CHAPTER 10 RISK AND RETURN: THE CAPITAL ASSET PRICING MODEL (CAPM

)
Answers to Concepts Review and Critical Thinking Questions 1.

Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of assets, this unique portion of the total risk can be eliminated at little cost. On the other hand, there are some risks that affect all investments. This portion of the total risk of an asset cannot be costlessly eliminated. In other words, systematic risk can be controlled, but only by a costly reduction in expected returns.
a. b. c. d. e. f.

2.

systematic unsystematic both; probably mostly systematic unsystematic unsystematic systematic

3.

No to both questions. The portfolio expected return is a weighted average of the asset’s returns, so it must be less than the largest asset return and greater than the smallest asset return. False. The variance of the individual assets is a measure of the total risk. The variance on a welldiversified portfolio is a function of systematic risk only. Yes, the standard deviation can be less than that of every asset in the portfolio. However, βp cannot be less than the smallest beta because βp is a weighted average of the individual asset betas. Yes. It is possible, in theory, to construct a zero beta portfolio of risky assets whose return would be equal to the risk-free rate. It is also possible to have a negative beta; the return would be less than the risk-free rate. A negative beta asset would carry a negative risk premium because of its value as a diversification instrument. The covariance is a more appropriate measure of a security’s risk in a well-diversified portfolio because the covariance reflects the effect of the security on the variance of the portfolio. Investors are concerned with the variance of their portfolios and not the variance of the individual securities. Since covariance measures the impact of an individual security on the variance of the portfolio, covariance is the appropriate measure of risk.

4.

5.

6.

7.

B-248 SOLUTIONS
8.

If we assume that the market has not stayed constant during the past three years, then the lack in movement of Southern Co.’s stock price only indicates that the stock either has a standard deviation or a beta that is very near to zero. The large amount of movement in Texas Instrument’ stock price does not imply that the firm’s beta is high. Total volatility (the price fluctuation) is a function of both systematic and unsystematic risk. The beta only reflects the systematic risk. Observing the standard deviation of price movements does not indicate whether the price changes were due to systematic factors or firm specific factors. Thus, if you observe large stock price movements like that of TI, you cannot claim that the beta of the stock is high. All you know is that the total risk of TI is high. The wide fluctuations in the price of oil stocks do not indicate that these stocks are a poor investment. If an oil stock is purchased as part of a well-diversified portfolio, only its contribution to the risk of the entire portfolio matters. This contribution is measured by systematic risk or beta. Since price fluctuations in oil stocks reflect diversifiable plus non-diversifiable risk, observing the standard deviation of price movements is not an adequate measure of the appropriateness of adding oil stocks to a portfolio.

9.

10. The statement is false. If a security has a negative beta, investors would want to hold the asset to reduce the variability of their portfolios. Those assets will have expected returns that are lower than the risk-free rate. To see this, examine the Capital Asset Pricing Model:

E(RS) = Rf + βS[E(RM) – Rf] If βS < 0, then the E(RS) < Rf
Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic
1.

The portfolio weight of an asset is total investment in that asset divided by the total portfolio value. First, we will find the portfolio value, which is: Total value = 70($40) + 110($22) = $5,220 The portfolio weight for each stock is: WeightA = 70($40)/$5,220 = .5364 WeightB = 110($22)/$5,220 = .4636

40% 4.12) + .2(–. So.25) = .09(1 – wX) We can now solve this equation for the weight of Stock X as: . the expected return of the portfolio is: E(Rp) = . The expected return of an asset is the sum of the probability of each return occurring times the probability of that return occurring. The total value of the portfolio is: Total value = $1. The expected return of a portfolio is the sum of the weight of each asset times the expected return of each asset.16) = .64)($10. the weight of Stock Y must be one minus the weight of Stock X.000) = $6.1250 or 12. the expected return of the asset is: E(R) = . Mathematically speaking. Here we are given the expected return of the portfolio and the expected return of each asset in the portfolio and are asked to find the weight of each asset.11) + ($1.100)(0.20(.11) + .50% . the dollar amount invested in Stock X is the weight of Stock X times the total portfolio value.400 And the dollar amount invested in Stock Y is: Investment in Y = (1 – 0. So.200 + 1.14) = .1340 or 13.09 – .CHAPTER 10 B-249 2. or: Investment in X = 0.122 = . the expected return of this portfolio is: E(Rp) = ($1.05) + . Since the total weight of a portfolio must equal 1 (100%).000) = $3.05wX wX = 0.14wX + .64($10.64 So.032 = .09wX .3(. this means: E(Rp) = .100)(0.122 = .17) + .100 So.900 = $3. The expected return of a portfolio is the sum of the weight of each asset times the expected return of each asset.200/$3.30(.900/$3.600 5.1406 or 14.5(. We can use the equation for the expected return of a portfolio to solve this problem.50(.06% 3.14wX + .

