.12 Input 0.22 +
^
 SWAP = 1.353658537 (Slope = Beta)
rJ = 0.0525 + (0.11 - 0.0525)*(1.353658537) = 0.0525 + 0.0778 = 0.1303 =

13.03%
on the market is 11.00%. [HINT: using regression analysis and the concept of
CAPM/SML, you should now be able to determine the required rate of return for
Security J for the coming year.] Also assume that Security J has just paid a dividend
of $2.00 (D0 = $2.00), which is expected to grow at a long-run sustainable growth rate
of 4 percent. Given this information, determine how much you should be willing to pay
for Security J today.

1 5.00% 9.00%
2 10.00% 7.00%
3 8.00% 6.00%
4 6.00% 14.00%
5 12.00% 22.00%
A. $29.69
B. $26.55
C. $32.83
* D. $28.12
E. $31.26
0.05 Input 0.09 +

0.10 Input 0.07 +
0.08 Input 0.06 +
0.06 Input 0.14 +
0.12 Input 0.22 +
^
 SWAP = 1.079268293 (Slope = Beta)
rJ = 0.06 + (0.11 - 0.06)*(1.07926829) = 0.06 + 0.053963415 = 0.113963415
D1 = ($2.00)*(1.04) = $2.08
P0 = $2.08 / (.113963415 - .04) = $28.12
on the market is 11.00%. [HINT: using regression analysis and the concept of
CAPM/SML, you should now be able to determine the required rate of return for
Security J for the coming year.] Also assume that Security J has just paid a dividend
of $2.00 (D0 = $2.00), which is expected to grow at a long-run sustainable growth rate
of 5 percent. Given this information, determine how much you should be willing to pay
for Security J today.
1 5.00% 9.00%
2 10.00% 7.00%
3 8.00% 6.00%
4 6.00% 14.00%
5 12.00% 22.00%
A. $29.69
B. $26.55
* C. $32.83
D. $28.12
E. $31.26
0.05 Input 0.09 +

0.10 Input 0.07 +
0.08 Input 0.06 +
0.06 Input 0.14 +
0.12 Input 0.22 +
^
 SWAP = 1.079268293 (Slope = Beta)
rJ = 0.06 + (0.11 - 0.06)*(1.07926829) = 0.06 + 0.053963415 = 0.113963415
D1 = ($2.00)*(1.05) = $2.10
P0 = $2.10 / (.113963415 - .05) = $32.83
77. Assume that you are given the following probability distribution for the returns on
Security A. Given this information, determine the coefficient of variation for Security A.
State of Return on
Probability
Nature Security A
1 20.00% 10.00%
2 50.00% 14.00%
3 30.00% 20.00%
A. 0.6784
B. 0.5689
C. 0.4594
D. 0.3499
* E. 0.2404
Expected Return = (.2)*(.10) + (.5)*(.14) + (.3)*(.20) = 0.15
Variance = (.2)*(.10-.15)2 + (.5)*(.14-.15)2 + (.3)*(.20-.15)2
Variance = 0.0005 + 0.00005 + 0.00075 = 0.0013
Standard Deviation = (0.0013)1/2 = 0.036055513
Coefficient of Variation = 0.03605551 / 0.15 = 0.240370085 = 0.2404
78. Assume that a security has an expected return of 12.0 percent and a standard
deviation of 4.80 percent. Given this information, determine the probability of
observing an actual return between 2.0 percent and 22 percent.
A. 72.81%
B. 84.32%
* C. 96.24%
D. 90.50%
E. 78.17%
Z1 = (0.02 - 0.12) / 0.048 = -2.08
Prob(Z1) = .4812
Z2 = (0.22 - 0.12) / 0.048 = +2.08
Prob(Z2) = .4812
Total Probability = 0.4812 + 0.4812 = 0.9624 = 96.24%
79. Assume that you are given the following partial, covariance and correlation tables.
Given this information, determine the beta of Security K.
Covariance Matrix
Variables J K Market
J 0.0018490 0.0006020
K 0.0006020 0.0012250
Market 0.0016000
Correlation Matrix
J 1.00 0.40 0.80
K 0.40 1.00 0.60
Market 0.80 0.60 1.00
A. 0.860
B. 0.748
C. 0.637
* D. 0.525
E. 0.413
COVJM = JMCORJM
COVJM = 0.0013760
COVKM = 0.0008400
BetaKM = COVKM / 2M = 0.0008400 / 0.0016000 = 0.525
The completed tables would look as follows.
Covariance Matrix
J 0.0018490 0.0006020 0.0013760
K 0.0006020 0.0012250 0.0008400
Market 0.0013760 0.0008400 0.0016000
Correlation Matrix
J 1.00 0.40 0.80
K 0.40 1.00 0.60
Market 0.80 0.60 1.00
80. Assume that you are given the following historical returns on the Market and Security
A. Now assume that the return on the market for the coming year is expected to be
10.0 percent, while the risk-free rate is expected to be 4.0 percent. Using regression
analysis, determine the difference between the expected return on Security A over the
coming year and the required return on Security A.

