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# Chapter 7: Risk & Returns Critical Thinking Questions

7.1 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. 7.2 What is the difference between the expected rate of return and the required rate of return? What does it mean if they are different for a particular asset at a particular point in time? The required rate of return is the rate of return that investors require to compensate them for the risk associated with an investment. The expected return will not necessarily equal the required rate of return. The expected return can be lower, in which case the return will not be sufficient to compensate the investor for the risk associated with the investment if the expected return is realised. It can also be higher, in which case the expected return will be greater than that necessary to compensate the investor for the riskiness of the asset. 7.3 Suppose that the standard deviation of the returns on the shares of share at two different companies is exactly the same. Does this mean that the required rate of return will be the same for these two shares? How might the required rate of return on the share of a third company be greater than the required rates of return on the shares of the first two companies even if the standard deviation of the returns of the third company’s share is lower? No. Because some risk can be diversified away, it is possible that two shares with the same standard deviation of returns can have different required rates of return. One of these shares can have a higher systematic risk than the other share and, therefore, a higher required rate of return. The third share can have a higher required rate of return if its systematic risk is greater than the systematic risk of the share in the other two companies.

If the expected returns on shares C and B equal their required returns. Small shares have generally been riskier than large shares. You do believe. Explain why.2 .7 You are concerned about one of the investments in your fully diversified portfolio.5 The model where we know the return on a security for each possible outcome is overly simplistic in many ways. then you would expect your portfolio to earn less with share C. intermediate government bonds. however. Therefore. 7.5. Use the same type of explanation to help explain other investment choices since 1974. 7. would you buy share B or C? Would you expect the share you choose to affect the return that you earn on your portfolio? You would buy share C because it would result in your portfolio having a lower beta.50. These good and bad effects translate into a distribution with greater spread or greater risk than the other investments. If you want your portfolio to have the lowest possible risk. 7. that the comapany makes a good product and that it is appropriately priced by the market. and short-term government bonds. this fact has little bearing on the risk-free return. of that particular company. the required return for your portfolio would be lower than the required return would be if you bought share B. Should you be concerned about the effect on your portfolio if Shifty embezzles a portion of the company’s cash? The risk of Shifty embezzling is a nonsystematic risk that will most likely be offset by a more fortunate event affecting another holding in your portfolio. while the correlation between shares A and C is –0. The risk-free security delivers the same return in all states of the world. Iam Shifty. even though we cannot possibly predict all possible outcomes.4 The correlation between shares A and B is 0. The explanation for this can be best understood if we realise that shares in small companies will be affected to a greater extent than the list of investments above by either good or bad states of the world. the shortcoming of the model does not affect the risk-free security’s return. However. You already own share A and are thinking of buying either share B or share C. Shifty’s actions should not affect the risk that you bear by investing in your diversified portfolio (systematic risk). we do know that the Australian government will be able to repay its borrowing in every state of the world. longterm government bonds.7. long-term corporate bonds. 7. You just have an uneasy feeling about the CFO. If you buy share C. Even though we do not know all of the possible states of the world in future periods. Therefore.6 Which investment category has shown the greatest degree of risk in Australia since 1974? Explain why that makes sense in a world where the price of a small share is likely to be more adversely affected by a particular negative event than the price of a corporate bond.

if held in a diversified portfolio. Explain how debt securities are also subject to systematic risk. Therefore. 7. Assume that your house will comprise up to 75 per cent of your assets in the early part of your investment life.10 You may have heard the statement that you should not include your home as an asset in your investment portfolio. From a systematic risk measurement perspective. we can use the CAPM to price debt securities. way than the comapny’s share will be affected. In a volatile real estate market. and yet lessened. describe the effects on the risk in your portfolio. omitting the beta of your real estate investment. which does not have a beta equal to zero. then only the systematic risk component will be borne and then compensated for bearing.8 The CAPM is used to price the risk in any asset. That is.9 In recent years. could have a serious impact on your portfolio’s perceived systematic risk. then the Australia-only portfolio will probably have a small amount of nonsystematic risk that is not providing return compensation for that risk. Therefore. If you are an investor who only invests in Australian shares. systematic and nonsystematic factors will also affect returns for debt securities. 7. Evaluate omitting it from your portfolio when calculating the risk of your overall investment portfolio. However.7. Our examples have focused on shares. and in a flat real estate market.3 . you could be understating the risk in your portfolio. investors have correctly agreed that the market portfolio consists of more than just a group of Australian shares and bonds. but we could also price the expected rate of return for bonds. 7. If the market portfolio is composed of all assets. the portfolio is bearing too much risk given its expected returns. you could be overestimating the risk in your portfolio. A comapny’s ability to repay its debt obligations will be affected in a very similar.

