Financial Management 9

Chapter 09 - Characterizing Risk and Return
CHAPTER 9 – CHARACTERIZING RISK AND RETURN
Questions
LG1 1. Why is the percentage return a more useful measure than the dollar return?
The dollar return is most important relative to the amount invested. Thus, a $100 return is more
impressive from a $1,000 investment than a $5,000 investment. The percentage return
incorporates both the dollar return and the amount invested. Therefore, it is easier to compare
percentage returns across different investments.
LG2 2. Characterize the historical return, risk, and risk-return relationship of the stock, bond and cash
markets.
Examining Table 9.2, it is clear that the stock market has earned about double the return since
1950 than bonds. Bonds have returned about 50 percent more than the cash markets. The risk in
the stock market is also higher than the bond and cash markets according to the standard
deviation measurement (Table 9.4). Another illustration of the high risk is that the stock market
frequently loses money and sometimes does not earn more than the bond and cash markets over
short periods of time (Table 9.2). The risk-return relationship tells us that we should expect
higher returns on riskier investments.. In fact, we do see higher realized returns over the
longterm on the higher-risk asset classes.
LG3 3. How do we define risk in this chapter and how do we measure it?
Risk is defined as the volatility of an asset’s returns over time. Specifically, the standard
deviation of returns is used to measure risk. This computation measures the deviation from the
average return. The idea is to use standard deviation, a measure of volatility of past returns as a
proxy for how variable returns are expected to be in the future.
LG3 4. What are the two components of total risk? Which component is part of the risk-return
relationship? Why?
Total risk includes firm-specific risk and market risk. The firm-specific risk portion can be
eliminated through diversification by owning many different investments. The portion of total
risk that is left after diversifying, market risk, is the risk that is expected to be rewarded. Thus,
market risk in the risk of the risk-return relationship.
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LG3 5. What’s the source of firm-specific risk? What’s the source of market risk?
Firm-specific risk stems from the uncertainty arising from micro-events that primarily impact the
firm or industry. Market risk comes from the macro events that impact all firms to some extent.
LG3 6. Which company is likely to have lower total risk, General Electric or Coca-Cola? Why?
General Electric is a firm that has diversified business lines. It makes kitchen appliances, medical
devices, and locomotives, owns the TV network NBC, and is involved in financial services.
Thus, much of GE’s firm-specific risk is reduced. Coca-Cola does not have such business line
diversification. So GE’s total risk is likely to be lower because its firm-specific risk is lower.
LG3 7. Can a company change its total risk level over time? How?
A company can change its risk level over time by changing the mix of business lines it pursues.
Some industries are riskier than others. For example, the airline industry has more risk while the
utility industry has less risk. Companies can also change their risk level by changing the amount
of money they have borrowed (more borrowing is riskier).
LG4 8. What does the coefficient of variation measure? Why is a lower value better for the investor?
The coefficient of variation measures the amount of risk taken for each one percent of return
achieved. It is computed by dividing the standard deviation of return by the total return.
Investors would prefer to achieve a high return with little risk. In other words, they would like a
high return with little standard deviation. This is realized in the coefficient of variation measure
by a lower number.
LG4 9. You receive an investment newsletter advertisement in the mail. The letter claims that you
should invest in a stock that has doubled the return of the S&P 500 Index over the last three
months. It also claims that this stock is a surefire safe bet for the future. Explain how these two
claims are inconsistent with finance theory.
A stock that can earn a large return quickly versus the market is a very volatile stock. Thus, it is
a high-risk stock. The stock’s price may indeed increase in the future. However, high risk
means that it could also significantly decrease in price in the future. It is not a surefire safe bet.
LG5 10. What does diversification do to the risk and return characteristics of a portfolio?
Diversifying does little for the return of the portfolio. The portfolio return is the weighted
average of the investment returns in the portfolio. However, diversification can do much for
reducing the total risk of the portfolio as measured by the standard deviation. By combining
assets that perform differently in different economic environments, the overall level of the risk in
the portfolio is reduced. In addition, diversifying reduces the firm- specific risk as illustrated in
figure 9.1.
LG5 11. Describe the diversification potential of two assets with a −0.8 correlation. What’s the
potential if the correlation is +0.8?
The diversification potential is very good with two assets that have a −0.8 correlation. Since
these two assets tend to move in opposite directions, the combination will greatly reduce the risk
or volatility an investor would experience with only one of the assets. There is not much
diversification potential for two assets with a correlation close to one, like +0.8.
LG5 12. You are a risk adverse investor with a low-risk portfolio of bonds. How is it possible that
adding some stocks (which are riskier than bonds) to the portfolio can lower the total risk of the
portfolio?
Bonds and stocks have a low correlation (see Table 9.6). In some economic environments,
stocks do well and bonds do not. During other times, bonds do better. Adding a small portion of
stocks to a bond portfolio can actually decrease the volatility of the portfolio.
LG5 13. You own only two stocks in your portfolio but want to add more. When you add a third
stock, the total risk of your portfolio declines. When you add a tenth stock to the portfolio, the
total risk declines. Adding which stock, the third or the tenth, likely reduced the total risk more?
Why?
A portfolio of two stocks most likely still has a lot of firm-specific risk. Assuming that the
stocks are not highly correlated, a nine-stock portfolio should already have much of its firm-
specific risk diversified away. Therefore, the third stock added has much more potential for
reducing the risk of the portfolio than the tenth stock added.
LG5 14. Many employees believe that their employer’s stock is less likely to lose half of its value
than a well diversified portfolio of stocks. Explain why this belief is erroneous.
A single firm has a lot of firm-specific risk. This means that it has more volatility in its returns
than the overall stock market. Remember, high volatility means large price changes. Also
consider that if a well diversified stock portfolio falls by half, this means large declines for the
overall stock market and all firms, including the employer’s stock (known as market risk). But a
large decline in the employer’s stock does not mean a large decline occurs in the overall market
(firm-specific risk).
LG6 15. Explain what we mean when we say that one portfolio dominates another portfolio?
A dominate portfolio has a better risk-return relationship. This means that it either has a high
return for the level of risk taken or lower risk for the level of return achieved. Every investor
should want a dominate portfolio.
LG6 16. Explain what the efficient frontier is and why it is important to investors.
The efficient frontier is the set of efficient, or dominating, portfolios. These portfolios have the
highest return for each level of risk desired. Since all other portfolios are dominated by the
efficient frontier portfolios, all investors should prefer these efficient portfolios.
LG6 17. If an investor’s desired risk level changes over time, should the investor change the
composition of his or her portfolio? How?
Yes, investors should modify their portfolios to be consistent with their level of risk. For
example, many people want to reduce their level of risk as they approach their retirement years.
One way to change the level of risk in a portfolio is to change the allocation of stocks and bonds.
An increase in bonds would cause a decrease in the risk of the portfolio.
LG7 18. Say you own 200 shares of Boeing and 100 shares of Bank of America. Would your portfolio
return be different if you instead owned 100 shares of Boeing and 200 shares of Bank of
America? Why?
The portfolio return would be the weighted average of the Boeing and Bank of America stock
returns. The weights are determined by the proportion of money invested in each firm. The
portfolio’s return in these two cases would be different because the proportions of money
invested in each stock would be different.
Problems
basic problems
LG1 9-1 Investment Return FedEx Corp stock ended the previous year at $103.39 per share.
It paid a $0.35 per share dividend last year. It ended last year at $106.69. If you owned 200
shares of FedEx, what was your dollar return and percent return?
Dollar Return = (Ending Value − Beginning Value) + Income