30(.08) + . we first need to calculate the variance.07) + .1(.1450 or 14.1057)2 + .06) + .10(.1057)2 + . and then add all of these up.1570)2 = .2) + .92% σB2 =.50(. So.1057 or 10.20(. We then multiply each possible squared deviation by its probability.0192 or 1.20(. the expected return of the stock is: E(RA) = .00037)1/2 = .0810)2 + . the variance and standard deviation of each stock are: σA2 =.20(.50% If we own this portfolio.2 – .30(. the expected return of the portfolio is: E(Rp) = .30(.10(.07–.20(.00037 σA = (.044) + . The result is the variance.13) + .10(–.57% To calculate the standard deviation. To find the variance.0810 or 8.33) = .1570 or 15.24) = .1057)2 = .20(.1570)2 + .207) = .005187 σ = (. So.045) + .70(. So.13–.10% E(RB) = . we find the squared deviations from the expected return. The result is the variance.20% 8.02216 σB = (. The expected return of a portfolio is the sum of the weight of each asset times the expected return of each asset.0720 or 17.60(.06 – .70% To calculate the standard deviation.045 – . we first need to calculate the variance.1489 or 14. .1057)2 + .11) = . The expected return of an asset is the sum of the probability of each return occurring times the probability of that return occurring.12 – . We then multiply each possible squared deviation by its probability. the variance and standard deviation are: σ2 =.60(. The expected return of an asset is the sum of the probability of each return occurring times the probability of that return occurring. To find the variance. So.33 – .0810)2 = .30(.89% 7.50 percent. the expected return of each stock asset is: E(RA) = .12) + . and then add all of these up.B-250 SOLUTIONS 6. we would expect to get a return of 14.60(.50(.1570)2 + .022216)1/2 = .207 – .005187)1/2 = .11 – .10(–.10(–. we find the squared deviations from the expected return.15) + .0810)2 + . So.10(–.044 – .60(.

40(.30(.20(.12) + .30(.40(–.30(.0333 or 3.20(. we find the squared deviations from the expected return.0333) = . we can sum the returns of each asset and divide by the number of assets.29% . To find the expected return in an equally weighted portfolio.1127 or 11.03 −. To find the expected return of the portfolio.1650) = .06) = –. We still need to find the return of the portfolio in each state of the economy. we get: Boom: E(Rp)=. we will multiply the return of each asset by its portfolio weight and then sum the products to get the portfolio return in each state of the economy. The result is the variance. So.012708)1/2 = .20% Bust: E(Rp) = . To find the variance. To do this. and then sum.10% Poor: E(Rp) = .30(−.50% And the expected return of the portfolio is: E(Rp) = .30(–.20(.13) +.20(.2420 – .1682 or 16.33) =.70(. Doing so.33)/3 = . we get: Boom: E(Rp) = .30(.40(–.82% To calculate the standard deviation.33% Bust: E(Rp) = (.09) = –. so the expected return of the portfolio in each state of the economy is: Boom: E(Rp) = (. This portfolio does not have an equal weight in each asset.13 + .70(.25(–.1682)2 + .30(–.07 + . we first need to calculate the variance. we multiply the return in each state of the economy by the probability of that state occurring. we need to find the return of the portfolio in each state of the economy. and then add all of these up.3690 or 36. To do this.1210 or 12.33) = .20% Bust: E(Rp) =.0720 or –7.30(.1210) + . a. This portfolio does not have an equal weight in each asset.60(−.1383 or 13.30(–.15) + .012708 σp = (. We first need to find the return of the portfolio in each state of the economy.27% 10.1833) + .0040 or –0.2420) + .004) = .15 + .15) + .30(.1650 or –16. the variance and standard deviation the portfolio is: σp2 = .1833 or 18.1329 or 13.05(–.0720) + .33% To find the expected return of the portfolio.01) + .3) + .06) + .15) = .2420 or 24.03) + . Doing so.60(.70(. We then multiply each possible squared deviation by its probability.90% Good: E(Rp) = . we will multiply the return of each asset by its portfolio weight and then sum the products to get the portfolio return in each state of the economy.CHAPTER 10 B-251 9.83% b.40(.30(.45) + .05) = –. This portfolio is a special case since all three assets have the same weight.40% And the expected return of the portfolio is: E(Rp) = .06)/3 = .0040 – . a. Doing this. we find: E(Rp) = .07) +.1682)2 = .30) + .40(.30(−.3690) + .10) + .

