7-4.

Expected Return—Discrete Distribution

A stock's return has the following distribution:

Calculate the stock's expected return, standard deviation, and coefficient of variation.

Probability Rate of return Prob. X rate of return

Demand (P) (ri) (P x ri)
Weak 0.1 -30.0%
Below average 0.2 -5.0%
Average 0.4 10.0%
Above average 0.2 16.0%
Strong 0.1 40.0%
Expected rate of return ( r )

Return - Expected return (Return-expected return)2 (Return-expected

Demand return)2 X Probability
(ri - r) (ri - r)2 (ri - r)2 x P
Weak
Below average
Average
Above average
Strong
Variance =

C.V = Standard deviation / Expected return =

Risk per unit of return
7-2. Required Rate of Return
Assume that the risk-free rate is 6% and that the expected return on the market is 11%. What
is the required rate of return on a stock that has a beta of 0.6?
rs = rRF + (rM – rRF)b

7-3. Expected and Required Rates of Return

Assume that the risk-free rate is 5% and the market risk premium is 7%. What is the
expected return on (1) the market (2) a stock with a beta of 1.0 and (3) a stock with a beta of
1.7?

rs = rRF + (rM – rRF)b = rRF + RPM b

 7-14. Expected Returns and SML
Meera has the following portfolio:

Stock Amount Beta Expected

Invested Return
Bio-Eng Inc. $75,000 1.90 12.50%
Canada Pipelines Co. $125,000 0.75 6.75
Industrial Auto Parts $200,000 1.20 9.00
Upon further analysis, she determines that the current risk-free rate is 3%, while the market
risk premium is 5%.
1. What return does Meera expect on her portfolio, based on the individual stocks' expected
returns?

Stock Amount Weight Expected Wt. x

Invested return Expected
return
Bio-Eng Inc. $75,000

Canada $125,000
Pipelines Co.
Industrial $200,000
Auto Parts
2. What is the required return on the portfolio? What do the answers in part (a) and (b) tell you
about the stocks?

Stock Amount Weight Beta Wt. x Beta

Invested
Bio-Eng Inc. $75,000

Canada $125,000
Pipelines Co.
Industrial Auto $200,000
Parts
3. Meera is thinking of adding another stock, Offshore Oil Co., to her portfolio. Offshore has a
beta of 2.3 and an expected return of 14%. Should she add this stock? Briefly explain why or
why not.

4. Assuming that Offshore Oil does provide the expected return required and that Meera
invests another $100,000 in Offshore Oil, what will be her portfolio's new expected return?

Stock Amount Weight Expected Wt. x

Invested return Expected
return
Bio-Eng Inc. $75,000

Canada $125,000
Pipelines Co.
Industrial Auto $200,000
Parts
Offshore Oil $100,000
 Stock Amount Weight Beta Wt. x Beta
Invested
Bio-Eng Inc. $75,000

Canada $125,000
Pipelines Co.
Industrial Auto $200,000
Parts
Offshore Oil $100,000