= $106.69  200 - $103.39  200 + $0.35  200 = $700
Percentage Return = $700 / ($103.39 × 200) = 3.53%
LG1 9-2 Investment Return Sprint Nextel Corp stock ended the previous year at $23.36 per share. It
paid a $2.37 per share dividend last year. It ended last year at $18.89. If you owned 500 shares
of Sprint, what was your dollar return and percent return?
Dollar Return = (Ending Value − Beginning Value) + Income

= $18.89  500 - $23.36  500 + $2.37  500 = −$1,050
Percentage Return = -$1,050 / ($23.36 × 500) = -8.99%
LG2 9-3 Investment Return A corporate bond that you own at the beginning of the year is worth
$975. During the year, it pays $35 in interest payments and ends the year valued at $965. What
was your dollar return and percent return?
Dollar Return = Capital gain + Income = $965 - $975 + $35 = $25

Percent return = $25 / $975 = 2.56%
LG2 9-4 Investment Return A Treasury bond that you own at the beginning of the year is worth
$1,055. During the year, it pays $35 in interest payments and ends the year valued at $1,065.
What was your dollar return and percent return?
Dollar Return = Capital gain + Income = $1,065 - $1,055 + $35 = $45

Percent return = $45 / $1,055 = 4.27%
LG3 9-5 Total Risk Rank the following three stocks by their level of total risk, highest to lowest. Rail
Haul has an average return of 12 percent and standard deviation of 25 percent. The average
return and standard deviation of Idol Staff are 15 percent and 35 percent; and of Poker-R-Us are
9 percent and 20 percent.
Rank by standard deviation: Idol Staff, Rail Haul, and then Poker-R-Us
LG3 9-6 Total Risk Rank the following three stocks by their total risk level, highest to lowest. Night
Ryder has an average return of 12 percent and standard deviation of 32 percent. The average
return and standard deviation of WholeMart are 11 percent and 25 percent; and of Fruit Fly are
16 percent and 40 percent.
Rank by standard deviation: Fruit Fly, Night Ryder, and then WholeMart
LG4 9-7 Risk versus Return Rank the following three stocks by their risk-return relationship, best to
worst. Rail Haul has an average return of 12 percent and standard deviation of 25 percent. The
average return and standard deviation of Idol Staff are 15 percent and 35 percent; and of Poker-
R-Us are 9 percent and 20 percent.
Rank by coefficient of variation: Rail Haul CoV = 25 / 12 = 2.08, Poker-R-Us CoV = 20 / 9 =