05)(1.06βi βi = 1.40(.03171)1/2 = . We must be careful not to use this value as the expected return of the market.3) = . The beta of a portfolio is the sum of the weight of each asset times the beta of each asset. We need to substitute these values into the CAPM. Since the beta of the market is one.1650 – . To find the variance.0 = 1/3(0) + 1/3(1. Using the CAPM. the variance and standard deviation the portfolio is: σp2 = .1329)2 σp2 = .20 12. So.1329)2 + .05(–.1210 – .25 (–. Setting up the equation for the beta of our portfolio. and then add all of these up.15(1. So.40(1.B-252 SOLUTIONS b. We also need to remember that the beta of the risk-free asset is zero.70% 14. we know the beta of our portfolio is one.1781 or 17. It has to be zero since the asset has no risk. we find the squared deviations from the expected return. The market risk premium is the expected return of the market minus the risk-free rate. CAPM states the relationship between the risk of an asset and its expected return. and solve for the β of the stock. We are given the values for the CAPM except for the β of the stock. To calculate the standard deviation.10 13. One important thing we need to realize is that we are given the market risk premium. The result is the variance. We then multiply each possible squared deviation by its probability. the beta of the portfolio is: βp = . The beta of a portfolio is the sum of the weight of each asset times the beta of each asset. CAPM is: E(Ri) = Rf + [E(RM) – Rf] × βi Substituting the values we are given. we find: E(Ri) = . we find: E(Ri) = .1329)2 + . we get: βX = 1.34) = 1.14 = .1329)2 + .15) + .81% 11.0720 – .1670 or 16.04 + .6) + . we get: βp = 1.03171 σp = (.20(1.05 + (. we first need to calculate the variance.9) + 1/3(βX) Solving for the beta of Stock X.30(. If the portfolio is as risky as the market it must have the same beta as the market.7) + .25(.3690 – .14 – .67 .

we find: E(Ri) = . a. and solving for the expected return of the market.2727(1.75/1. the weight of the risk-free asset is: wRf = 1 – . Substituting the values given. or 100 percent. We also know the weight of the risk-free asset is one minus the weight of the stock since the portfolio weights must sum to one.17 = Rf + .2727 So.0433 or 4. So: E(Rp) = .055 + [E(RM) – .1197 or 11.75 = wS(1.2wS + 0 – 0wS wS = 0. The expected return of the portfolio is: E(Rp) = (.50% b.6250 = . Substituting the values given.9Rf Rf = .2727)(0) = 0.16wS + .97% 16.055](.9) .2) + (1 – .33% 17. Again.05(1 – wS) .11 – Rf)(1.2) + (1 – wS)(0) 0.08 = .05 – .3750 c. So: βp = 0.11 = . the β of the portfolio will be: βp = .05)/2 = . or 100 percent. so we can sum the returns of each asset and divide by the number of assets. we have a special case where the portfolio is equally weighted.05wS wS = .85) E(RM) = .17 = Rf + (. We also know the weight of the risk-free asset is one minus the weight of the stock since the portfolio weights must sum to one.327 .1050 or 10.6250 And.75. we find: E(Ri) = .08 = . We need to find the portfolio weights that result in a portfolio with an expected return of 8 percent. Here we need to find the risk-free rate using the CAPM. We know the β of the risk-free asset is zero.16wS + .2 wS = .16 + . We need to find the portfolio weights that result in a portfolio with a β of 0. and solving for the risk-free rate.209 – 1.CHAPTER 10 B-253 15. Here we need to find the expected return of the market using the CAPM.75 = 1.

