Tutorial & Computer Lab – Week 5

Parrino et al. Chapter 7

Instructions

• Spend the first 50 min on these tutorial questions

• Spend the remaining 40 min on working through the Computer Lab Exercise at the
end of this document (students may work in groups of up to 3 people)

Note: Tutors may not be able to cover all tutorial questions/excel exercises during the
tutorial time. Students are expected to complete all remaining exercises as part of their own
self-study.

1. Explain the relationship between risk and return.

Investors require greater returns for taking greater risk. They prefer the investment with the
highest possible return for a given level of risk or the investment with the lowest risk for a
given level of return.

2. Describe the two components of a total holding period return, and calculate this return for an
asset.

The total holding period return on an investment consists of a capital appreciation

component and an income component. This return is calculated using equation 5.1. It is
important to recognise that investors do not care whether they receive a dollar of return
through capital appreciation or as a cash dividend. Investors value both sources of return
equally.

3. Discuss which type of risk matters to investors and why.

Investors care about only systematic risk. This is because they can eliminate unique risk by
holding a diversified portfolio. Diversified investors will bid up prices for assets to the point at
which they are just being compensated for the systematic risks they must bear.
4. Given that you know the risk as well as the expected return for two shares, discuss what process
you might utilise to determine which of the two shares is a better buy. You may assume that the
two shares will be the only assets held in your portfolio.

You should be looking to maximise your expected return on an investment given the level of
risk that such an investment requires the investor to bear. Therefore, you should compare the
expected return and risk associated with each of the two shares. If the shares have the same
expected return, then choose the share with the lower risk. If the shares have the same risk,
then choose the share with the greatest expected return. If the expected return and risk of the
two assets have no common level, perhaps you should compare the ratio of the risk/expected
return to see which share contains the least risk per unit of expected return.

5. Expected returns: You have chosen biology as your college major because you would like to be a
medical doctor. However, you find that the probability of being accepted into medical school is
about 18 per cent. If you are accepted into medical school, then your starting salary when you
graduate will be $346 085 per year. However, if you are not accepted, then you would choose to
work in a zoo, where you will earn $42 530 per year. Without considering the additional educational
years or the time value of money, what is your expected starting salary as well as the standard
deviation of that starting salary?

E(salary) = 0.82($42,530) + (0.18) ($346,085) = $97,169.90

σ2salar = 0.82($42,530 – $97,169.90)2 + (0.18) ($346,085 – $97,169.90)2 =

$13,600,696,172.4900

σsalary = ($13,600,696,172.4900)1/2 = $116,622.02

6. Single-asset portfolios: Shares A, B, and C have expected returns of 17.12 per cent, 12.62 per cent,
and 11.34 per cent, respectively, while their standard deviations are 41.54 per cent, 26.55 per cent,
and 34.63 per cent, respectively. If you were considering the purchase of each of these shares as the
only holding in your portfolio, then which share should you choose?

Since the holding will be made in a completely undiversified portfolio, then we can calculate
the risk per unit of return for each share, the coefficient of variation, and choose the share
with the lowest value.

CV(RA) = 0.4154/0.1712 = 2.43

 CV(RB) = 0.2655/0.1262 = 2.10

CV(RC) = 0.3463/0.1134 = 3.05 ===> Choose B

Alternatively, we could have noted that the expected return for A and B was the same, with
A having a greater degree of risk. B and C have the same degree of risk, but B has a greater
expected return. This would lead you to the conclusion, just as our coefficient of variation
calculations did, that Share B is superior.

7. CAPM: Describe the Capital Asset Pricing Model (CAPM) and what it tells us.

The CAPM is a model that describes the relation between systematic risk and the expected
return. The model tells us that the expected return on an asset with no systematic risk equals
the risk-free rate. As systematic risk increases, the expected return increases linearly with
beta. The CAPM is written as E(Ri) = Rrf + βi(E(Rm) – Rrf).

8. Calculating the variance and standard deviation: You are considering purchasing shares in Lake
Awoonga Scenic Tours Ltd. You have observed the following returns on this share over the
last four years:

Year 1 2 3 4
Return – 8% 3% 16% 5%

What is the expected return and standard deviation of the return on Awoonga Scenic Tours
shares?

The average return is:

∑ (R ) i R + R ++ R
E(R Asset ) = i =1
= 1 2 n

n n
−8 + 3 + 16 + 5 16
= = = 4%
4 4

The variance of returns is:

 ∑[Ri − E(R)]
n
2

σ R2 = i =1

n −1 2
[R − E(R)] + [R − E(R)] + [R − E(R)] + [R − E(R)]
2 2 2

i i i i
=
4 −1
[−8 − 4] 2 + [3 − 4] 2 + [16 − 4] 2 + [5 − 4] 2
=
3
−122 − 12 + 122 + 12 144 + 1 + 144 + 1
= =
3 3
290
= = 96.67% 2

The standard deviation of returns is:

1

σ R = (σR2 )2 = σ R2
= 96.67 = 9.83%

Note: You may find it easier to calculate the variance of returns using a table format as
shown below.