2.22, and Idol Staff CoV = 35 / 15 = 2.33.
LG4 9-8 Risk versus Return Rank the following three stocks by their risk-return relationship, best to
worst. Night Ryder has an average return of 12 percent and standard deviation of 32 percent.
The average return and standard deviation of WholeMart are 11 percent and 25 percent; and of
Fruit Fly are 16 percent and 40 percent.
Rank by coefficient of variation: WholeMart CoV = 25 / 11 = 2.27, Fruit Fly CoV = 40 / 16 =

2.5,and Night Ryder CoV = 32 / 12 = 2.67
LG6 9-9 Dominant Portfolios Determine which one of these three portfolios dominates another.
Name the dominated portfolio and the portfolio that dominates it. Portfolio Blue has an expected
return of 12 percent and risk of 18 percent. The expected return and risk of portfolio Yellow are
15 percent and 17 percent, and for the Purple portfolio are 14 percent and 21 percent.
Portfolio Yellow dominates Portfolios Blue and Purple because it has both a higher expected
return and a lower risk level.
LG6 9-10 Dominant Portfolios Determine which one of the three portfolios dominates another.
Name the dominated portfolio and the portfolio that dominates it. Portfolio Green has an
expected return of 15 percent and risk of 21 percent. The expected return and risk of portfolio
Red are 13 percent and 17 percent, and for the Orange portfolio are 13 percent and 16 percent.
Portfolio Orange dominates Portfolio Red because it has the same expected return with a lower
risk level.
LG7 9-11 Portfolio Weights An investor owns $6,000 of Adobe Systems stock, $5,000 of Dow
Chemical, and $5,000 of Office Depot. What are the portfolio weights of each stock?
Total portfolio = $6,000 + $5,000 + $5,000 = $16,000

Adobe System weight = $6,000 / $16,000 = 0.3750
Dow Chemical weight = $5,000 / $16,000 = 0.3125
Office Depot weight = $5,000 / $16,000 = 0.3125
LG7 9-12 Portfolio Weights An investor owns $3,000 of Adobe Systems stock, $6,000 of Dow
Chemical, and $7,000 of Office Depot. What are the portfolio weights of each stock?
Total portfolio = $3,000 + $6,000 + $7,000 = $16,000