1875 .05 + MRP(1. First. Using these equations to fill in the table.0846βp The slope of the SML is equal to the market risk premium. we get the following results: wW 0% 25 50 75 100 125 150 E(Rp) . we simply multiply the weight of the stock times its β. This represents borrowing at the risk-free rate to buy more of the stock.4 = wS(1. Any combination of this stock. Solving for the β of the portfolio as we did in part a. Even though we are solving for the β and expected return of a portfolio of one stock and the risk-free asset for different portfolio weights.2150 ßp 0 0.3 = . we need to find the β of the portfolio.1050 .0846 or 8.0500 .3wW So.05 + . or any portfolio of stocks. and the risk-free asset will fall on the SML.650 0. so using the CAPM and the information concerning this stock. to find the β of the portfolio for any weight of the stock.300 1.2 = 2 wRf = 1 – 2 = –1 The portfolio is invested 200% in the stock and –100% in the risk-free asset. will fall on the SML.46% So. 18.16 = . a portfolio of any stock and the risk-free asset.B-254 SOLUTIONS d.1325 .0846. For that matter.30) MRP = . the market risk premium is: E(RW) = . we are really solving for the SML.325 0.950 . the β of the portfolio is: ßp = wW(1. now we know the CAPM equation for any stock is: E(Rp) = . We know the slope of the SML line is the market risk premium.3) + (1 – wW)(0) = 1. and the weight of the risk-free asset is one minus the weight of the stock.2) + (1 – wS)(0) wS = 2.4/1.975 1.11/1. we find: βp = 2.625 1.1600 .0775 . which is 0. The β of the risk-free asset is zero.

so the reward-to-risk ratio for the market is 0.5 percent.50 = .17 – . and the stock is overvalued. its price must increase to reduce the expected return to 16. we find: E(RZ) = . its price must decrease to increase the expected return to 11.0625 The reward-to-risk ratio for Stock Z is too low. Its price must increase until its reward-to-risk ratio is equal to the market reward-to-risk ratio.75 percent. This means the stock return is too high.055 + .50 percent based on its level of risk. the return of the stock based on its level of risk.50Rf Rf = .17 – Rf) = 1.105 – Rf)/0. which means the stock plots below the SML.17 – Rf)/1. Its price must decrease until its reward-to-risk ratio is equal to the market reward-to-risk ratio. which is: (. This is also know as the Treynor ratio or Treynor index. We are given the market risk premium. We can also answer this question using the reward-to-risk ratio. We will work through both. we can use the CAPM.11. we find: Reward-to-risk ratio Z = (. For Stock Z.075(1. that is. and the stock is undervalued. Substituting in the value we are given for each stock.80 We can cross multiply to get: 0. given its level of risk. and we know the β of the market is one.1150 or 11. We need to set the reward-to-risk ratios of the two assets equal to each other (see the previous problem). In other words. we find: 0. but according to the CAPM. we find: Reward-to-risk ratio Y = (. 20. There are two ways to correctly answer this question.5 percent.055 + .07% .1575 – 1. First.055) / 1. The reward-to-risk ratio is the risk premium of the asset divided by its β. For Stock Z. Stock Z plots below the SML and is overvalued. or 7.50 = (. the expected return should be 16.0307 or 3.105 – .0767 The reward-to-risk ratio for Stock Y is too high.1675 or 16. Stock Y plots above the SML and is undervalued.75% It is given in the problem that the expected return of Stock Y is 17 percent.80 = . This follows from the linearity of the SML in Figure 11.50(.80(.105 – Rf) Solving for the risk-free rate.50) = .50 percent. In other words.CHAPTER 10 B-255 19. which means the stock plots above the SML.075(0. every asset must have the same ratio of the asset risk premium to its beta.075.136 – 0. but according to the CAPM the expected return of the stock should be 11. we find: E(RY) = .75 percent.80) = . Calculating the reward-to-risk ratio for Stock Y.80Rf = 0.50% The return given for Stock Z is 10.055) / . All assets must have the same reward-to-risk ratio.