1 5% 13%
2 8% 17%
3 9% 19%
4 4% 12%
5 7% 16%
* A. 7.80%
B. 6.80%
C. 5.80%
D. 4.80%
E. 3.80%
Calculate slope and intercept:
0.05 Input 0.13 +

0.08 Input 0.17 +
0.09 Input 0.19 +
0.04 Input 0.12 +
0.07 Input 0.16 +
0  y,m = 0.06267 (intercept)
 Swap = 1.3837 (slope)
Calculate required rate:
rJ = 4.0% + (10.0% - 4.0%)*(1.3837) = 12.302%
Calculate expected rate:
rJ = 6.267% + (10.0%)*(1.3837) = 20.104%
Calculate difference:
20.104% - 12.302% = 7.80%
81. Assume that you are given the historical return data for Security J and the Market
listed below. Given this information, and assuming that the risk-free rate was 3
percent and constant over this period, calculate the value of Jensen’s Alpha.

1 6.00% 9.120%
2 8.00% 11.020%
3 9.00% 11.970%
4 5.00% 8.170%
5 4.00% 7.220%
A. 2.27%
B. 2.77%
* C. 3.27%
D. 3.77%
E. 4.27%
First Method:
Calculate Beta and Intercept using the data above:
0.06 Input 0.0912 +
0.08 Input 0.1102 +
0.09 Input 0.1197 +
0.05 Input 0.0817 +
0.04 Input 0.0722 +
0  y,m = 0.0342 = Intercept
Theoretical Intercept = (rRF)*(1 - J)
Theoretical Intercept = (0.03)*(1 - 0.95) = 0.0015
Now Calculate Jensen’s Alpha:
Jensen’s Alpha = 0.0342 - (0.0015) = 3.27%
Second Method:
Calculate Beta and Intercept using the excess return data derived from the data
above:
0.03 Input 0.0612 +

0.05 Input 0.0802 +
0.06 Input 0.0897 +
0.02 Input 0.0517 +
0.01 Input 0.0422 +
0  y,m = 0.0327 = Intercept = 3.27% = Jensen’s Alpha
Third Method:
Calculate average rates of return over the last five years.

_
rJ = [0.0912 + 0.1102 + 0.1197 + 0.0817 + 0.0722] / 5 = 0.095
_
rM = [0.06 + 0.08 + 0.09 + 0.05 + 0.04] / 5 = 0.064
Given the beta for Security J calculated above, calculate the required rate of return for
Security J.
rJ = 0.03 + (0.064 - 0.03)*(0.95) = 0.0623
Jensen’s Alpha = 0.0950 - 0.0623 = 3.27%
82. Assume that you are given the following historical returns for Securities J and K, as
well as their average return and their variance of returns over this time period. Given
this information, determine the correlation between Securities J and K.
Year Security J Security K