Adobe System weight = $3,000 / $16,000 = 0.1875
Dow Chemical weight = $6,000 / $16,000 = 0.375
Office Depot weight = $7,000 / $16,000 = 0.4375
LG7 9-13 Portfolio Return Year-to-date, Oracle had earned a −1.34 percent return. During the same
time period, Valero Energy earned 7.96 percent and McDonalds earned 0.88 percent. If you
have a portfolio made up of 30 percent Oracle, 25 percent Valero Energy, and 45 percent
McDonalds, what is your portfolio return?
Portfolio Return = (0.30 × −1.34%) + (0.25 × 7.96%) + (0.45 × 0.88%) = 1.98%
LG7 9-14 Portfolio Return Year to date, Yum Brands had earned a 3.80 percent return. During the
same time period, Raytheon earned 4.26 percent and Coca-Cola earned −0.46 percent. If you
have a portfolio made up of 30 percent Yum Brands, 30 percent Raytheon, and 40 percent Coca-
Cola, what is your portfolio return?
Portfolio Return = (0.3 × 3.80%) + (0.3 × 4.26%) + (0.4 × −0.46%) = 2.23%
intermediate problems
LG1 9-15 Average Return The past five monthly returns for Kohl’s are 4.11 percent, 3.62 percent,
−1.68 percent, 9.25 percent, and −2.56 percent. What is the average monthly return?
Average Return = (4.11% + 3.62% − 1.68% + 9.25% − 2.56%) / 5 = 2.548%
LG1 9-16 Average Return The past five monthly returns for PG&E are −3.17 percent, 3.88 percent,
3.77 percent, 6.47 percent, and 3.58 percent. What is the average monthly return?
Average Return = (−3.17% + 3.88% + 3.77% + 6.47% + 3.58%) / 5 = 2.906%
LG3 9-17 Standard Deviation Compute the standard deviation of Kohls’ monthly returns shown in
Problem 9-15.
(4.11% − 2.548%)2 + (3.62% − 2.548%)2 + (− 1.68% − 2.548%)2 + (9.25% − 2.548%)2 + (− 2.56% − 2.548%)2 = 4.81%
5 −1
LG3 9-18 Standard Deviation Compute the standard deviation of PG&E’s monthly returns shown in
Problem 9-16.
(− 3.17% − 2.906% )2 + (3.88% − 2.906% )2 + (3.77% − 2.906% )2 + (6.47% − 2.906%)2 + (3.58% − 2.906% )2 = 3.60%
5 −1
LG2&4 9-19 Risk versus Return in Bonds Assess the risk-return relationship of the bond market (see
Tables 9.2 and 9.4) during each decade since 1950.
Compute the coefficient of variation for each decade using the standard deviation and average
return:
Decade CoV
1950s NA
1960s 3.88
1970s 1.19
1980s 1.12
1990s 1.35
2000s 1.29
The lower the coefficient of variation, the better the risk-return relationship. The early two
decades, 1950s and 1960s, have a poor risk-return relationship for bonds. The 1950s coefficient
of variation is not defined because the average return is zero. The poor relationship in the 1960s
is caused by the very low return in that decade. The three full decades since 1970 have had a
good risk-return relationship.
LG2&4 9-20 Risk versus Return in T-bills Assess the risk-return relationship in T-bills (see Tables 9.2
and 9.4) during each decade since 1950.
Compute the coefficient of variation for each decade using the standard deviation and average
return:
Decade CoV
1950s 0.40
1960s 0.33
1970s 0.29
1980s 0.29
1990s 0.24
2000s 0.68
The lower the coefficient of variation, the better the risk-return relationship. All these CoVs are
very low. While they appear to have great risk-return relationships, it is because the risk is very
low. T-bills are very safe instruments. However, they offer very low returns.
LG4&5 9-21 Diversifying Consider the characteristics of the following three stocks:
Expected Standard
Return Deviation
Thumb 13% 23%
Devices
Air Comfort 10 19
Sport Garb 10 17
The correlation between Thumb Devices and Air Comfort is −0.12. The correlation between
Thumb Devices and Sport Garb is −0.21. The correlation between Air Comfort and Sport Garb
is 0.77. If you can pick only two stocks for your portfolio, which would you pick? Why?
Air Comfort and Sport Garb have similar expected returns and standard deviations. Since their
correlation is very high, minimal risk reduction will occur by combining these two stocks..
Combining either stock with Thumb Devices has good potential for risk reduction as they have a
low (negative) correlation. Since Sport Garb has both lower risk (standard deviation) and lower
correlation with Thumb Devices than does Air Comfort, you should combine Sport Garb and
Thumb Devices.
LG4&5 9-22 Diversifying Consider the characteristics of the following three stocks:
Expected Standard
Return Deviation
Pic Image 11% 19%
Tax Help 9 19
Warm Wear 14 25
The correlation between Pic Image and Tax Help is 0.88. The correlation between Pic Image
and Warm Wear is −0.21. The correlation between Tax Help and Warm Wear is −0.19. If you
can pick only two stocks for your portfolio, which would you pick? Why?
Pic Image and Tax Help have similar expected returns and standard deviations. Since their
correlation is very high, minimal risk reduction will occur by combining these two stocks.
Combining either stock with Warm Wear has good potential for risk reduction as they have a low
(negative) correlation. Since Pic Image has both higher expected return and lower correlation
with Warm Wear than does Tax Help, you should combine Pic Image and Warm Wear.
LG7 9-23 Portfolio Weights If you own 200 shares of Alaska Air at $42.88, 350 shares of Best Buy
at $51.32, and 250 shares of Ford Motor at $8.51, what are the portfolio weights of each stock?
Total portfolio = (200 × $42.88) + (350 × $51.32) + (250 × $8.51) = $28,665.50

Alaska Air weight = (200 × $42.88) / $28,665.50 = 0.299
Best Buy weight = (350 × $51.32) / $28,665.50 = 0.627
Ford Motor weight = (250 × $8.51) / $28,665.50 = 0.074
LG7 9-24 Portfolio Weights If you own 400 shares of Xerox at $17.34, 500 shares of Qwest at $8.15,
and 350 shares of Liz Claiborne at $44.73, what are the portfolio weights of each stock?
Total portfolio = (400 × $17.34) + (500 × $8.15) + (350 × $44.73) = $26,666.50

Xerox weight = (400 × $17.34) / $26,666.50 = 0.260
Qwest weight = (500 × $8.15) / $26,666.50 = 0.153
Liz Claiborne weight = (350 × $44.73) / $26,666.50 = 0.587
LG7 9-25 Portfolio Return At the beginning of the month, you owned $5,500 of General Dynamics,
$7,500 of Starbucks, and $8,000 of Nike. The monthly returns for General Dynamics, Starbucks,
and Nike were 7.44 percent, −1.36 percent, and −0.54 percent. What is your portfolio return?
Total portfolio = $5,500 + $7,500 + $8,000 = $21,000

General Dynamics weight = $5,500 / $21,000 = 0.2619
Starbucks weight = $7,500 / $21,000 = 0.3571
Nike weight = $8,000 / $21,000 = 0.3810
Portfolio return = (0.2619 × 7.44%) + (0.3571 × −1.36%) + (0.3810 × −0.54%) = 1.26%
LG7 9-26 Portfolio Return At the beginning of the month, you owned $6,000 of News Corp, $5,000
of First Data, and $8,500 of Whirlpool. The monthly returns for News Corp, First Data, and
Whirlpool were 8.24 percent, −2.59 percent, and 10.13 percent. What’s your portfolio return?
Total portfolio = $6,000 + $5,000 + $8,500 = $19,500