60) = .12) + .196 – .118) + .1440)2 + .1960 or –19. We then multiply each possible squared deviation by its probability.1% For a portfolio that is equally invested in small stocks and Treasury bills: Return = (17. We know that the reward-to-risk ratios for all assets must be equal (See Question 19). The result is the variance. we first need to calculate the variance. the variance and standard deviation of the portfolio is: σ2p = .50) = –. Doing so. So.1969 or 19.4% + 5.4(–.8%)/2 = 9.35) + . so: RPA/βA = RPB/βB We can rearrange this equation to get: βB/βA = RPB/RPA If the reward-to-risk ratios are the same.1440 or 14.2(.05) = .80% Bust: E(Rp) = .2(–. For a portfolio that is equally invested in large-company stocks and long-term bonds: Return = (12.3400 or 34.03876)1/2 = .4(. We need to find the return of the portfolio in each state of the economy.4(.2(. 23. To do this.34 – . a. we find the squared deviations from the expected return.65% 22.1180 or 11.4(.4(.1440)2 + .4(.B-256 SOLUTIONS Intermediate 21. This can be expressed as: [E(RA) – Rf]/βA = [E(RB) – Rf]/ßB The numerator of each equation is the risk premium of the asset.60% And the expected return of the portfolio is: E(Rp) = . the ratio of the betas of the assets is equal to the ratio of the risk premiums of the assets.118 – .4(.4(. To find the variance. we get: Boom: E(Rp) = .4(.8%)/2 = 10.196) = .03876 σp = (.69% . than add all of these up.1440)2 σ2p = .2(–.40% To calculate the standard deviation.15) + .5% + 3. we will multiply the return of each asset by its portfolio weight and then sum the products to get the portfolio return in each state of the economy.20) + .34) + .01) + .25) + .2(–.00% Normal: E(Rp) = .4(.

so: Approximate expected real return = . so we can find the weight of these two stocks.000. We can use the equation for the β of a portfolio to find the weight of the third stock.86% 24.000 = . the β of the portfolio must be equal to one.5) + wRf(0) Solving for the weight of Stock C. The weights of Stock A and Stock B are: wA = $200.1090 or 10. T-bills are often used as the risk-free rate.035 = . Doing so.1440 = (1. We know the total portfolio value and the investment of two stocks in the portfolio.035) – 1 = .1440/1.53% The approximate real risk premium is the expected return minus the inflation rate.1060/1.343333 So. minus the risk-free rate.0 = wA(.343333($1. we will use the Fisher equation.0350)[1 + e(ri)] e(ri) = (1.000 = . we find: βp = 1.90% To find the exact real return.000.1440 – . The approximate expected real return is the expected nominal return minus the inflation rate.0710 or 7. we get: 1 + E(Ri) = (1 + h)[1 + e(ri)] 1. We also know the β of the risk-free asset is zero.3) + wC(1.333 .035 = .000 / $1. Doing so.000) = $343.8) + wB(1.038 = .000. we find: wC = .20 wB = $250.1440 – .CHAPTER 10 B-257 b.0686 or 6. so: Approximate expected real risk premium = . Doing do. we find: Exact expected real risk premium = (1. The risk premium is the return of a risky asset.25 Since the portfolio is as risky as the market.1060 – .1053 or 10.10% To find the exact expected real risk premium we use the Fisher effect.60% c. so: RPi = E(Rp) – Rf = .000/$1.035) – 1 = . the dollar investment in Stock C must be: Invest in Stock C = .1060 or 10.

We are given the expected return and β of a portfolio and the expected return and β of assets in the portfolio.064) + .33(. We know the β of the risk-free asset is zero.6538462 wRf = 0.33(–.667 25. If you short sell a stock. The expected return of an asset is the sum of the probability of each return occurring times the probability of that return occurring. You must then purchase the stock at a later date to repay the borrowed stock.25 + .0933 or 9.206667 So.105) + .B-258 SOLUTIONS We also know the total portfolio weight must be one.000) = $206.80% E(RB) = . so the weight of the risk-free asset must be one minus the asset weight we know. we find that: wX = –0. 26.8) + wY(1.33(.206667($1.0833333 wY = 0. We also know the sum of the weights of each asset must be equal to one.33% .33(. it means you borrow a stock today and sell it.3) + (1 – wX – wY)(0) We have two equations and two unknowns.4298472 The amount to invest in Stock X is: Investment in stock X = –0. If you are not familiar with short selling.20 + . we can express the expected return of the portfolio as: E(Rp) = .000) = –$8. the dollar investment in the risk-free asset must be: Invest in risk-free asset = .33 A negative portfolio weight means that you short sell the stock.33(. you make a profit if the stock decreases in value.135 = wX(.1080 or 10.000.20) + (1 – wX – wY)(. Using this relationship.0833333($100. So.333.037) + .07) And the β of the portfolio is: βp = .253) = . the weight of the risk-free asset is one minus the weight of Stock X and the weight of Stock Y.156) = . So. or: 1 = wA + wB + wC + wRf 1 = .33(.7 = wX(1.34333 + wRf wRf = . the expected return of each stock is: E(RA) = .31) + wY(.063) + . Solving these equations.