1 0.05000 0.10000
2 0.10000 0.08000
3 0.28000 0.32000
4 0.22000 0.08000
5 0.12000 0.18000
Average 0.15400 0.15200
Variance 0.00878 0.01052
* A. 0.644
B. 0.568
C. 0.496
D. 0.424
E. 0.352
COVJK = [(.05-.154)(.10-.152) + (.10-.154)(.08-.152) + (.28-.154)(.32-.152)
+ (.22-.154)(.08-.152) + (.12-.154)(.18-.152)] [5 - 1]
COVJK = [0.005408 + 0.003888 + 0.021168 - 0.004752 - 0.000952]/[4]
COVJK = 0.02476 / 4 = 0.00619
J = (0.00878)1/2 = 0.093701654
K = (0.01052)1/2 = 0.10256705
CORJK = (0.00619) / (0.093701654 * 0.102567051)
CORJK = (0.00619) / (0.009610702) = 0.644073635 = 0.644
83. Assume that you are given the following correlation matrix for Securities J and K and
the Market, as well as the variance of their returns. Now assume that the risk-free rate
is 4.0 percent and the return on the market is 10.0 percent. Given this information,
and using the concept of CAPM/SML, determine the required rate of return on Security
K.
Correlation Security J Security K Market
Security J 1.000000 0.612000 0.823000
Security K 0.612000 1.000000 0.454000
Market 0.823000 0.454000 1.000000
Variance 0.007056 0.003844 0.001936
A. 13.43%
B. 12.03%
C. 10.64%
D. 9.24%
* E. 7.84%
J = (0.007056)1/2 = 0.084
K = (0.003844)1/2 = 0.062
M = (0.001936)1/2 = 0.044
COVKM = K M CORKM = (0.062)*(0.044)*(0.454) = 0.001238512
K = COVKM / 2M = (0.001238512) / (0.001936) = 0.639727273
rK = 4.0% + (10.0% - 4.0%)*(0.639727273) = 7.84%
84. Assume that a project has the following cash flows. Also assume that this project has
a beta of 1.40. If the risk-free rate is 6.0 percent and the risk premium on the market is
5.0 percent, then, using the concept of CAPM/SML, determine the net present value
(NPV) for this project.
Year Cash Flow

0 -$1,000.00
1 $300.00
2 $300.00
3 $300.00
4 $300.00
5 $200.00
6 $200.00
7 $200.00
8 $200.00
9 $150.00
10 $100.00
A. $270.07
B. $292.24
C. $314.42
* D. $336.59
E. $358.76
rP = 6.0% + (5%)(1.40) = 13.0%
CFj -1,000
CFj 300
Nj 4
CFj 200
Nj 4
CFj 150
CFj 100
I/YR 13
Solve for NPV = $336.59
Year 1 Market Security J

1 10.00% 22.05%
2 12.00% 25.10%
3 6.00% 15.95%
4 4.00% 12.90%
5 18.00% 34.25%
85. Assume that the risk-free rate is expected to be 6.0 percent for the coming year and
the return on the market is expected to be 12.0 percent for the coming year. Using
regression analysis to calculate the beta for Security J, determine the required rate of
return for Security J for the coming year.
A. 14.65%
B. 14.95%
* C. 15.15%
D. 15.45%
E. 15.75%
0.10 Input 0.2205 +

0.12 Input 0.2510 +
0.06 Input 0.1595 +
0.04 Input 0.1290 +
0.18 Input 0.3425 +
0  y,m = 0.068 (intercept)
 Swap = 1.525 (slope)
rJ = 6.0% + (12.0% - 6.0%)*(1.525) = 15.15%
86. Assume that over the last five years the risk-free rate was 4.0 percent. Given this,
determine the value of Jensen’s Alpha.
A. 9.60%
B. 9.45%
C. 9.30%
D. 9.15%
* E. 8.90%
Method 1:
Using the data from Problem 31.
Theoretical Intercept = (rRF)*(1 - J) = (0.04)*(1 - 1.525) = -0.021
Jensen’s Alpha = Actual - Theoretical = 0.068 - (-0.021) = 0.089 = 8.90%
Method 2:
Average Return on Security J = (22.05% + 25.10% + 15.95% + 12.90% + 34.25%)/(5)
Average Return on Security J = 22.05%
Average Return on the Market = (10.0% + 12.0% + 6.0% + 4.0% + 18.0%)/(5) =

10.0%
Required Return on J = 4.0% + (10.0% - 4.0%)*(1.525) = 13.15%
Jensen’s Alpha = Average Return - Required Return = 22.05% - 13.15% = 8.90%
Method 3:
Put all returns on an excess return basis and then rerun the regression.
0.06 Input 0.1805 +

0.08 Input 0.2110 +
0.02 Input 0.1195 +
0.00 Input 0.0890 +
0.14 Input 0.3025 +
0  y,m = 0.089 = 8.90% (intercept = Jensen’s Alpha)
 Swap = 1.525 (slope - does not change)
87. Assume that you are given the following historical returns for the Market and Security
J. Also assume that the expected return on the market during the coming year (2009)
is 10 percent, while the risk-free rate is expected to be 4 percent. Based on this data,
and using regression analysis, determine the difference between the expected return
on Security J and the required return on Security J.