if you are not accepted.000.912.319. The expected return is a return that is based on the probability-weighted average of the possible returns from an investment.50)2 = $9.000) = $66.912.000 – $66.912.2 Expected returns: John is watching an old game show on rerun television called Let’s Make a Deal in which you have to choose a prize behind one of two curtains. It describes a possible return (or even a return that may not be possible) for a yet to occur investment period.218.000 7. then you would choose to work in a zoo.Questions and Problems BASIC 7.75($150) + (0. If you are accepted into medical school. what is your expected starting salary as well as the standard deviation of that starting salary? Solution: E(salary) = 0. The holding period return is the total return over some investment or “holding” period.052. What is the expected value of the selection. However.1 Returns: Describe the difference between a total holding period return and an expected return.50 σ2prize = 0.200.75)1/2 = $3.000)2 = $6.000 per year.000)1/2 = $78. The game show has placed a subliminal message on the curtain containing the gag prize. and what is the standard deviation of that selection? Solution: E(prize) =0 . However.084.000. which makes the probability of choosing the gag prize equal to 75 per cent.000) + (0.9($40.1) ($300.000 σsalary = ($6. 7.000 – $66. you find that the probability of being accepted into medical school is about 10 per cent.74 7. The holding period return reflects past performance.000 σ2salary = 0. One of the curtains will yield a gag prize worth $150.218. It consists of a capital appreciation component and an income component.50)2 + (0.9($40. and the other will give a car worth $7.25) ($7.084.319.1) ($300.000 per year.75 => σprize = ($9.200 – $1.3 Expected returns: You have chosen biology as your college major because you would like to be a medical doctor.25) ($7.75($150 – $1.000)2 + (0.200) = $1. then your starting salary when you graduate will be $300. where you will earn $40.4 . Without considering the additional educational years or the time value of money.

0 CV(RC) = 0.4 Historical market: Describe the general relation between risk and return that we observe in the historical bond and share market data. 7. and 12 per cent. B and C have the same degree of risk. and C have expected returns of 15 per cent. the greater the return describes the historical returns of the bond and share market. The general axiom that the greater the risk. CV(RA) = 0. and choose the share with the lowest value.7 Systematic risk: Define systematic risk. It is the only type of risk that exists in a diversified portfolio. respectively.15 = 3. The comparison shows that the riskier the investment category.7. with A having a greater degree of risk. respectively.0 CV(RB) = 0. 30 per cent. just as our coefficient of variation calculations did.15 = 2. the greater the average return as well as standard deviation of returns. This is because the movements in the values of the different investments will partially cancel each other out. 7.12 = 2. and 30 per cent. then we can calculate the risk per unit of return for each share. B. the average return and standard deviation of the small shares are greater.30/0. 7. This would lead you to the conclusion. Risk that cannot be diversified away is called systematic risk. while their standard deviations are 45 per cent. and it is the only type of risk that is rewarded in asset markets. Large share average returns and standard deviation numbers are larger than those of long-term government bonds. 15 per cent.6 Diversification: Describe how investing in more than one asset can reduce risk through diversification.4 in the text. we could have noted that the expected return for A and B was the same.45/0. which are larger than those of intermediate-term government bonds. An investor can reduce the risk of his or her investments by investing in two or more assets whose values do not always move in the same direction at the same time.30/0. the coefficient of variation. we see that small shares have averaged the greatest returns but that they also have the greatest standard deviation for the returns. If you were considering the purchase of each of these shares as the only holding in your portfolio.5 Single-asset portfolios: Shares A. If we look at Exhibit 7.5 ===> Choose B Alternatively. then which share should you choose? Since the holding will be made in a completely undiversified portfolio. which in turn are larger than those of Australian notes or bonds. that Share B is superior. When compared to large shares. 7.5 . but B has a greater expected return.

