Solution Q-3 Case Study

a. For stock A: Expected return = (0.2 x -18) + (0.5 x 20) + (0.3 x 42) = 19

Standard deviation = [ 0.2 ( -18 -19)2 + 0.5 (20-19)2 + 0.3 (42 19)2 ] 1/2 = [273.8 + 0.5 + 158.7]1/2 = 20.07 For stock B: Expected return = (0.2 x 25) + (0.5 x 5) + [ 0.3 x (-) 12] = 3.9

Standard deviation = [0.2 ( 25 3.9)2 + 0.5 (5 -3.9)2 + 0.3 (-123.9)2]1/2 = (89.04 + 0.61 + 75.84) = 12.86 For stock C: Expected return = [0.2 x (-6)] + (0.5 x 15) + (0.3 x 26)] = 14.1

Standard deviation = [0.2 (-6 14.1)2 + 0.5 (15 -14.1)2 + 0.3 (26-14.1)2] = [80.80 + 0.41 + 42.48] = 11.12 For market portfolio: Expected return = [0.2 x (-)10] + (0.5 x 16) + (0.3 x 30) = -2 + 8 + 9 = 15

Standard deviation = [0.2 (-10-15)2 + 0.5(16-15)2 + 0.3 (30 15)2] = ( 125 + 0.5 + 67.5 ) = 13.89 b. State of the Economy Recession Normal Boom Probability (p) 0.2 0.5 0.3 Return on A (%) (RA) -18 20 42 Return B (%) (RB) 25 5 -12 RA-E(RA) RB-E(RB) p x [RA-E(RA)] x[RB-E(RB)] -156.14 0.55 - 109.71 - 265.30

-37.0 1.0 23.0

21.1 1.1 -15.9 total =

Covariance between the returns of A and B is (-) 265.3 (-) 265.3

Coefficient of correlation between the returns of A and B = (-) 1 c. Portfolio in which stocks A and B are equally weighted: Economic condition Recession Normal Boom Probability 0.2 0.5 0.3

= -----------20.07 x 12.86

Overall expected return 0.5 x (-) 18 + 0.5 x 25 = 3.5 0.5 x 20 + 0.5 x 5 = 12.5 0.5 x 42 + 0.5 x (-)12 = 15.0

Expected return of the portfolio = (0.2 x 3.5) + (0.5 x 12.5) + (0.3 x 15.0) = 0.7 + 6.25 + 4.5 = 11.45 Standard deviation of the portfolio = [ 0.2 (3.5 11.45)2 + 0.5 (12.5 11.45)2 + 0.3 (15.0 11.45)2]1/2 = [ 12.64 + 0.55 + 3.78] = 4.12 Portfolio in which weights assigned to stocks A, B and C are 0.4, 0.4 and 0.2 respectively. Expected return of the portfolio = (0.4 x 19.0) + (0.4 x 3.9) + 0.2 x 14.1) = 7.6 + 1.56 + 2.82 = 11.98 For calculating the standard deviation of the portfolio we also need covariance between B and C, which is calculated as under: State of the Economy Recession Normal Boom Probability (p) 0.2 0.5 0.3 Return on B (%) (RB) 25 5 (-)12 Return on C (%) (RC) - 6.0 15.0 26.0 RB-E(RB) RC-E(RC) p x[RB-E(RB)] x[RC-E(RC)] (-) 84.82 0.50 (-) 56.76 (-)141.08

21.1 1.1 (-)15.9

-20.1 0.9 11.9 total =

Covariance between the returns of B and C is (-)141.08 We have the following values: WA = 0.4 WB = 0.4 A = 20.07 B = 12.86 AB = (-)265.3 AC = 231.3 Standard deviation WC = 0.2 C = 11.12 BC = (-) 141.08

= [ (0.4 x 20.07)2 + (0.4 x 12.86)2 + (0.2 x 11.12)2 + [ 2 x 0.4 x 4 x (-) 265.3 ] + + [2 x 0.4 x 0.2 x 231.3] + [2 x 0.4 x 0.2 x (-) 141.08]1/2 = (64.45 + 26.46 + 4.95 84.90 + 37.01 22.57)1/2 = 5.04 d. (i) Risk-free rate is 6% and market risk premium is 15 6 = 9% The SML relationship is Required return = 6% + x 9% (ii) For stock A: Required return = 6 % + 1.3 x 9 % = 17.7 %; Expected return = 19 % Alpha = 19 17.7 = 1.3% For stock B: Required return = 6 % - 0.60 x 9 % = 0.6%; Expected return = 3.9 % Alpha = 3.9 0.6 = 3.3 % For stock C: Required return = 6% + 0.95 x 9 % = 14.55 %; Expected return = 14.1% Alpha = 14.1 14.55 = (-) 0.45 % e. Period RD (%) 1 -15 2 7 3 14 4 22 5 5 RM (%) -5 4 8 15 9 _ _ _ _ _ RD-RD RM-RM (RM-RM )2 (RD-RD) (RM-RM) -21.6 -11.2 125.44 241.92 0.4 -2.2 4.84 -0.88 7.4 1.8 3.24 13.32 15.4 8.8 77.44 135.52 -1.6 2.8 7.84 - 4.48 _ _ _ (RM-RM)2 = 218.80 (RD-RD) (RM-RM) = 385.4 2m = 218.8/4 = 54.7 Cov (D,M) = 385.4/4 = 96.35

RD = 33 RM = 31 _ _ RD = 6.6 RM = 6.2 = 96.35 / 54.7 = 1.76

Interpretation: The change in return of D is expected to be 1.76 times the expected change in return on the market portfolio.