Prof.

Rushen Chahal

CHAPTER 6

Risk and Rates of Return

CHAPTER ORIENTATION
This chapter introduces the concepts that underlie the valuation of securities and their rates of return. We are specifically concerned with common stock, preferred stock, and bonds. We also look at the concept of the investor's expected rate of return on an investment.

CHAPTER OUTLINE
I. The relationship between risk and rates of return A. B. Data have been compiled by Ibbotson and Sinquefield on the actual returns for various portfolios of securities from 1926-2002. The following portfolios were studied. 1. 2. 3. 4. 5. C. D. II. Common stocks of small firms Common stocks of large companies Long-term corporate bonds Long-term U.S. government bonds U.S. Treasury bills

Investors historically have received greater returns for greater risk-taking with the exception of the U.S. government bonds. The only portfolio with returns consistently exceeding the inflation rate has been common stocks. When a rate of interest is quoted, it is generally the nominal or, observed rate. The real rate of interest represents the rate of increase in actual purchasing power, after adjusting for inflation.

Effects of Inflation on Rates of Return A.

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B. Consequently, the nominal rate of interest is equal to the sum of the real rate of interest, the inflation rate, and the product of the real rate and the inflation rate.

III.

Term Structure of Interest Rates The relationship between a debt securitys rate of return and the length of time until the debt matures is known as the term structure of interest rates or the yield to maturity.

IV.

Expected Return A. B. The expected benefits or returns to be received from an investment come in the form of the cash flows the investment generates. Conventionally, we measure the expected cash flow, X , as follows: N X = XiP(Xi) i where N Xi = = the number of possible states of the economy. the cash flow in the ith state of the economy. the probability of the ith cash flow.

P(Xi) = V. Riskiness of the cash flows A. B. C.

Risk can be defined as the possible variation in cash flow about an expected cash flow. Statistically, risk may be measured by the standard deviation about the expected cash flow. Risk and diversification 1. Total variability can be divided into: a. b. 2. 3. The variability of returns unique to the security (diversifiable or unsystematic risk) The risk related to market movements (nondiversifiable or systematic risk)

By diversifying, the investor can eliminate the "unique" security risk. The systematic risk, however, cannot be diversified away. The market rewards diversification. We can lower risk without sacrificing expected return, and/or we can increase expected return without having to assume more risk. Diversifying among different kinds of assets is called asset allocation. Compared to diversification within the different asset classes, the benefits received are far greater through effective asset allocation. Risk and being patient

4.

5.

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a. b. An investor in common stocks must often wait longer to earn the higher returns than those provided by bonds. The capital markets reward us not just for diversifying, but also for being patient. The returns tend to converge toward the average as we lengthen our holding period.

6.

The characteristic line tells us the average movement in a firm's stock price in response to a movement in the general market, such as the stock market. The slope of the characteristic line, which has come to be called beta, is a measure of a stock's systematic or market risk. The slope of the line is merely the ratio of the "rise" of the line relative to the "run" of the line. If a security's beta equals one, a 10 percent increase (decrease) in market returns will produce on average a 10 percent increase (decrease) in security returns. A security having a higher beta is more volatile and thus more risky than a security having a lower beta value. A portfolio's beta is equal to the average of the betas of the stocks in the portfolio.

7.

8. 9. VI.

Required rate of return A. The required rate of return is the minimum rate necessary to compensate an investor for accepting the risk he or she associates with the purchase and ownership of an asset. Two factors determine the required rate of return for the investor: 1. 2. C. The risk-free rate of interest which recognizes the time value of money. The risk premium which considers the riskiness (variability of returns) of the asset and the investor's attitude toward risk. The required rate of return for a given security can be expressed as Required risk-free market risk-free = rate + beta x return - rate rate or kj = krf + j (km - krf) 2. Security market line a. b. Graphically illustrates the CAPM. Designates the risk-return trade-off existing in the market, where risk is defined in terms of beta according to the CAPM equation.

B.

Capital asset pricing model-CAPM 1.