Susan’s portfolio is not expected to have losses quite as large as that of the market portfolio. The CAPM is written as E(Ri) = Rrf + βi(E(Rm) – Rrf) . A large beta portfolio would have larger losses than that of the market portfolio. Since she is managing a mutual fund. the expected return increases linearly with beta. As systematic risk increases. That is logical given that we know that a government bond has no risk at all since it is a riskless asset. then we can use that logic to help us understand the beta of a government note or bond. she is allowed to adjust the beta of her portfolio. However.9 Measuring systematic risk: Describe and justify what the value of the beta of an Australian government bond should be. 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.10 Measuring systematic risk: If the expected rate of return for the market is not much greater than the risk-free rate of return. what is the general level of compensation for bearing systematic risk? Such a situation suggests that return compensation for investing in an asset is determined more by the risk-free return than by the market’s compensation for bearing systematic risk. If we purchased a government bond five years ago and held the same bond through each of the last 60 months. This may be caused by a very low perceived level of risk in the market or by an abundance of funds in the market seeking to be invested in risky assets. This means that the price for bearing systematic risk is very low. What kind of beta would you recommend for Susan’s portfolio? If we confine our analysis to portfolios with positive beta values. the vertical axis coordinates of each of the monthly returns would have the same value and the slope (beta) of the line of best fit would be zero. If Susan could construct a negative beta portfolio. 7. and since beta describes how much and what direction our portfolio is expected to vary with the market portfolio.6 . then she would like to construct as negative a portfolio beta as possible. In that case.8 Measuring systematic risk: Susan is expecting the returns on the market portfolio to be negative in the near term. then Susan should construct a very low beta portfolio. 7. 7.11 CAPM: Describe the Capital Asset Pricing Model (CAPM) and what it tells us.7. The meaning of a beta of zero means that our government bond has no systematic risk. 7. then the return for each of those 60 months would be exactly the same. Since the beta of any asset is the slope of the line of best fit for the plot of an asset against that of the market return. Therefore. she must remain invested in a portfolio of shares.

13 The market risk premium is (E(RM) – Rrf) = 0.12 The Security market line: If the expected return on the market is 10 per cent and the riskfree rate is 4 per cent.7.7 .04) = 0.5? What is the market risk premium for the set of circumstances described? Solution: Following the CAPM prediction: (Rcs) = Rrf + β (E(RM) – Rrf) = 0.04 + 1.1 – 0. what is the expected return for a share with a beta equal to 1.06 7.5(0.

10. If the standard deviation of grades is 7.02623)1/2 = 0.14 Interpreting the variance and standard deviation: The distribution of grades in an introductory finance class is normally distributed.000 x 0.96(7) = 61. the most Nehul should pay for the machine is $1.250 Therefore. and 0. while the return will be –25 per cent if the economy slips into a recession.1) (–.1.13 Expected returns: Nehul is thinking about purchasing a soft drink machine and placing it in a business office.3 – 0.05 x $.15 Calculating the variance and standard deviation: Chie recently invested in real estate with the intention of selling the property one year from today.250. 7.4)(0.1) (–0.3) + (0. If the probabilities of the healthy. the return will be 10 per cent.145)2 + (0. respectively. If Nehul expects a thousand people per day to pass by the machine and requires a complete return of his investment in one year. then what are the expected return and the standard deviation for Chie’s investment? Solution: E(Ri) = (0. as predicted. with an expected grade of 75.145 σ2return = (0. Solution: E(Revenue) = 1. He knows that there is a 5 per cent probability that someone who walks by the machine will make a purchase from the machine. 0. She believes that if the economy stays healthy.25 – 0.02623 σreturn = (0. then her investment will generate a 30 per cent return.5) (0.4)(0. in what range would you expect 90 per cent of the grades to fall? Solution: 95% is 1.8 . then what is the maximum price that he should be willing to pay for the soft drink machine? Assume 250 working days in a year and ignore taxes. and he knows that the profit on each soft drink sold is $0. soft.10 x 250 days = $1.16194 7.25) = 0. and recessionary states are 0.28 7.1) + (0.4. However.1 – 0. if the economy softens.5.145)2 = 0.INTERMEDIATE 7. She has modeled the returns on that investment based on three economic scenarios.145)2 + (0.5) (0.96 standard deviations from the mean 75 – 1.