0608 or 6.050) + .33(–.B = Cov(A.01445)1/2 = .0933) + .0933)2 + . The sum of these products is the covariance.105 – .105 – .0933) Cov(A.074 – .1080)(.1080)2 = .156 – . So.037 – .00145)1/2 = .0933) + .02% To find the covariance.33(. we find the squared deviations from the expected return. We then multiply each possible squared deviation by its probability. To find the variance.0380)(.25(.25(–.15(.063 – .80% And the standard deviation of Stock B is: σ2 =.B = .33(.092) + .004539 And the correlation is: ρA.1080)(–.154 – .B) = .80% And the standard deviation of Stock B is: 2 2 2 σ2 B =.1080)2 + .15(.074) = .33(.0075 or 0.1080)(.B) / σA σB ρA.15(.1080)2 + .0733) + .00336)1/2 = .062 – . we multiply each possible state times the product of each assets’ deviation from the mean in that state.092 – . The expected return of an asset is the sum of the probability of each return occurring times the probability of that return occurring. we first need to calculate the variance. the covariance is: Cov(A.01445 σ = (. So.004539 / (.0380 or 3.154) = .00336 σA = (.064 – .60(.063 – .25(–.75% .0733 or 7. the variance and standard deviation of Stock A are: σ2 =.B) = .020) + .1202) ρA.156 – .064 – .0608) + . the variance and standard deviation of Stock A are: 2 2 2 σ2 A =.050 – .15(.037 – .0580 or 5.60(.CHAPTER 10 B-259 To calculate the standard deviation.00006)1/2 = .33(.08% To calculate the standard deviation.020 – .33(. So. The result is the variance.253 – .0733) + .00145 σ = (.60(. we find the squared deviations from the expected return. we first need to calculate the variance.0933)2 + . and then add all of these up.0608) + .062) + . So. and then add all of these up.60(.33(.B = . The result is the variance.33(.33(.25(. We then multiply each possible squared deviation by its probability. To find the variance.00006 σB = (.0933)2 = .0733) = .33% E(RB) = . the expected return of each stock is: E(RA) = .0608) = .9931 27.1202 or 12.253 – .

so: E(RP) = wAE(RA) + wBE(RB) E(RP) = .25(–.40 ) + .1620 or 16.65 ) + 2(.B = Cov(A.20) σ2 P = .15(.B = .B-260 SOLUTIONS To find the covariance.4900 or 49.154 – .34)(.60(. a. So.0608) + .25) E(RP) = .65)(.000425 And the correlation is: ρA.40)(. a.70 (. so: E(RP) = wFE(RF) + wGE(RG) E(RP) = . The sum of these products is the covariance. the standard deviation is: σ = (. The expected return of the portfolio is the sum of the weight of each asset times the expected return of each asset.18) E(RP) = .14718)1/2 = .B 2 2 2 2 σ2 P = .00% .34 ) + .60(.0733)(.70(.0608) + .020 – .50 ) + 2(.0733)(.30(.2100 or 21.50)(.B) = .0608) Cov(A.50) σ2 P = .60)(.062 – .074 – .20% b.0580)(.24010)1/2 = .40(. the standard deviation is: σ = (.000425 / (.050 – .G 2 2 2 2 σ2 P = .B) / σA σB ρA.36% 29.B = . the covariance is: Cov(A.70)(.B) = .12) + .00% The variance of a portfolio of two assets can be expressed as: 2 2 2 2 σ2 P = w A σ A + w B σ B + 2wAwBσAσBρA.9783 28. The variance of a portfolio of two assets can be expressed as: 2 2 2 2 σ2 P = w F σ F + w G σ G + 2wFwG σFσGρF.3836 or 38.15) + . we multiply each possible state times the product of each assets’ deviation from the mean in that state.0075) ρA.14718 So.40)(. The expected return of the portfolio is the sum of the weight of each asset times the expected return of each asset.0733)(.60 (.092 – .30 (.30)(.40 (.24010 So.