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ANSWERS TO END-OF-CHAPTER QUESTIONS
6-1. Data have been compiled by Ibbotson and Sinquefield on the actual returns for the following portfolios of securities from 1926-2002. 1. 2. 3. 4. 5. U.S. Treasury bills U.S. government bonds Corporate bonds Common stocks for large firms Common stocks for small firms

Investors historically have received greater returns for greater risk-taking with the exception of the U.S. government bonds. Also, the only portfolio with returns consistently exceeding the inflation rate has been common stocks. 6-2 When a rate of interest is quoted, it is generally the nominal or, observed rate. The real rate of interest represents the rate of increase in actual purchasing power, after adjusting for inflation. Consequently, the nominal rate of interest is equal to the sum of the real rate of interest, the inflation rate, and the product of the real rate and the inflation rate. The relationship between a debt securitys rate of return and the length of time until the debt matures is known as the term structure of interest rates or the yield to maturity. In most cases, longer terms to maturity command higher returns or yields. (a) (b) The investor's required rate of return is the minimum rate of return necessary to attract an investor to purchase or hold a security. Risk is the potential variability in returns on an investment. Thus, the greater the uncertainty as to the exact outcome, the greater is the risk. Risk may be measured in terms of the standard deviation or by the variance term, which is simply the standard deviation squared. A large standard deviation of the returns indicates greater riskiness associated with an investment. However, whether the standard deviation is large relative to the returns has to be examined with respect to other investment opportunities. Alternatively, probability analysis is a meaningful approach to capture greater understanding of the significance of a standard deviation figure. However, we have chosen not to incorporate such an analysis into our explanation of the valuation process. Unique risk is the variability in a firm's stock price that is associated with the specific firm and not the result of some broader influence. An employee strike is an example of a company-unique influence. Systematic risk is the variability in a firm's stock price that is the result of general influences within the industry or resulting from overall market or

6-3

6-4.

(c)

6-5.

(a)

(b)

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economic influences. A general change in interest rates charged by banks is an example of systematic risk. 6-6. Beta indicates the responsiveness of a security's returns to changes in the market returns. Beta is multiplied by the market risk premium and added to the risk-free rate of return to calculate a required rate of return. The security market line is a graphical representation of the risk-return trade-off that exists in the market. The line indicates the minimum acceptable rate of return for investors given the level of risk. Since the security market line results from actual market transactions, the relationship not only represents the risk-return preferences of investors in the market but also represents the investors' available opportunity set. The beta for a portfolio is equal to the weighted average of the individual stock betas, weighted by the percentage invested in each stock. If a stock has a great amount of variability about its characteristic line (the graph of the stock's returns against the market's returns), then it has a high amount of unsystematic or company-unique risk. If, however, the stock's returns closely follow the market movements, then there is little unsystematic risk.

6-7.

6-8. 6-9.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

Solutions to Problems Set A
6-1A. krf = .045 + .073 + (.045 x .073) krf = .1213 or 12.13% = nominal rate of interest 6-2A. krf = .064 + .038 + (.064 x .038) krf = .1044 or 10.44% = nominal rate of interest

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6-3A. (A) Probability P(ki) .15 .30 .40 .15 (B) Return (ki) -1% 2 3 8 (A) x (B) Expected Return k -.15% 0.60% 1.20% 1.20% 2.85% Weighted Deviation (ki - k )2P(ki) 2.223% 0.217% 0.009% 3.978% 6.427% 2.535%

k=

= =

No, Pritchard should not invest in the security. The level of risk is excessive for a return which is less than the rate offered on treasury bills. 6-4A. Common Stock A: (A) Probability P(ki) 0.3 0.4 0.3 (B) Return (ki) 11% 15 19 (A) x (B) Expected Return k 3.3% 6.0 5.7 15.0% Weighted Deviation (ki - k )2P(ki) 4.8% 0.0 4.8 9.6% 3.10%

k =

2 = =

Common Stock B (A) Probability P(ki) 0.2 0.3 0.3 0.2 (B) Return (ki) -5% 6 14 22 (A) x (B) Expected Return k -1.0% 1.8 4.2 4.4 9.4% Weighted Deviation (ki - k )2P(ki) 41.472% 3.468 6.348 31.752 2 = 83.04% = 9.11%

k =

Common Stock A is better. It has a higher expected return with less risk.

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6-5A. Common Stock A: (A) Probability P(ki) 0.2 0.5 0.3 (B) Return (ki) - 2% 18 27 (A) x (B) Expected Return k -0.4% 9.0 8.1 16.7% Weighted Deviation (ki - k )2P(ki) 69.9% 0.8 31.8 102.5% 10.12%

k =

2 = =

Common Stock B: (A) Probability P(ki) 0.1 0.3 0.4 0.2 (B) Return (ki) 4% 6 10 15 (A) x (B) Expected Return k 0.4% 1.8 4.0 3.0 9.2% Weighted Deviation (ki - k )2P(ki) 2.704% 3.072 0.256 6.728 12.76% 3.57%

2 = =

Common Stock A k = 16.7% = 10.12%

Common Stock B k = 9.2% = 3.57%

We cannot say which investment is "better." It would depend on the investor's attitude toward the risk-return tradeoff. 6-6A. (a) Required rate Risk-free Market Risk of return = rate + Beta Premium = 6 % + 1.2 (16% - 6%) = 18% (b) The 18 percent "fair rate" compensates the investor for the time value of money and for assuming risk. However, only nondiversifiable risk is being considered, which is appropriate.