News Corp weight = $6,000 / $19,500 = 0.3077
First Data weight = $5,000 / $19,500 = 0.2564
Whirlpool weight = $8,500 / $19,500 = 0.4359
Portfolio return = (0.3077 × 8.24%) + (0.2564 × −2.59%) + (0.4359 × 10.13%) = 6.29%
advanced problems
LG2&5 9-27 Asset Allocation You have a portfolio with an asset allocation of 50 percent stocks,
40 percent long-term Treasury bonds, and 10 percent T-bills. Use these weights and the returns
in Table 9.2 to compute the return of the portfolio in the year 2010 and each year since. Then
compute the average annual return and standard deviation of the portfolio and compare them
with the risk and return profile of each individual asset class.
These answers were computed using a spreadsheet. The portfolio return is computed as:
(0.5 × 15.1%) + (0.4 × 9.4%) + (0.1 × 0.01%) = 11.3%
11.3% 2010
13.0% 2011
9.4% 2012
11.1% 2013
16.9% 2014
0.2% 2015
6.5% 2016
14.4% 2017
10.4% = Ave
5.15 = St Dev
The portfolio has the second highest return with the second lowest level of risk. Combining these
assets achieved some risk reduction as seen in the standard deviation.
LG2&5 9-28 Asset Allocation You have a portfolio with an asset allocation of 35 percent stocks, 55
percent long-term Treasury bonds, and 10 percent T-bills. Use these weights and the returns in
Table 9.2 to compute the return of the portfolio in the year 2010 and each year since. Then
compute the average annual return and standard deviation of the portfolio and compare them
with the risk and return profile of each individual asset class.
These answers were computed using a spreadsheet. The portfolio return is computed as:
(0.35 × 15.1%) + (0.55 × 9.4%) + (0.1 × 0.01%) = 10.46%
10.5% 2010
17.2% 2011
7.6% 2012
4.4% 2013
18.6% 2014
-0.1% 2015
4.9% 2016
12.4% 2017
9.4% = Ave
6.5% = St Dev
The portfolio has the second highest return with the second lowest level of risk. Combining
these assets achieved some risk reduction. Compare these results to the results of problem 9-27
to see the effects caused by changing the portfolio weights.
LG7 9-29 Portfolio Weights You have $15,000 to invest. You want to purchase shares of Alaska Air
at $42.88, Best Buy at $51.32, and Ford Motor at $8.51. How many shares of each company
should you purchase so that your portfolio consists of 30 percent Alaska Air, 40 percent Best
Buy, and 30 percent Ford Motor? Report only whole stock shares.
Alaska Air: 0.30 × $15,000 / $42.88 = 105 shares

Best Buy: 0.40 × $15,000 / $51.32 = 117 shares
Ford Motor: 0.30 × $15,000 / $8.51 = 529 shares
Because of rounding up, this adds up to slightly more than $15,000. So, you might have to
purchase a share or two less of a stock to allow for this overage and also to allow for any
commission or trading costs.
LG7 9-30 Portfolio Weights You have $20,000 to invest. You want to purchase shares of Xerox at
$17.34, Qwest at $8.15, and Liz Claiborne at $44.73. How many shares of each company should
you purchase so that your portfolio consists of 25 percent Xerox, 40 percent Qwest, and 35
percent Liz Claiborne? Report only whole stock shares.
Xerox: 0.25 × $20,000 / $17.34 = 288 shares

Qwest: 0.40 × $20,000 / $8.15 = 982 shares
Liz Claiborne: 0.35 × $20,000 / $44.73 = 156 shares
Excluding commissions paid, you will still have a cash balance of $24.90.
LG7 9-31 Portfolio Return The table below shows your stock positions at the beginning of the year,
the dividends that each stock paid during the year, and the stock prices at the end of the year.
What is your portfolio dollar return and percentage return?
Beginning Dividend End of
Company Shares of Year per Year
Price Share Price
US Bank 300 $43.50 $2.06 $43.43
PepsiCo 200 59.08 1.16 62.55
JDS Uniphase 500 18.88 16.66
Duke Energy 250 27.45 1.26 33.21
Solution by spreadsheet:
Company Beginning Portfolio Capital Percentage

Value Weight Gain Income Total Return Return
US Bank
$13,050.00 0.3170 ($21.00) $618.00 $597.00 4.57%
PepsiCo 11,816.00 0.2870 694.00 232.00 926.00 7.84
JDS
Uniphase 9,440.00 0.2293 (1,110.00) $0.00 (1,110.00) -11.76
Duke
Energy 6,862.50 0.1667 1,440.00 315.00 1,755.00 25.57
Total = $41,168.50 $2,168.00
Portfolio
Return = 5.27%
LG7 9-32 Portfolio Return The table below shows your stock positions at the beginning of the year,
the dividends that each stock paid during the year, and the stock prices at the end of the year.
What is your portfolio dollar return and percentage return?
Beginning Dividend End of