7.3) (0.00773 = (0.2) (–0.00% Solution: E(Ri) = 0.125)2 = 0.2) (0. 7.105)2 σreturn 7.00% Good 0.12) = 0.00% Level 0.105)2 + (0.15 – 0.05) = 0.2 30.16 Calculating the variance and standard deviation: Ling Ying is considering investing in a share.125)2 + (0. and is aware that the return on that investment is particularly sensitive to how the economy is performing.2) (0.08789/0. She knows that the return on the Utility 7.4) + (0.3 15.00% Slump 0.1 45.145 = 1.3 – 0.34069 (using the exact values rather than the printed) 7.4 – 0.125)2 + (0.2) (0.2 2.15) + (0.16.125)2 + (0.02809)1/2 = 0. Solution: Coefficient of variation = σReturn / E(Ri) Problem 15: 0. Use the following table of states.16194/0. Probability Return Boom 0.3) + (0.105 σ2return = 0.105)2 + (0. find the expected return and the standard deviation of the return on Ling Ying’s investment.4) (0. calculate each coefficient of variation.2 -5.125)2 + (0.18 Single-asset portfolios: Using the information from Problems 7.00% Solution E(Ri) = 0.2 -12. and returns to determine the expected return on Ben’s gold investment.08789 Calculating the variance and standard deviation: Ben would like to invest in gold and is aware that the returns on such an investment can be quite volatile.1 25. Probability Return Boom 0.1(0.16759/0.25) + (0.1(0.4) (0. Using the table of returns and probabilities below.00773)1/2 = 0.17 = 0.125 = 1.125 σ2return = 0.4 15.2) (–o.083707 (using the exact values rather than the printed) Problem 17: 0.25 – 0. probabilities.105 = 0.15) + (0.12 – 0.00% Good 0.3) (0.15 – 0.105)2 + (0.02 – 0. and 7.3 10.1) + (0.2) (0.1 – 0.2) (–0.15.2) (–0.1(0.17.02) + (0.00% OK 0.00% Level 0.00% Slump 0.16759 7. Her analysis suggests that four states of the economy can affect the return on the investment.5 – 0.9 .3) (0.3) (0.11684 (using the exact values rather than the printed) Problem 16: 0.19 Portfolios with more than one asset: Jackie is analysing a two-share portfolio that consists of a Utility share and a Commodity share.02809 σreturn = (0.1(0.