6-7A. Eye balling the characteristic line for the problem, the rise relative to the run is about 0.5. That is, when the S & P 500 return is eight percent Aram's expected return would be about four percent. Thus, the beta is also approximately 0.5 (4 8). 150

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6-8A. Risk-Free Rate A B C D 6.75% 6.75% 6.75% 6.75% + + + + + Expected Market - Risk-Free Return Rate x (12% (12% (12% (12% Risk-Free Rate 6.75%) 6.75%) 6.75%) 6.75%) x x x x Beta = 1.50 0.82 0.60 1.15 = = = = Required Rate of Return 14.63% 11.06% 9.90% 12.79%

Required 6-9A.` Rate of Return

= = =

(Market Return - Risk-Free Rate) X Beta

7.5% + (11.5% - 7.5%) x 0.765 10.56%

6-10A. If the expected market return is 12.8 percent and the risk premium is 4.3 percent, the riskless rate of return is 8.5 percent (12.8% - 4.3%). Therefore; Tasaco LBM Exxos 6-11A. Asman Time 1 2 3 4 Price $10 12 11 13 Return 20.00% -8.33 18.18 Price $30 28 32 35 Salinas Return -6.67% 14.29 9.38 = = = 8.5% + (12.8% - 8.5%) x 0.864 = 12.22% 8.5% + (12.8% - 8.5%) x 0.693 = 11.48% 8.5% + (12.8% - 8.5%) x 0.575 = 10.97%

A holding-period return indicates the rate of return you would earn if you bought a security at the beginning of a time period and sold it at the end of the period, such as the end of the month or year.

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6-12A.a. Month 1 2 3 4 5 6 Sum Average monthly return (Sum 6) Annualized average returns Variance (Sum 5) Standard deviation b. Required Rate of Return = = c. Zemin kb (kb - k )2 6.00% 3.00 1.00 -3.00 5.00 0.00 12.00 16.00% 1.00 1.00 25.00 9.00 4.00 56.00 Market kb (kb - k )2 4.00% 2.00 -1.00 -2.00 2.00 2.00 7.00 8.03% 0.69 4.69 10.03 0.69 0.69 24.82

2.00%

1.17%

24.00% 11.20%

14.04% 4.97%

3.35%

2.23%

Risk-Free + (Market Return - Risk-Free Rate) X Beta Rate 8% + [(14% - 8%) X 1.54] = 17.24%

Zemin's historical return of 24 percent exceeds what we would consider a fair return of 17.24 percent, given the stock's systematic risk.

6-13A. a. The portfolio expected return, k p, equals a weighted average of the individual stock's expected returns.
kp

(0.20)(16%) + (0.30)(14%) + (0.15)(20%) + (0.25)(12%) + (0.10)(24%) 15.8%

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b. The portfolio beta, p, equals a weighted average of the individual stock betas p = (0.20)(1.00) + (0.30)(0.85) + (0.15)(1.20) + (0.25)(0.60) + (0.10)(1.60) 0.95

= c.

Plot the security market line and the individual stocks

25.00 20.00 3 P 1 M 2 4

Expected Return

15.00 10.00 5.00 0.00 0.00

0.50

1.00 Beta

1.50

2.00

d.

A "winner" may be defined as a stock that falls above the security market line, which means these stocks are expected to earn a return exceeding what should be expected given their beta or systematic risk. In the above graph, these stocks include 1, 3, and 5. "Losers" would be those stocks falling below the security market line, which are represented by stocks 2 and 4 ever so slightly. Our results are less than certain because we have problems estimating the security market line with certainty. For instance, we have difficulty in specifying the market portfolio.

e.