Company Shares of Year per Year
Price Share Price
Johnson Controls 350 $72.91 $1.17 $85.92
Medtronic 200 57.57 0.41 53.51
Direct TV 500 24.94 24.39
Qualcomm 250 43.08 0.45 38.92
Company Beginning
Value Portfolio Capital Percent
Weight Gain Income Total Return Return
Johnson
Controls $25,518.50 0.4234 $4,553.50 $409.50 $4,963.00 19.45%
Medtronic
$11,514.00 0.1910 (812.00) 82.00 (730.00) -6.34
Direct TV $12,470.00 0.2069 (275.00) 0.00 (275.00) -2.21
Qualcomm
$10,770.00 0.1787 (1,040.00) 112.50 (927.50) -8.61
Total = $60,272.50 $3,030.50
Portfolio
Return = 5.03%
LG3&4 9-33 Risk, Return, and Their Relationship Consider the following annual returns of Estee
Lauder and Lowe’s Companies:
Estee Lauder Lowe’s

Companies
Year 1 23.4% −6.0%
Year 2 −26.0 16.1
Year 3 17.6 4.2
Year 4 49.9 48.0
Year 5 −16.8 −19.0
Compute each stock’s average return, standard deviation, and coefficient of variation. Which
stock appears better? Why?
Estee Lowe’s
Lauder Companies
Average
= 9.62% 8.66%
Std dev
= 31.00% 25.51%
CoV = 3.22 2.95
Estee Lauder has experienced a higher average return than Lowe’s but also has more risk
(standard deviation). On a risk-return basis, Lowe’s appears to be the better stock as it has less
risk per unit of return (coefficient of variation).
LG3&4 9-34 Risk, Return, and Their Relationship Consider the following annual returns of Molson
Coors and International Paper:
Molson International
Coors Paper
Year 1 16.3% 4.5%
Year 2 −9.7 −17.5
Year 3 36.5 −0.2
Year 4 −6.9 26.6
Year 5 16.2 −11.1
Compute each stock’s average return, standard deviation, and coefficient of variation. Which
stock appears better? Why?
Molson International
Coors Paper
Average
= 10.48% 0.46%
Std dev
= 19.06% 17.00%
CoV = 1.82 36.96
Molson Coors has experienced a much higher average return than International Paper with
slightly more risk (standard deviation). Thus, it is not a surprise that Molson Coors has a
significantly better (lower) coefficient of variation. Molson Coors is superior on a risk-return
basis.
9-35 Excel Problem Below are the monthly returns for March 2011 to February 2016 of three
international stock indices; All Ordinaries of Australia, Nikkei 225 of Japan, and FTSE 100 of
England.
A. Compute and compare each indices’ monthly average return and standard deviation.
B. Compute the correlation between i) All Ordinaries and Nikkei 225, ii) All Ordinaries and
FTSE 100, and iii) Nikkei 225 and FTSE 100, and compare them.
C. Form a portfolio consisting of one third of each of the indices and show the portfolio return
each year, and the portfolio’s return and standard deviation.
A.
All
Ordinaries NIKKEI 225 FTSE
Ave = 0.10% 0.83% 0.05%
Std. Dev. = 3.63% 5.37% 3.36%
The NIKKEI 225 index had the highest monthly return with the highest risk.
B. Correlations
All
Ordinaries NIKKEI 225 FTSE
All
Ordinaries 1
NIKKEI 225 0.431 1
FTSE 0.688 0.529 1
The correlations are quite high. Nikkei and the All Ordinaries are the least correlated. The All
Ordinaries and the FTSE have the highest correlation.
C.
Date Portfolio
February-16 -3.57%
January-16 -5.30%
December-15 -0.99%
November-15 0.69%
October-15 6.41%
September-15 -4.69%
August-15 -7.67%
July-15 2.88%
June-15 -4.61%
May-15 1.90%
April-15 0.96%
March-15 -0.31%
February-15 5.18%
January-15 2.37%
December-14 -0.22%
November-14 1.77%
October-14 1.42%
September-14 -1.29%
August-14 0.03%
July-14 2.43%
June-14 0.16%
May-14 1.10%
April-14 0.16%
March-14 -1.14%
February-14 2.71%
January-14 -4.92%
December-13 2.08%
November-13 2.05%
October-13 2.39%
September-13 3.51%
August-13 -1.14%
July-13 3.97%
June-13 -3.04%
May-13 -1.06%
April-13 5.29%
March-13 1.77%
February-13 3.20%
January-13 6.22%
December-12 4.61%
November-12 2.29%
October-12 1.43%
September-12 0.81%
August-12 1.39%
July-12 0.47%
June-12 3.39%
May-12 -8.34%
April-12 -1.68%
March-12 0.89%
February-12 5.08%
January-12 3.76%
December-11 -0.10%
November-11 -3.63%
October-11 6.18%
September-11 -4.88%
August-11 -6.35%
July-11 -1.81%
June-11 -0.72%
May-11 -1.72%
April-11 1.03%
March-11 -3.17%
Ave = 0.33%
Std. Dev. = 3.43%
9-36 Spreadsheet Problem Create the spreadsheet below. The spreadsheet should use the
returns for assets A and B to form a portfolio return using the weights for each asset shown in
cells E1 and E2. The average portfolio return and standard deviation should compute at the
bottom of the column of portfolio returns. When you change the weights, the portfolio returns,
average, and standard deviation should recalculate.
A B Weight A = 0.50 Portfolio