The risk-free security has no risk and therefore requires no compensation for risk bearing.12—in order to understand how the variance of such a portfolio would react.12 and –0.12: (0.12) = 0.3)2 + 2(0. 0.5)(0. σ12 = 0.12: (0. σ12 = -0. Explain why the expected return of that portfolio should be greater than the expected return of a risk-free security.5)2 (0.20 Portfolios with more than one asset: Given the returns and probabilities for the three possible states listed here. R B ) = σ AB = 0.5)(0.35(0.12) = 0.10 Poor 0. respectively. Do the calculation for each of the extreme cases (0.has a standard deviation of 40 per cent. assume that the expected returns of Share A and Share B are 11.1 − 0. However.0625 Part 3.3)2 + 2(0. calculate the covariance between the returns of Share A and Share B.25 -0.4)2 + (0. Jackie would like to plot the variance of the portfolio for each of three cases —covariance of 0. and the return on the Commodity has a standard deviation of 30 per cent.4)2 + (0.5)(0.1175)(0.50 OK 0. Solution: 2 2 Var ( R2 asset port ) = x12σ 12 + x 2 σ 2 + 2 x1 x 2σ 12 Part 1. Solution: Your portfolio contains no nonsystematic risk but it does in fact contain systematic risk.5 − 0.5)2 (0.25 − 0. The expected return of the portfolio should therefore be greater than the return of the risk-free security.5)2 (0.18) = 0.0025 7. assuming an equal proportion of each share in Jackie’s portfolio.35 0.75 per cent and 18 per cent.5)2 (0.50 0.12.30 0.15(−0.15 -0. the market should compensate the holder of this portfolio for the systematic risk that the investor bears.4)2 + (0.1175)(0.5)(-0.0) = 0.10 .5(0.5)(0.18) + 0.12). Probability Return(A) Return(B) Good 0. and –0.0: (0. ρ = 0.1225 Part 2.5)(0.30 Solution: Cov ( R A . 7.1 − 0. Therefore.1175)(−0.5)2 (0. For convenience.0476 7. she does not know the exact covariance in the returns of the two shares.3)2 + 2(0.18) + 0.3 − 0.3 − 0.21 Compensation for bearing systematic risk: You have constructed a diversified portfolio of shares such that there is no nonsystematic risk.10 0.5)2 (0.

Return 2 ) = σ R12 = ∑ p i x (Return1. we would only be eliminating nonsystematic risk.7. Solution: Cov(Return1 . the expected rate of return on the market portfolio would be equal to the risk-free rate of return. 7. Asset 1 and Asset 2. then the second term in the equation will always be equal to zero. The systematic risk generated by the portfolio would remain. What is the expected return on Damien’s portfolio? Solution: Following the CAPM prediction: (Rcs) = Rrf + β (E(RM) – Rrf) = Rrf + E(RM) – Rrf = E(RM) = 0.i − E(Return 2 ) i =1 n ( ) We know that all state probabilities must be greater than zero. If that occurs.11 . Even if we could afford such a portfolio and thus completely diversify our portfolio. Another way of saying that is for one of the assets to have a constant return in all states. to have a value in all states j that is equal to the expected return of Number 1(2).i − E(Return1 ) x (Return 2. The easiest way for the entire probability weighted sum to equal zero is for one of the assets. Solution: The statement is false. 7. to be zero.22 Compensation for bearing systematic risk: Write out the equation for the covariance in the returns of two assets. but he does not know the risk-free rate of return or the market risk premium. Otherwise. or covariance.23 Compensation for bearing systematic risk: Evaluate the following statement: By fully diversifying a portfolio. causing the sum. and thus the source of a zero covariance cannot be from the state probabilities.24 CAPM: Damien knows that the beta of his portfolio is equal to 1. He also knows that the expected return on the market is 8 per cent. explain the easiest way for the two asset returns to have a covariance of zero. thereby creating a synthetic Treasury bill.08 7. such as by buying every asset in the market. we can completely eliminate all types of risk. Using that equation. say Number 1(2). We know that to be a false statement.