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6-14A a. Month Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Jan-03 Feb-03 Mar-03 Apr-03 May-03 Jun-03 Jul-03 Sum b) Average monthly return Standard deviation c)
25.00% Mathews 20.00% 15.00% 10.00% 5.00% 0.00% -5.00% 0.00% -5.00% -10.00% -15.00% Market Index 5.00% 10.00% 15.00%

Price 1328.72 1320.41 1282.71 1362.93 1388.91 1469.25 1394.46 1366.42 1498.58 1452.43 1420.60 1454.60 1430.83

Market kt -0.63% -2.86% 6.25% 1.91% 5.78% -5.09% -2.01% 9.67% -3.08% -2.19% 2.39% -1.63% 8.52%

(kt - k )

Price 34.50 41.09 37.16 38.72 38.34 41.16 49.47 56.50 65.97 63.41 62.34 66.84 66.75

Mathews kt (kt - k )2 19.10% -9.56% 4.20% -0.98% 7.36% 20.19% 14.21% 16.76% -3.88% -1.69% 7.22% -0.13% 72.79% 0.0170 0.0244 0.0003 0.0050 0.0002 0.0199 0.0066 0.0114 0.0099 0.0060 0.0001 0.0038 0.1048

0.0002 0.0013 0.0031 0.0001 0.0026 0.0034 0.0007 0.0080 0.0014 0.0008 0.0003 0.0005 0.0225

0.71% 4.52%

6.07% 9.76%

-10.00%

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d. Mathews returns seem to correlate to the market returns during the majority of the year, but show great volatility.

6-15A Stock 1 (A) Probability P(ki) 0.15 0.40 0.30 0.15 (B) Return (ki) 2% 7 10 15 (A) x (B) Expected Return k 0.30% 2.80 3.00 2.25 8.35% Weighted Deviation (ki - k )2P(ki) 6.048% 0.729 0.817 6.633 14.227% 3.77%

k =

2 = =

Stock 2 (A) Probability P(ki) 0.25 0.50 0.25 (B) Return (ki) -3% 20 25 (A) x (B) Expected Return k -0.75% 10.00 6.25 15.50% Weighted Deviation (ki - k )2P(ki) 85.56% 10.13 22.56 118.25% 10.87%

k
Stock 3 (A) Probability P(ki) 0.10 0.40 0.30 0.20 (B) Return (ki) -5% 10 15 30

2 = =

(A) x (B) Expected Return k -0.50% 4.00 4.50 6.00 14.00%

Weighted Deviation (ki - k )2P(ki) 36.1% 6.4 0.3 51.2 94.0% 9.7%

k =

2 = =

We cannot say which investment is "better." It would depend on the investor's attitude toward the risk-return tradeoff.

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6-16A Risk-Free + Rate H T P W 6-17A Time 1 2 3 4 6-18A (a) Required rate Risk-free Market Risk = rate + Beta Premium of return = 5 % + 1.2 (9% - 5%) = 9.8% (b) Required rate Risk-free Market Risk = rate + Beta Premium of return = 5 % + 0.85 (9% - 5%) = 8.4% (c) If beta is 1.2: Required rate of return If beta is 0.85: Required rate of return = 5 % + 0.85 (12% - 5%) = 10.95% = 5 % + 1.2 (12% - 5%) = 13.4% Williams Price Return $33 27 -18.18% 35 29.63 39 11.43 Davis Price $19 15 14 23 Return -21.05% -6.67 64.29 5.5% 5.5% 5.5% 5.5% + + + + Expected Market - Risk-Free Return Rate x (11% (11% (11% (11% 5.5%) 5.5%) 5.5%) 5.5%) x x x x Required Rate of Return 9.63% 13.20% 10.73% 12.38%

Beta 0.75 1.40 0.95 1.25

= = = = =

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SOLUTION TO INTEGRATIVE PROBLEM
1. Holding-period returns for Market, Reynolds Computer, and Andrews Market kt (kt - k )2 0.0007 0.0006 0.0251 0.0025 0.0046 0.0022 0.0019 0.0008 0.0020 0.0007 0.0006 0.0014 0.0018 0.0020 0.0004 0.0017 0.0025 0.0000 0.0021 0.0040 0.0011 0.0071 0.0019 0.0012 .0689 Reynolds Computer Price kt (kt - k )2 20.60 23.20 27.15 25.00 32.88 32.75 30.41 36.59 50.00 40.06 40.88 41.19 34.44 37.00 40.88 48.81 41.81 40.13 43.00 51.00 38.44 40.81 53.94 50.13 43.13 12.62% 17.03% -7.92% 31.52% -0.40% -7.15% 20.32% 36.65% -19.88% 2.05% 0.76% -16.39% 7.43% 10.49% 19.40% -14.34% -4.02% 7.15% 18.60% -24.63% 6.17% 32.17% -7.06% -13.96% 106.62% 0.0067 0.0158 0.0153 0.0733 0.0023 0.0134 0.0252 0.1037 0.0592 0.0006 0.0014 0.0434 0.0009 0.0037 0.0224 0.0353 0.0072 0.0007 0.0201 0.0845 0.0003 0.0769 0.0132 0.0339 Andrews kt (kt - k )2 11.33% -21.63% -24.64% 14.64% 19.90% 6.32% 21.68% -7.23% 1.58% 6.13% 31.65% -0.16% 1.84% -38.10% -1.59% 8.30% 9.73% -2.32% -8.70% 31.96% 9.78% 27.55% -32.54% 12.47% 77.95% 0.0065 0.0619 0.0778 0.0130 0.0277 0.0009 0.0340 0.0110 0.0003 0.0008 0.0806 0.0012 0.0002 0.1710 0.0023 0.0026 0.0042 0.0031 0.0143 0.0824 0.0043 0.0591 0.1281 0.0085 .7958

