Exercises Financial Management

Chapter 4 - The relationship between the required rate of return

and risk
Prof. Dr. Marc Deloof
Assistant Nina Marien

Exercise 1
The following table shows the return of the shares De Neef and Deboer in case the economy
slows down, accelerates, or grows normally:

Table 1: Data exercise 1

Beta Slow growth Normal growth Accelerated growth

De Neef 1.2 7% 11% 15%
Deboer 1.5 4% 15% 21%

There is a 20% chance that economic growth will slow down, a 50% chance that it will grow
normally, and a 30% chance that economic growth will accelerate. The expected market return
is 7% and the risk-free interest rate is 5%.

I. Calculate the expected return and the risk (using the standard deviation) of both shares.
II. Are the shares over-or undervalued?

Exercise 2
By next year, the economy is expected to slow down at 40%. There is a 60% chance of increased
activity.

The expected returns of share Grove and share Marga are under the above situations:

Table 2: Data exercise 2

Slow growth Accelerated growth

Grova - 10% + 20%
Marga - 30% + 35%

I. Determine the expected return and risk of both shares.

II. Determine the expected return and risk of the portfolio, which consists of 30% Grova
and 70% of Marga.
a. If the shares are perfectly positively correlated.
b. If the shares are perfectly negatively correlated.
c. If the shares have a correlation of 45%.
Exercise 3
You no longer wish to keep your savings in the bank but decides to invest in shares instead.
You decide to limit your investment to a combination of shares Ter Beke and Solvay. You have
collected the following information regarding these shares:

Table 3: Data exercise 3

Ter Beke Solvay

Expected return 12% 8%
Standard deviation 8% 5%

The correlation between the two shares is 20%.

I. Calculate the expected return and risk of the following portfolios:

a. 50% Ter Beke and 50% Solvay.

b. 25% Ter Beke and 75% Solvay.

c. 75% Ter Beke and 25% Solvay.

II. Draw the set of portfolios that can be put together with Ter Beke and Solvay shares.
Which portfolios do you prefer?
III. Assume you can invest and borrow at an interest rate of 5%. Draw the new opportunity
set. Which portfolio will you invest in?

Exercise 4
Assume that the risk-free interest rate equals 5% and the expected market return is 8% with a
standard deviation of 12%.

I. Determine the Sharpe ratio.

II. Calculate the beta of a portfolio with a standard deviation of 10%.
III. Suppose an investor is willing to bear a standard deviation of 20% for his portfolio.
What is the required return on this portfolio?
IV. Suppose the required return is equal to the expected return, how much is invested in the
market portfolio compared to the risk-free investment? Explain your results.
Exercise 5
Table 4: Data exercise 5

Portfolio A B C D E F G H
Expected return 10% 12.5% 15% 16% 17% 18% 18% 20%
Standard deviation 23% 21% 25% 29% 29% 32% 35% 45%

I. Plot the above portfolios on a risk-return diagram.

II. Which portfolios are efficient?
III. Assume that you can borrow/invest risk-free at 12%. Which of the above portfolios is
the most interesting?
IV. Suppose you are willing to bear a standard deviation of 25%.
a. What is the maximum return if you cannot borrow/invest at 12%?
b. What is the maximum return if you can borrow/invest at 12%?

Exercise 6
The Warelife investment fund invested in the following 4 shares:

Table 5: Data exercise 6

Share Investment Beta

A 160 000 0.8
B 120 000 1.2
C 80 000 1.6
D 40 000 2

The expected market return is estimated as follows:

Table 6: Data exercise 6

Probability Market return

0.1 10%
0.2 12%
0.4 14%
0.2 16%
0.1 18%

The risk-free interest rate is currently estimated at 7%.

I. Calculate the expected market return.

II. What is the risk premium of the market portfolio?
III. What is the required return of the Warelife investment?
Assume there is a proposal to include a new share E in the fund for a total amount of $50 000.
The share has an expected return of 18%. The beta-coefficient is estimated at 1.3.

IV. Is it appropriate to include the new share E?

V. What is the minimum expected return for the proposal to be accepted?

Exercise 7
Florenta is considering the following projects:

Table 7: Data exercise 7

Project Beta Expected return

A 0.5 12%
B 0.8 13%
C 1.2 18%
D 1.6 19%

Which projects will Florenta implement if the market return is 15% and the risk-free interest
rate is 8%?

Exercise 8
As a financial analyst, you check the Belgian Stock Exchange every day. You also look for
market imperfections daily. Today, your attention is focused on investment funds A, B, and C.
These funds invest in Belgian shares and are listed on Euronext Brussels. Investment fund A is
listed at €200. It pays out a constant dividend of €20 annually. The beta coefficient of A is 1.4.
The expected return is 10%. Investment fund B is listed at €300. Annually, it pays out a constant
dividend of €15, which will grow at 4.6% per year. The beta coefficient of B is 1.2. The
expected return is 9.6%. Investment fund C is listed at €400 and does not distribute dividends.
However, a capital gain of 8.5% is expected. The beta coefficient of C is 0.8. The interest on
government bonds is 6%. On BEL-20, a return of 9% is expected.

I. Which of the above investments seem most interesting to you?

II. Would your answer to I. change if A, B and C are not equity funds but individual shares?
III. You own €10 000 that you want to invest. Put together a portfolio with the highest
possible return and a beta equal to 0.6. What is the required return on this portfolio?
(Tip: think about CML)
IV. Repeat question III. with a beta of 1.2.
Exercise 9
Assume we live in a world where people have homogeneous expectations (everyone agrees on
the values of expected returns and standard deviations). In this world, the market portfolio has
an expected return of 12% and a standard deviation of 10%. The risk-free interest rate is 5%.

I. What is the value of the expected return of a portfolio if the standard deviation would
be 7%?
II. What is the standard deviation of that portfolio if it had an expected return of 20%?

Exercise 10
The following data on the shares of three different companies and the market are given:

Table 8: Data exercise 10

Average return Standard deviation Correlation with Beta

market portfolio
Company A 0.13 0.12 a 0.90
Company B 0.16 b 0.40 1.10
Company C 0.25 0.24 0.75 c
The market 0.15 0.10 d e
Government bonds 0.05 f g h

Suppose we live in a world where CAPM applies.

I. Fill in the missing values.

II. Evaluate the performance of the shares of the 3 companies.
III. If you had some extra money to invest, which of the 3 companies would you invest in?