2008 10.00% 22.00%
2007 14.00% 27.60%
2006 8.00% 19.20%
2005 4.00% 13.60%
2004 15.00% 29.00%
A. 8.40%
B. 8.80%
C. 9.20%
* D. 9.60%
E. 10.00%
0.10 Input 0.220 +

0.14 Input 0.276 +
0.08 Input 0.192 +
0.04 Input 0.136 +
0.15 Input 0.290 +
0  y,m = 0.08 = Intercept
Expected Return = 0.08 + (0.10)*(1.40) = 22.00%
Required Return = 0.04 + (0.10 - 0.04)*(1.40) = 12.40%
Difference = 22.00% - 12.40% = 9.60%

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Risk and Rates of Return - Solutions

1. The variance of a portfolio consisting of Securities 1 through 5, with weights W1 through

P2 = W1212 + W2222 + W3232 + W4242+ W5252

+ 2W1W2COV12 + 2W1W3COV13 + 2W1W4COV14 + 2W1W5COV15

+ 2W2W3COV23 + 2W2W4COV24 + 2W2W5COV25 + 2W3W4COV34

8. The variance of a 4-security portfolio can be calculated as follows:

2P = W1221 + W2222 + W3223 + W4224

+ W1W212COR12 + W1W313COR13 + W1W414COR14

+ W2W323COR23 + W2W424COR24 + W3W434COR34

1. Which of the following statements is not (or least) correct?

A. The coefficient of variation is a measure of a distribution’s degree of dispersion

2. Select the statement that is most correct.

4. Which of the following statements is most correct?

A. Portfolio diversification reduces the variability of the returns on the individual

5. Which of the following statements is most correct?

KM = [-.05 + .12 + .10 + .20 + .18]/[5] = .11

KJ = [-.08 + .25 + .15 + .20 + .28]/[5] = .16

COVJM = [-.05-.11][-.08-.16] = .0384

2M = [(-.05-.11)2 + (.12-.11)2 + (.10-.11)2 + (.20-.11)2 + (.18-.11)2]/[4] = .00970

2. A security has the following ex ante probability distribution of possible returns:

State Probability Return

Mean value = 19%

Z1 = (0.00 - 0.19) / (0.128062) = -1.48 => Probability = 43.06%

Z2 = (0.25 - 0.19) / (0.128062) = 0.47 => Probability = 18.08%

Total Probability = 43.06% + 18.08% = 61.14%

State Probability Return

Based on this information, what is the coefficient of variation for Security A?

Expected Return = (0.30)(0.05) + (0.40)(0.10) + (0.30)(0.15)

Expected Return = 0.015 + 0.04 + 0.045 = 0.10

Variance = (0.30)(0.05-0.10)2 + (0.40)(0.10-0.10)2 + (0.30)(0.15-0.10)2

Standard Deviation = (0.0015)1/2 = 0.038729833

Coefficient of Variation = 0.038729833 / 0.10 = 0.3873

Year Market Security A

Do the following on your HP-10BII

0  y,m -0.116929791 (intercept)

K = .04 + (.07)(2.017649341) = 18.12%

YOU ARE GIVEN THE FOLLOWING DATA FOR PROBLEMS 5 - 7:

BetaA = 0.00393250 / 0.00302500 = 1.3

KA = .04 + (.07)(1.3) = 13.10%

P2 = (.5)2(.00390625) + (.5)2(.00504100) + (2)(.5)(.5)(.00221875)

P = [.003346188]1/2 = 0.057846244 = 5.78%

Z1 = (.0503 - .10) / .071 = -.70

Total Probability = 25.80% + 25.80% = 51.60%

Year Market Security A

Do the following on your HP-10BII

0  y,m -0.116929791 (intercept)

K = .05 + (.04)(2.017649341) = 13.07%

From table, Probability of 1.50%  ZA = 2.17

A = 0.1085 / 2.17 = 0.05

From table, Probability of 4.01%  ZB = 1.75

B = 0.105 / 1.75 = 0.06

COVAB = (CORAB)(A)(B) = (.75)(0.05)(0.06) = 0.00225

0.13 = 0.05 + (0.05)(BetaJ)

BetaJ = 1.60 = COVJM / 2M

M = [.002125]1/2 = 0.046097722 = 4.61%

M = 0.00108 / (0.8)(0.045) = 0.03

2M = (0.03)2 = 0.0009

BetaJ = 0.00108 / 0.0009 = 1.20

KJ = 0.05 + (0.05)(1.2) = 0.11 = 11.0%

13.0% = 6.0% + (kM - kRF)(1.4)

Now calculate the required return for Company B:

kA = 6.0% + (11.0% - 6.0%)A.