Price 01May June July Aug Sept Oct Nov Dec 02Jan Feb Mar Apr May June July Aug Sept Oct Nov Dec 03Jan Febr Mar Apr May Sum

Price 24.00 26.72 20.94 15.78 18.09 21.69 23.06 28.06 26.03 26.44 28.06 36.94 36.88 37.56 23.25 22.88 24.78 27.19 26.56 24.25 32.00 35.13 44.81 30.23 34.00

1090.82 1133.84 3.94% 1120.67 -1.16% 957.28 -14.58% 1017.01 6.24% 1098.67 8.03% 1163.63 5.91% 1229.23 5.64% 1279.64 4.10% 1238.33 -3.23% 1286.37 3.88% 1335.18 3.79% 1301.84 -2.50% 1372.71 5.44% 1328.72 -3.20% 1320.41 -0.63% 1282.71 -2.86% 1362.93 6.25% 1388.91 1.91% 1469.25 5.78% 1394.46 -5.09% 1366.42 -2.01% 1498.58 9.67% 1452.43 -3.08% 1420.60 -2.19% 30.07%

2.

Average Monthly Return Standard Deviation

1.25%

4.44%

3.25%

5.47%

16.93%

18.60%

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3.
Reynolds vs Market

0.4 0.3 0.2

Market

0.1 0 -0.2 -0.1 -0.1 -0.2 -0.3 Reynolds

Andrews vs. Market 0.4 0.3 0.2 0.1

0.1

0.2

Andrews

0 -0.2 -0.1 -0.1 -0.2 -0.3 -0.4 -0.5 0 0.1 0.2

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4 Reynoldss returns have a great amount of volatility with some correlation to the market returns. The same can be said of Andrews. The returns show a great amount of volatility that followed the market returns only part of the time. 5. Monthly returns of a portfolio of equal amounts of Reynolds and Andrews. Monthly Returns 11.98% -2.32% -16.27% 23.08% 9.74% -0.41% 21.02% 14.70% -9.16% 4.09% 16.20% -8.28% 4.65% -13.81% 8.90% -3.00% 2.84% 2.43% 4.95% 3.66% 7.97% 29.87% -19.80% -0.75% 3.84% 12.29%

2001 June July August September October November December 2002 January February March April May June July August September October November December 2003 January February March April May Average return Standard deviation

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6.
Reynolds and Andrews 40.00%

30.00%

50% Reynolds 50% Andrews

20.00%

10.00%

-20.00%

-10.00%

0.00% 0.00% -10.00%

10.00%

20.00%

-20.00%

-30.00% Market

We see in this new graph where both stocks are included as a single portfolio that the relationship of the stocks with the market approximates an average of the relationships taken alone. Note the reduction in volatility that occurs when risk is diversified even between just two stocks.

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7. Monthly holding-period returns for long-term government bonds Annual Monthly (ki - k )2 Return Return 2001 June 5.70% 0.48% 0.000000% July 5.68% 0.47% 0.000001% August 5.54% 0.46% 0.000004% September 5.20% 0.43% 0.000023% October 5.01% 0.42% 0.000041% November 5.25% 0.44% 0.000020% December 5.06% 0.42% 0.000036% 2002 January 5.16% 0.43% 0.000027% February 5.37% 0.45% 0.000012% March 5.58% 0.47% 0.000003% April 5.55% 0.46% 0.000004% May 5.81% 0.48% 0.000000% June 6.04% 0.50% 0.000005% July 5.98% 0.50% 0.000003% August 6.07% 0.51% 0.000006% September 6.07% 0.51% 0.000006% October 6.26% 0.52% 0.000016% November 6.15% 0.51% 0.000009% December 6.35% 0.53% 0.000022% 2003 January 6.63% 0.55% 0.000050% February 6.23% 0.52% 0.000014% March 6.05% 0.50% 0.000005% April 5.85% 0.49% 0.000000% May 6.15% 0.51% 0.000009% Average Monthly Return Standard Deviation 0.04%