-9.1% 20.11% Weight B = 0.50 5.51%
11.9% 4.56% sum = 1 8.23%
-22.1% 7.17% -7.47%
28.7% 2.06% 15.38%
10.9% 7.70% 9.30%
4.9% -6.50% -0.80%
15.8% 1.85% 8.82%
3.5% 9.81% 6.66%
-5.5% 22.7% 8.60%
-
23.45% 12.19% 5.63%
15.06% 9.38% 12.22%
2.11% 29.93% 16.02%
16.00% 3.56% 9.78%
-
32.39% 12.66% 9.87%
13.69% 15.07% 14.38%
9.4% 6.8% = Average Average = 8.1%

14.41% 12.04% =StDev StDev = 6.07%
A. Create the spreadsheet.

B. Use the Solver function to find the weights that provide the highest return for a standard
deviation of 6%, 7.5%, 9%, 10.5%, 12%, and 13.5%. Report the weights and the return for each
of these portfolio standard deviations. The Solver function is found in the Data tab. (You may
have to enable the function through the File tab, then Options, then Add-ins.) The solver image
illustrates the maximizing of the average return for the specific constraints. The constraints are
that the weights must be between 0 and 1, inclusive, and must sum to 1. Lastly, set the standard
deviation constraint to the desired level.
A. Student should build the spreadsheet that looks like the one in the problem.
B. Answers are:
Standard Deviation Weight A Weight B Average Return
6% 0.48 0.52 8.1%
7.5 0.64 0.36 8.5
9 0.73 0.27 8.7
10.5 0.81 0.19 9.0
12 0.89 0.11 9.1
13.5 0.96 0.04 9.3
Research It!: Following a Portfolio
Following stocks in a portfolio is easier than ever. Many financial Web sites have the capability
to follow the stocks in your portfolio over time. Just enter your stocks, the number of shares,
your purchase price, and your commission cost and you can see how your portfolio is doing.
These portfolio managers will update your portfolio as stock prices change, minute to minute.
Yahoo! Finance has a portfolio management tool. Go to the site and start a portfolio to watch
(which requires free registration). Try entering symbols EBAY, T, LMT, DUK, and GSK. As a
start, assume you own 200 shares of each. You can watch the value of the portfolio change and
see how each stock is doing every day. (http://www.finance.yahoo.com/)
The portfolio might look something like this:

integrated minicase: Diversifying with Other Asset Classes
Many more types of investments are available besides stocks, bonds, and cash securities. Many
people invest in real estate and in precious metals, primarily gold. What are the risk and return
characteristics of these investments and do they provide diversification opportunities to the
typical stock investor?
You can invest in real estate in many ways. You can build properties, own rental units,
and trade raw land. These activities take enormous time and expertise. One of the easiest ways
to invest in real estate is through real estate investment trusts (REITs) that trade
like stocks on the stock exchanges. A REIT represents ownership in a portfolio consisting of a
pool of real estate assets. An index of all REITs is a good measure of the performance of the real
estate market. The table below shows the annual returns for the All REITs Index alongside the
returns of the S&P 500 Index.
S&P 500 All REITs Gold

Index Index Price
1975 37.2% 36.3% -19.9%
1976 23.8% 49.0% -4.1%
1977 -7.2% 19.1% 22.6%
1978 6.6% -1.6% 37.0%
1979 18.4% 30.5% 126.5%
1980 32.4% 28.0% 15.2%
1981 -4.9% 8.6% -32.6%
1982 21.4% 31.6% 14.9%
1983 22.5% 25.5% -16.3%
1984 6.3% 14.8% -19.2%
1985 32.2% 5.9% 5.7%
1986 18.5% 19.2% 21.3%
1987 5.2% -10.7% 22.2%
1988 16.8% 11.4% -15.3%
1989 31.5% -1.8% -2.8%
1990 -3.2% -17.3% -1.5%
1991 30.6% 35.7% -10.1%
1992 7.7% 12.2% -5.7%
1993 10.0% 18.5% 17.7%
1994 1.3% 0.8% -2.2%
1995 37.4% 18.3% 1.0%
1996 23.1% 35.8% -4.6%
1997 33.4% 18.9% -21.4%
1998 28.6% -18.8% -0.8%
1999 21.0% -6.5% 0.9%
2000 -9.1% 25.9% -5.4%
2001 -11.9% 15.5% 0.7%
2002 -22.1% 5.2% 25.6%
2003 28.7% 38.5% 19.9%
2004 10.9% 30.4% 4.6%
2005 4.9% 8.3% 17.8%
2006 15.8% 34.4% 24.0%
2007 3.5% -17.8% 31.1%