from each other in given states of nature.165 7.15) + (0. and 3. 2. 7. Without knowing the expected return of the two assets. 50 per cent in Share 2. then what is the minimum expected annual return for Share 3 that will enable Megan to achieve her investment requirement? Solution: The formula for the expected return of a three-share portfolio is: E ( R3 asset port ) = x1 E ( R1 ) + x2 E ( R2 ) + x3 E ( R3 ) Therefore.7)(0. Solution: The covariance measure is dependent on the expected return of the two assets in questions. She has decided to invest in Shares 1. with respect to their own means.7)(0.ADVANCED 7. If David plans to invest 30 per cent of his funds in Iron and the remainder in Copper. Megan requires a portfolio with an expected return of 12 per cent per year over the next 30 years. respectively.25 David is going to purchase two shares to form the initial holdings in his portfolio.3)(0. it is difficult to characterise the scale of the covariance.15) + (0.25(0. explain what that covariance means.5(0.26 Sumeet knows that the covariance in the return on two assets is –0.1) + 0. while Copper share has an expected return of 20 per cent. we can solve as in the following: 0. we can say that generally the two assets move in opposite directions.12 . If Shares 1 and 2 have expected returns of 9 per cent and 10 per cent per year.2) = 0.2) = 0. since the covariance is negative.25E(R3) 0. so without the expected return of the two assets.19 = E(R3) 7. then what will be the expected return from his portfolio? What if David invests 70 per cent of his funds in Iron share? Solution: Part 1: E(Rport) = (0.12 = 0. Iron share has an expected return of 15 per cent. and 25 per cent in Share 3.185 Part 2: E(Rport) = (0. with 25 per cent in Share 1. However.09) + 0.27 In order to fund her retirement.0025.3)(0.

The beta measures only the systematic risk or variation in the returns of the asset. ignore the actual values of the variance and covariance terms and explain their importance conceptually.30 Brad is about to purchase an additional asset for his well-diversified portfolio. The prediction error reflects the nonsystematic risk inherent in the returns of the asset and will consequently not affect the beta of the asset. Given that. and therefore the equilibrium return for an asset. the diversified investor is the marginal investor whose purchase will determine the equilibrium price. The variance of the portfolio will be composed of 10 (n = 10) individual share variance terms and 45 ((n2 –n)/2) covariance terms (really 90). It will have no effect on the beta of the asset. the vast majority of the portfolio variance calculation will be determined by the covariance terms of the portfolio in most cases. What is the relative importance of the variance for each share versus the covariance for the pairs of shares? For this exercise. This implies that the asset must be the riskless asset. consequently. 7. we can see that diversified investors will be willing to pay a greater price for an asset than undiversified investors. If we assume that all investors will seek to be compensated (generate returns) for the level of risk that they are bearing. 7. the expected return on the asset is equal to the risk-free rate of return. then we can see that undiversified investors will require a greater return for a given investment than diversified investors will. 7. Discuss what the asset must be. practically speaking.29 Explain why investors who have diversified their portfolios will determine the price and.7. Therefore.31 The beta of an asset is equal to 0. He notices that when he plots the historical returns of the asset against those of the market portfolio. the line of best fit tends to have a large amount of prediction error for each data point (the scatter plot is not very tight around the line of best fit). Therefore.28 Tonalli is putting together a portfolio of 10 shares in equal proportions. 7. Do you think that this will have a large or a small impact on the beta of the asset? Explain your opinion.13 . Following the CAPM prediction: (Rcs) = Rrf + β (E(RM) – Rrf) = Rrf + 0 (E(RM) – Rrf) = Rrf Therefore. or. the expected return on an asset. it must be a T-bill. The only way an asset could generate a risk-free rate of return is if the asset had no systematic risk (otherwise the asset would have to compensate an investor for such risk bearing).

32 The expected return on the market portfolio is 15 per cent.14 . 7. we can use the Security Market Line graph to determine the halfway point between the point (1.5 is 10 per cent. we need only connect the dots: We can see from the following diagram that an asset with expected return of 4 per cent and a beta of –1. investors will purchase the asset. the expected return from purchasing the asset will decrease because you are paying a higher initial cost for the asset.33 Draw the Security Market Line (SML) for the case where the market risk premium is 5 per cent and the risk-free rate is 7 per cent. explain what we might expect to happen to the price of this security in the market. 15%) and the point (0.) 18% Expected Return 15% 12% 9% 6% 3% 0% 0 1 2 Beta The investment will fall here in this plot 7.0 and an expected return of 4 per cent. Next. Plot it on your graph. To draw this SML. We can then average the first and second values of the two coordinates to arrive at ((1 + 0)/2. Is the security properly priced? If not. Therefore. The Security Market Line (SML) shows the relationship between an asset’s expected return and its beta. As the market becomes aware of this underpricing. Therefore. and the market is expected to return 5 per cent more than this. We know the market has a beta of one.5? The beta of the market portfolio is equal to 1. 10%). explain what we might expect to happen to the price of this security in the market. Now.0 and an expected return of 20 per cent. What is the expected return on a portfolio with a beta equal to 0. (Recall that as the initial purchase price of an asset increases. 5%).0 is underpriced (its expected return is too high). Plot it on the graph. 2) or (0. the expected rate of return for the market (a beta one asset) is 12 per cent. (15% + 5%).7. Is this security properly priced? If not. The risk-free rate of return is 7 per cent. suppose another asset has a beta of 3. which means that the expected return of a portfolio with a beta equal to 0. bidding up its price until its expected return falls on the SML. and the return on the risk-free security is 5 per cent. and we know the risk-free rate has a beta of zero. suppose an asset has a beta of –1.5.