(1) (2) (3) (4)

Actual Average Deviation Squared
Year Return Return (1) – (2) Deviation
Ri E(R) Ri – E(R) [Ri – E(R)]2
1 –8 4 – 12 144
2 3 4 –1 1
3 16 4 12 144
4 5 4 1 1
Totals 16 0.0 290

∑ [ R i − E(R)]
2
= 290
i =1
290 290
σ2= = = 96.67%2
R
n −1 3

9. Calculating the variance and standard deviation: Sandra is considering investing in a share and is
aware that the return on that investment is particularly sensitive to how the economy is performing.
Her analysis suggests that four states of the economy can affect the return on the investment. Using
the table of returns and probabilities below, find the expected return and the standard deviation of
the return on Sandra’s investment.
 Probability Return

Boom 0.3 25.00%

Good 0.4 15.00%

Level 0.2 10.00%

Slump 0.1 -5.00%

E(Ri) = 0.3(0.25) + (0.4) (0.15) + (0.2) (0.1) + (0.1) (–o.05) = 0.1500

σ2retur = 0.3(0.25 – 0.1500)2 + (0.4) (0.15 – 0.1500)2 + (0.2) (0.1 – 0.1500)2 + (0.1) (–0.5 – 0.1500)2

= 0.007500

σreturn = (0.007500)1/2 = 0.0866

10. Portfolios with more than one asset: Given the returns and probabilities for the three possible
states listed here, calculate the covariance between the returns of Share A and Share B. For
convenience, assume that the expected returns of Share A and Share B are 11.75 per cent and 18
per cent, respectively.

Probability Return(A) Return(B)

Good 0.30 0.30 0.50

OK 0.50 0.10 0.10
Poor 0.2 -0.25 -0.30

Cov(RA , RB ) = σ AB = 0.30(0.3 − 0.1175)(0.5 − 0.18) + 0.5(0.1 − 0.1175)(0.1 − 0.18) +

0.2(−0.25 − 0.1175)(−0.3 − 0.18) = 0.0535

11. Compensation for bearing systematic risk: You have constructed a diversified portfolio of shares
such that there is no unsystematic risk. Explain why the expected return of that portfolio should be
greater than the expected return of a risk-free security.
 Your portfolio contains no non-systematic risk but it does in fact contain systematic risk.
Therefore, the market should compensate the holder of this portfolio for the systematic risk
that the investor bears. The risk-free security has no risk and therefore requires no
compensation for risk bearing. The expected return of the portfolio should therefore be
greater than the return of the risk-free security.

12. David is going to purchase two shares to form the initial holdings in his portfolio. Iron share has
an expected return of 14 per cent, while Copper share has an expected return of 28 per cent. If David
plans to invest 30 per cent of his funds in Iron and the remainder in Copper, then what will be the
expected return from his portfolio? What if David invests 70 per cent of his funds in Iron shares?

Part 1: E(Rport) = (0.3)(0.14) + (0.7)(0.28) = 0.2380

Part 2: E(Rport) = (0.7)(0.14) + (0.3)(0.28) = 0.1820

Computer Lab Exercise

Download acst6003-week5-computer-lab.docx Excel file from iLearn (under Week 5

tutorial). The file contains monthly data for 10 year government bond rate (risk-free), All
Ordinaries Share price index (market), and share prices for BHP, Qantas and Commonwealth
bank over the period 2000 – 2020.
1. Add a new sheet called “returns” and compute monthly returns for the All Ordinaries,
𝑃𝑃𝑡𝑡
BHP, QAN and CBA using the following formula 𝑅𝑅𝑡𝑡 = �𝑃𝑃 − 1�. Compute a monthly
𝑡𝑡−1
𝑅𝑅𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎,𝑡𝑡
10 year bond rate as follows: 𝑅𝑅𝑟𝑟𝑟𝑟,𝑡𝑡 = � �
12

2. Compute 𝐸𝐸(𝑅𝑅), 𝜎𝜎 𝑎𝑎𝑎𝑎𝑎𝑎 𝐶𝐶𝐶𝐶 for each of the returns series. Also compute the correlation
coefficient and covariance between each return series and the market. Comment on your
analysis.
3. Create a new sheet called “excess returns” and compute excess returns for the market,
𝑒𝑒
i.e., market risk premium as 𝑅𝑅𝑚𝑚.𝑡𝑡 = 𝑅𝑅𝑚𝑚,𝑡𝑡 − 𝑅𝑅𝑟𝑟𝑟𝑟,𝑡𝑡 where 𝑅𝑅𝑚𝑚,𝑡𝑡 is the return on the All
Ords computed in 1, and 𝑅𝑅𝑟𝑟𝑟𝑟,𝑡𝑡 indicates the monthly return on the 10 yea bond rate
computed in 1. Also compute the excess return for each of BHP, QAN and CBA as
follows: 𝑅𝑅𝑡𝑡𝑒𝑒 = 𝑅𝑅𝑡𝑡 − 𝑅𝑅𝑟𝑟𝑟𝑟,𝑡𝑡
4. Estimate the CAPM betas for each of the BHP, QAN and CBA using excess returns by
estimating the following regressions:
𝑅𝑅𝑡𝑡𝑒𝑒 = 𝛼𝛼 + 𝛽𝛽𝛽𝛽𝑚𝑚,𝑡𝑡
𝑒𝑒
− 𝜇𝜇𝑡𝑡

You will need to use Regression model in excel to run this model. In Excel click Data
Analysis  Regression  For Y range highlight each of the BHP, QAN and CBA (one
at a time) for X range highlight (excess return on All Ords).
5. Comment on the three estimated beta coefficients, i.e., for BHP, QAN and CBA.