2008 -35.5% -40.0% 4.3%
2009 23.5% 20.9% 25.0%
2010 15.1% 22.8% 25.3%
2011 2.1% 3.6% 8.9%
2012 16.0% 15.5% 8.3%
2013 32.4% 2.9% -27.3%
2014 13.7% 28.0% 0.1%
2015 1.4% 2.8% -11.9%
2016 12.0% 8.6% 7.8%
2017 21.8% 8.7% 12.7%
Gold has been a highly sought-after asset all over the world, and has retained at least
some economic value over thousands of years. The United States has had a very chaotic
history with gold. Americans have sought to “strike it rich” through gold rushes in North
Carolina (early 1800s), California and Nevada (mid-1800s), and Alaska (late 1800s). Struggling
in the Great Depression, President Franklin D. Roosevelt ordered U.S. citizens to hand in all the
gold they possessed. The ban on U.S. citizens owning gold was not lifted until the end of 1974.
The table also shows the return from gold prices.
The returns for stocks, real estate, and gold are all volatile. However, during many years,
the return of one asset is up while the others are down. This looks promising for diversification
opportunities.
a. Using a spreadsheet, compute the average return and standard deviation of each of the
three asset classes.
b. Compute the annual returns of a portfolio consisting of 50% stocks / 40% real estate / 10%
gold. What is the average return and standard deviation of this portfolio? Also compute the
average return and standard deviation of the following portfolios: 75%/20%/5% and
80%/5%/15%. How do these portfolios perform compared to owning just stocks?
c. Plot the average return and standard deviation of the three assets and the three portfolios
on a risk-return graph like Figure 9.3.
SOLUTION:
a.
S&P 500 All REITs Gold

Index Index Price
Ave = 13.3% 13.4% 7.0%
Std.
Dev.= 16.2% 18.1% 24.9%
b.
50/40/10 75/20/5 80/5/15

Ave = 12.7% 13.0% 12.4%
Std.
Dev.= 13.3% 14.2% 13.6%
The portfolio is dominated by the first portfolio because it has lower return and higher risk. The
second portfolio achieved a very slight higher return than the first, but need more risk to do it.
c.
14.0%
13.0%
12.0%
50/40/10
11.0%
Average Return
75/20/5
80/5/15
10.0%
S&P 500 Index
All REITs Index
9.0% Gold Price
8.0%
7.0%
6.0%
10.0% 15.0% 20.0% 25.0% 30.0%
Standard Deviation of Annual Returns

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Chapter 09 - Characterizing Risk and Return

CHAPTER 9 – CHARACTERIZING RISK AND RETURN

Dollar Return = (Ending Value − Beginning Value) + Income

Percentage Return = $700 / ($103.39 × 200) = 3.53%

Dollar Return = (Ending Value − Beginning Value) + Income

Percentage Return = -$1,050 / ($23.36 × 500) = -8.99%

Dollar Return = Capital gain + Income = $965 - $975 + $35 = $25

Dollar Return = Capital gain + Income = $1,065 - $1,055 + $35 = $45

Rank by coefficient of variation: Rail Haul CoV = 25 / 12 = 2.08, Poker-R-Us CoV = 20 / 9 =

Rank by coefficient of variation: WholeMart CoV = 25 / 11 = 2.27, Fruit Fly CoV = 40 / 16 =

Total portfolio = $6,000 + $5,000 + $5,000 = $16,000

Total portfolio = $3,000 + $6,000 + $7,000 = $16,000

Portfolio Return = (0.30 × −1.34%) + (0.25 × 7.96%) + (0.45 × 0.88%) = 1.98%

Portfolio Return = (0.3 × 3.80%) + (0.3 × 4.26%) + (0.4 × −0.46%) = 2.23%

Average Return = (4.11% + 3.62% − 1.68% + 9.25% − 2.56%) / 5 = 2.548%

Average Return = (−3.17% + 3.88% + 3.77% + 6.47% + 3.58%) / 5 = 2.906%

Total portfolio = (200 × $42.88) + (350 × $51.32) + (250 × $8.51) = $28,665.50

Total portfolio = (400 × $17.34) + (500 × $8.15) + (350 × $44.73) = $26,666.50

Total portfolio = $5,500 + $7,500 + $8,000 = $21,000

Total portfolio = $6,000 + $5,000 + $8,500 = $19,500

Alaska Air: 0.30 × $15,000 / $42.88 = 105 shares

Xerox: 0.25 × $20,000 / $17.34 = 288 shares

Company Beginning Portfolio Capital Percentage

Beginning Dividend End of

Estee Lauder Lowe’s

A B Weight A = 0.50 Portfolio

9.4% 6.8% = Average Average = 8.1%

A. Create the spreadsheet.

Research It!: Following a Portfolio

The portfolio might look something like this:

integrated minicase: Diversifying with Other Asset Classes

S&P 500 All REITs Gold

2007 3.5% -17.8% 31.1%

S&P 500 All REITs Gold

50/40/10 75/20/5 80/5/15

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