Practice Problem Set #9: Risk and Return I

Theoretical and conceptual questions:

(see notes or textbook for solutions)

1. What are the components of total return?

2. Differentiate between realized and unrealized returns.
3. Why does everyone not just invest in common stocks if common stock returns have been
superior to other asset classes in the long term?
4. Compare T-bill, bond and equity returns over the long term. What observations and
conclusions can you make regarding risk and return?
5. What is meant by a risk premium in the context of financial market returns?
6. Discuss the risk-return trade-off.
7. Why are the assumptions of normal distribution of returns and the risk-reward trade off
important in investment theory?
8. Explain the difference between an arithmetic and geometric average return.

Practice Problems:

1. The returns of shares A and B for the coming period are represented by the following joint-
probability distribution:

Share A

6% 10% 12%

8% .02 .13 .50

Share B 9% .05 .01 .04

10% .18 .06 .01

(a) For Share A and Share B, compute the expected value, the variance, and the
standard deviation of return.

(b) Compute and . Briefly interpret your findings.

2. Assume the following information about two shares A and B:

(a) What is the expected return and standard deviation of returns of a portfolio that
consists of 60 percent of A and 40 percent of B?

(b) If the correlation coefficient were zero, would your answer to (a) change? If so,
recompute the standard deviation and expected return of the portfolio.
3. You believe that the future price of Prime Resources depends on whether they find gold in
the Yukon, and this will happen with 0.50 probability. If they strike gold, Prime's price one
year from now will be $3; if they don't strike gold, it will be $1.50. If the current price is $2
and you expect a dividend of $0.20 regardless of whether they find gold, what is your
expected return over the next year if you buy Prime Resources stock today?

4. A share of XYZ common stock has the following return characteristics

r p(r)
0.00 0.25
0.15 0.25
0.30 0.50

(a) What is the expected return on XYZ?

(b) What is the standard deviation of this return?

5. Suppose returns on Pixie Corp. shares have the following probability distribution

r p(r)
-0.05 0.10
0.00 0.15
0.10 0.50
0.15 0.15
0.20 0.10

(a) Calculate the expected return for Pixie.

(b) Calculate the standard deviation of Pixie's return.

(c) Suppose new information has been released on Pixie Corp. that its returns in
each state will be 5 percentage points higher. This means that 0.05 must be
added to each value in column 1 in the above table. What will happen to
Pixie's expected return? What about its standard deviation?
6. Returns on Kwikee Market shares are given by the following probability distribution

r p(r)
-0.20 0.20
-0.10 0.20
0.10 0.20
0.20 0.20
0.30 0.20

(a) Calculate the expected return for Kwikee Mart.

(b) Calculate the standard deviation of Kwikee Mart' s return.

(c) If you had to choose between Kwikee Mart shares and Pixie Corp shares,
which would you invest in? Why?

7. Public Image Ltd. (PIL) and Big Audio Dynamite (BAD) have the following joint distribution
of returns

PIL

6% 12%

8% 0.20 0.30
BAD 10% 0.40 0.10

(a) Find the expected returns and standard deviations of PIL and BAD.

(b) Find the covariance and correlation of their returns.

(c) Suppose you invest 60% of your wealth in PIL and 40% in BAD. What is your
expected return and standard deviation of your return?