0.48%

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8. Monthly portfolio returns when portfolio consists of equal amounts invested in Reynolds, Andrews, and long-term government bonds. Monthly Returns 8.14% -1.39% -10.69% 15.53% 6.63% -0.13% 14.15% 9.94% -5.95% 2.88% 10.95% -5.36% 3.27% -9.04% 6.10% -1.83% 2.07% 1.79% 3.48% 2.63% 5.49% 20.08% -13.04% -0.33% 65.36% 2.72% 8.19% (ki - k )2 0.0029 0.0017 0.0180 0.0164 0.0015 0.0008 0.0131 0.0052 0.0075 0.0000 0.0068 0.0065 0.0000 0.0138 0.0011 0.0021 0.0000 0.0001 0.0001 0.0000 0.0008 0.0301 0.0248 0.0009 0.1542

2001 June July August September October November December 2002 January February March April May June July August September October November December 2003 January February March April May Sum

Average Monthly Return

Std. Dev..

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9. Comparison of average returns and standard deviations Average Returns 4.44% 3.25% 0.48% 3.84% 2.72% 1.25% Standard Deviations 16.93% 18.60% 0.04% 12.29% 8.19% 5.47%

Reynolds Andrews Government security Reynolds & Andrews Reynolds, Andrews, & government security Market

From the findings above, we see that higher average returns are associated with higher risk (standard deviations), and that by diversification we can reduce risk, possibly without reducing the average return. 10. Based on the standard deviations, Andrews has more risk than Reynolds, 18.60 percent standard deviation versus 16.93 percent standard deviation. However, when we only consider systematic risk, Andrews is slightly less risky--Reynolds's beta is 1.96 compared to Andrews beta of 1.49. (The betas given here for Reynolds and Andrews come from financial services who calculate firms' betas. These are not consistent with the graphs above where we see Andrews' returns as being more responsive to the general market. We are seeing the problem of using only 24 months of returns as we have done.) Required Risk-Free Rate of = + (Market Return - Risk-Free Rate) X Beta Rate Return Market Return = 1.25 % Average Monthly Return X 12 Months = 15%. (The average returns for the market over a two-year period may be high or low relative to the longer-term past, and as a result should not be considered as typical investor expectations. For instance, if we used information from Ibbotson & Sinquefield for the years 1926-2002, the market risk premiummarket return less risk-free ratewas 8.4 percent, and not the 19 percent that we use below. The point: Do not think two years fairly captures what we can expect in the future?) Reynolds: 23.64% = 6% + (15% - 6%) X 1.96 Andrews: 19.41% = 6% + (15% - 6%) X 1.49 And if we used the market premium of 8.4 percent: Reynolds: 22.46% = 6% + 8.4% X 1.96 Andrews: 18.52% = 6% + 8.4% X 1.49

11.

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Solutions to Problem Set B
6-1B. krf = .05 + .07 + (.05 x .07) krf = .1235 or 12.35% = nominal rate of interest 6-2B. krf = .03 + .05 + (.03 x .05) krf = .0815 or 8.15% = nominal rate of interest 6-3B. (A) Probability P(ki) .15 .30 .40 .15 (B) Return (ki) -3% 2 4 6 (A) x (B) Expected Return k -0.45% 0.60 1.60 0.90 2.65% Weighted Deviation (ki - k )2P(ki) 4.788 0.127 0.729 1.683 7.327% 2.707%

2 = =

No, Gautney should not invest in the security. The securitys expected rate of return is less than the rate offered on treasury bills. 6-4B. Security A: (A) Probability P(ki) 0.2 0.5 0.3 (B) Return (ki) - 2% 19 25 (A) x (B) Expected Return k -0.4% 9.5 7.5 16.6% Weighted Deviation (ki - k )2P(ki) 69.19% 2.88 21.17 93.24% 9.66%

k =

2 = =

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Security B: (A) Probability P(ki) 0.1 0.3 0.4 0.2 (B) Return (ki) 5% 7 12 14 (A) x (B) Expected Return k 0.5% 2.1 4.8 2.8 10.2% Weighted Deviation (ki - k )2P(ki) 2.704% 3.072 1.296 2.888 9.96% 3.16%