this asset is overpriced. until the asset’s expected return falls on the SML. The asset only has an expected return of 20 per cent.0 should have an expected return of 7% + (3)(5%) = 22%. Therefore.18% Expected Return 15% 12% 9% 6% 3% 0% -1 0 1 2 Beta As we can see from the following diagram. driving down its market price. Demand for this asset will be low. 23% 18% Expected Return 14% 9% 5% 0% 0 1 Beta 2 3 The investment will fall here in this plot 7. an asset with a beta of 3.15 .

then a 95 per cent confidence level corresponds to 1. then what is the expected price of the share one year from today? Solution: Using the formula for an asset’s return during a period.2. in what range will the share return fall 95 per cent of the time? Solution: Since the return distribution for the share is normal. P − P0 P − $37.50 per share.5 x 12% = 30%.23(x) + 0. our best estimate for the return on Pear during this time period is 2.5. and Share Y. 0. and therefore.08(1 – x) = 0.0312 or 3. If you know that the market generated a return of 12 per cent and that the risk-free rate is 5 per cent.16 ==> x = 0. then what would your best estimate be for the return of Pear Computer during that same time period? Solution: Since the line of best fit has a slope of 2.3 Elaine has narrowed her investment alternatives to two shares (at this time she is not worried about diversifying): Share M. and the general market.96(0. we can expect the return on Pear to be 2. If Elaine requires a 16 per cent return on her total investment. 7. 7.Sample Test Problems 7.50 R T = R CA = 1 ⇒ 0.03) = 0.53 or 53 per cent of the portfolio is to be invested in M.16 .50 7.5.9 comparing historical data for Pear Computer Corp. you find that the slope of that line is 2. what proportion of her portfolio will she invest in each share? Solution: If we let x = the proportion of the portfolio invested in M and (1 – x) = the proportion invested in Y. which has an 8 per cent expected return.12% is the return that we would expect to be exceeded 95 per cent of the time. Therefore. Chun Yiu’s parents are about to invest their nest egg in a share that he has estimated to have an expected return of 9 per cent over the next year.00 P0 $37. then we can solve 0.4 You have just prepared a graph similar to Exhibit 7. 47 per cent of the portfolio is to be invested in Y.09 – 1.5. 7.1 Friendly Airlines share is selling at a current price of $37. If the share is normally distributed with a 3 per cent standard deviation. This tells us that for every 1 per cent change in the return on the market.12 = 1 ⇒ P1 = $42. which has a 23 per cent expected return. then we know that the beta of Pear Computer is also 2. Therefore. If the share does not pay a dividend and has a 12 per cent expected return. When you plot the line of best fit for these data.5 per cent.96 standard deviations.

236 = 0.6 per cent.3 7. then what is MoonBucks’s beta? Solution: Using the CAPM.08 + ßMoonBucks(0.20 – 0. If the risk-free rate of return is 8 per cent and the expected return on the market is 20 per cent. we find E(RMoonBucks) = Rrf + ßMoonBucks(E[RM] – Rrf) 0.08) ßMoonBucks= 1.5 You know that the CAPM predicts that the return of MoonBucks Tea Ltd is 23.7.17 .