k =

2 = =

Security A k = 16.6% = 9.66%

Security B k = 10.2% = 3.16%

We cannot say which investment is "better." It would depend on the investor's attitude toward the risk-return tradeoff. 6-5B. Common Stock A: (A) Probability P(ki) 0.2 0.6 0.2 (B) Return (ki) 10% 13 20 (A) x (B) Expected Return k 2.0% 7.8 4.0 13.8% Weighted Deviation (ki - k )2P(ki) 2.89% 0.38 7.69 2 = 10.96% = 3.31%

k =

Common Stock B (A) Probability P(ki) 0.15 0.30 0.40 0.15 (B) Return (ki) 6% 8 15 19 (A) x (B) Expected Return k 0.9% 2.4 6.0 2.85 12.15% Weighted Deviation (ki - k )2P(ki) 5.67% 5.17 3.25 7.04 21.13% 4.60%

k =

2 = =

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Common Stock A is better. It has a higher expected return with less risk. 6-6B. (a) Required rate Risk-free Market Risk = rate + Beta Premium of return = 8 % + 1.5 (16% - 8%) = 20% (b) The 20 percent "fair rate" compensates the investor for the time value of money and for assuming risk. However, only nondiversifiable risk is being considered, which is appropriate.

6-7B. Eye balling the characteristic line for the problem, the rise relative to the run is about 1.75. That is, when the S & P 500 return is four percent Bram's expected return would be about seven percent. Thus, the beta is also approximately 1.75 (7 4). 6-8B. Risk-Free Rate A B C D 6.75% 6.75% 6.75% 6.75% + + + + + Expected Market Risk-Free - Rate Return (12% (12% (12% (12% 6.75%) 6.75%) 6.75%) 6.75%) x x x x x Beta 1.40 0.75 0.80 1.20 = = = = = Required Rate of Return 14.10% 10.69% 10.95% 13.05%

Required 6-9B. Rate of Return

= =

Risk-Free + (Market Return - Risk-Free Rate) X Beta Rate 7.5% + (10.5% - 7.5%) x 0.85

= 10.05% 6-10B. If the expected market return is 12.8 percent and the risk premium is 4.3 percent, the riskless rate of return is 8.5 percent (12.8% - 4.3%). Therefore; Dupree Yofota = 8.5% + (12.8% - 8.5%) x 0.82 = 12.03% = 8.5% + (12.8% - 8.5%) x 0.57 = 10.95%

MacGrill = 8.5% + (12.8% - 8.5%) x 0.68 = 11.42% 6-11B. O'Toole Time Price Return 1 $22 2 24 9.09% 3 20 -16.67% 4 25 25.00% Baltimore Price Return $45 50 11.11% 48 -4.00% 52 8.33%

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A holding-period return indicates the rate of return you would earn if you bought a security at the beginning of a time period and sold it at the end of the period, such as the end of the month or year,

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6-12B. (a) Month 1 2 3 4 5 6 Sum Average monthly return (Sum 6) Annualized average returns Variance (Sum 5) Standard deviation b. Required Risk-Free Rate of = + (Market Return - Risk-Free Rate) X Beta Rate Return = c. 6-13B a. The portfolio expected return, k p, equals a weighted average of the individual stock's expected returns. (0.10)(12%) + (0.25)(11%) + (0.15)(15%) + (0.30)(9%) + kp = (0.20)(14%) = 11.7% 8% + [(15% - 8%) X 1.18] = 16.26% Sugita kt (kt - k )2 1.80% 0.01% -0.50 5.68 2.00 0.01 -2.00 15.08 5.00 9.71 5.00 9.71 11.30 40.20 Market kt (kt - k )2 1.50% 0.06% 1.00 0.06 0.00 1.56 -2.00 10.56 4.00 7.56 3.00 3.06 7.50 22.86

1.88%

1.25%

22.60% 8.04%

15.00% 4.58%

2.84%

2.14%

Sugita's historical return of 22.6 percent exceeds what we would consider a fair return of 16.26 percent, given the stock's systematic risk.

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b.

The portfolio beta, p, equals a weighted average of the individual stock betas p = (0.10)(1.00) + (0.25)(0.75) + (0.15)(1.30) + (0.30)(0.60) + (0.20)(1.20) 0.90

= c.

Plot the security market line and the individual stocks

16.00 14.00
Expected Return

3 P 1 M 5

12.00 10.00 8.00 6.00 4.00 2.00 0.00 0.00 0.20 0.40 0.60 4

0.80

1.00

1.20

1.40

Beta
d. A "winner" may be defined as a stock that falls above the security market line, which means these stocks are expected to earn a return exceeding what should be expected given their beta or systematic risk. In the above graph, these stocks include 1, 2, 3, and 5. "Losers" would be those stocks falling below the security market line, that being stock 4. Our results are less than certain because we have problems estimating the security market line with certainty. For instance, we have difficulty in specifying the market portfolio.

e.

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6-14B a) Month Jul-02 Aug-02 Sep-02 Oct-02 Nov-02 Dec-02 Jan-03 Feb-03 Mar-03 Apr-03 May-03 Jun-03 Jul-03 Sum b) Price 1328.72 1320.41 1282.71 1362.93 1388.91 1469.25 1394.46 1366.42 1498.58 1452.43 1420.60 1454.60 1430.83 Market kt (kt - k )2 -0.63% -2.86% 6.25% 1.91% 5.78% -5.09% -2.01% 9.67% -3.08% -2.19% 2.39% -1.63% 8.52% 0.71% 4.52% 0.0002 0.0013 0.0031 0.0001 0.0026 0.0034 0.0007 0.0080 0.0014 0.0008 0.0003 0.0005 0.0225 Price 21.00 19.50 17.19 16.88 18.06 24.88 22.75 26.25 33.56 43.31 43.50 43.50 43.63 Hilarys kt -7.14% -11.85% -1.80% 6.99% 37.76% -8.56% 15.38% 27.85% 29.05% 0.44% 0.00% 0.30% 88.42% 7.37% 16.37% (kt - k )2 0.0211 0.0369 0.0084 0.0000 0.0924 0.0254 0.0064 0.0419 0.0470 0.0048 0.0054 0.0050 0.2948

Average Monthly Return Standard deviation

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c)

50.00%
Hilary's

40.00%

30.00%

20.00%

10.00% Market -10.00% 0.00% -5.00% 0.00% -10.00% 5.00% 10.00% 15.00%

-20.00%

d.

The Hilarys returns for the last six months of 2002 and the first six months of 2003 were partially correlated, but with a lot of the variance in the stocks returns, clearly not explained by the marketas would be expected.

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6-15B Stock A (A) Probability P(ki) 0.10 0.30 0.40 0.20 (B) Return (ki) -4% 2 13 17 (A) x (B) Expected Return k -0.40% 0.60 5.20 3.40 8.80% Weighted Deviation (ki - k )2P(ki) 16.384% 13.872 7.056 13.448 2 = 50.76% = 7.125%

k=

Stock B (A) Probability P(ki) 0.13 0.40 0.27 0.20 (B) Return (ki) 4% 10 19 23 (A) x (B) Expected Return k 0.52% 4.00 5.13 4.60 k = 14.25% Weighted Deviation (ki - k )2P(ki) 13.658% 7.225 6.092 15.31 42.285% 6.503%

2 = =

Stock C (A) Probability P(ki) 0.20 0.25 0.45 0.10 (B) Return (ki) -2% 5 14 25 (A) x (B) Expected Return k -0.40% 1.25 6.30 2.50 9.65% Weighted Deviation (ki - k )2P(ki) 27.145% 5.406 8.515 23.562 64.628% 8.039%

k =

2 = =

Stock B has a higher expected rate of return with less risk than Stocks A and C.

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6-16B Risk-Free Rate K G B U 6-17B Time 1 2 3 4 6-18B (a) Required rate Risk-free Market Risk = rate + Beta Premium of return = 4% + 0.95 (7% - 4%) = 6.85% (b) Required rate Risk-free Market Risk of return = rate + Beta Premium = 4 % + 1.25 (7% - 4%) = 7.75% (c) If beta is 0.95: Required rate of return If beta is 1.25: Required rate of return = 4 % + 1.25 (10% - 4%) = 11.5% = 4 % + 0.95 (10% - 4%) = 9.7% Watkins Price $40 45 43 49 Fisher Return 12.50% -4.44 13.95 Price $27 31 35 36 Return 14.81% 12.90 2.86 5.5% 5.5% 5.5% 5.5% Expected Market - Risk-Free Return Rate x (11% (11% (11% (11% 5.5%) 5.5%) 5.5%) 5.5%) x x x x Required Rate of Return 11.66% 12.65% 9.63% 11.11%

+ + + + +

Beta = 1.12 1.30 0.75 1.02 = = = =

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