M = 0.60)(.60(.40 ) + .60 (.00% The variance of a portfolio of two assets can be expressed as: 2 2 2 2 σ2 P = w A σ A + w B σ B + 2wAwBσAσBρA.M)(σI) / σM βI = (. we find: βI = (ρI.9 = (ρI.55 (iii) Using the equation to calculate beta.2100 or 21. so: E(RP) = wAE(RA) + wBE(RB) E(RP) = .65 ) + 2(. The expected return of the portfolio is the sum of the weight of each asset times the expected return of each asset.1 = (.M)(0.M)(σI) / σM 0.38) / 0.M)(σI) / σM 1.40)(.40)(σI) / 0.20 ρI.3396 or 33. a.40(. the standard deviation is: σ = (. (v) The beta of the market is 1.50) σ2 P = .25) E(RP) = . .20 σI = 0.CHAPTER 10 B-261 b.96% c. (i) We can use the equation to calculate beta.B 2 2 2 2 σ2 P = . we find: βI = (ρI. the standard deviation of the portfolio decreases.65) / 0.20 βI = 1.15) + .14 (iv) The market has a correlation of 1 with itself. or more negatively correlated.40 (.40)(.11530 So.65)(–. we find: βI = (ρI. As Stock A and Stock B become less correlated. 30.47 (ii) Using the equation to calculate beta.11530)1/2 = .35)(.

the expected return on Firm A’s stock should be 14 percent. and you should sell it. However.9(0. Therefore.05) / 0.1638 or 16.1(0.15 – 0. the expected return on Firm C’s stock should be 16. Firm B’s stock is correctly priced.70 a. the expected return on Firm B’s stock should be 16 percent. The expected return on the portfolio equals: E(RP) = Rf + SlopeCML(σP) E(RP) = .00% According to the CAPM.00% According to the CAPM.38 percent.14(0.05 + 1. Therefore.05) E(RC) = . The expected return on Firm B’s stock given in the table is also 16 percent. 31.07) E(RP) = . Firm C’s stock is underpriced. we find: Firm A: E(RA) = Rf + βA[E(RM) – Rf] E(RA) = 0.10 SlopeCML = 0.70(. However.05 + 1.38% According to the CAPM.05 + 0. Therefore. the expected return on Firm C’s stock given in the table is 20 percent. Firm C: E(RC) = Rf + βC[E(RM) – Rf] E(RC) = 0.05 + . Because a well-diversified portfolio has no unsystematic risk. Using the CAPM to find the expected return of the stock.B-262 SOLUTIONS (vi) The risk-free asset has zero standard deviation. Firm A’s stock is overpriced.0990 or 9.12 – 0.90% .1600 or 16. the expected return on Firm A’s stock given in the table is only 13 percent. Firm B: E(RB) = Rf + βB[E(RM) – Rf] E(RB) = 0. The slope of the CML equals: SlopeCML = [E(RM) – Rf] / σM SlopeCML = (0. (vii) The risk-free asset has zero correlation with the market portfolio. and you should buy it.15 – 0.05) E(RB) = . this portfolio should lie on the Capital Market Line (CML).1400 or 14. b.15 – 0. (viii) The beta of the risk-free asset is 0.05) E(RA) = .

20 = .70(σP) σP = .00% .02 0.05 0 0 0.39)(σM) σM = (.15 0. we can solve for the standard deviation of the market portfolio which is: E(RM) = Rf + SlopeCML(σM) . and the slope of the Capital Market Line.12 – .05 + .05) / (.04 0. The expected return on the portfolio equals: E(RP) = Rf + SlopeCML(σP) . These two points must lie on the Capital Market Line.39 σM = .05 + (.05) / . the risk-free rate. The slope of the Capital Market Line equals: SlopeCML = Rise / Run SlopeCML = Increase in expected return / Increase in standard deviation SlopeCML = (. We know that the risk-free rate asset has a return of 5 percent and a standard deviation of zero and the portfolio has an expected return of 14 percent and a standard deviation of 18 percent.01 0.3 Expected Return 0.03 0.12 = .18 – 0) SlopeCML = .CHAPTER 10 B-263 b.39 According to the Capital Market Line: E(RI) = Rf + SlopeCML(σI) Since we know the expected return on the market portfolio.43% Capital Market Line 0.25 0.1 0.1800 or 18. we can calculate the standard deviation of the market portfolio using the Capital Market Line (CML).05 Standard Deviation 32.2143 or 21. First.12 – .2 0.

The amount of systematic risk is measured by the β of an asset.148 – . Doing so.15(.1354 or 13.04 + . The expected return of Stock I is: E(RI) = .2232 βZ = .54% 34.26) = .1783)1/2 σZ = .15(.05 + 1. we find the beta of the security is: βI = (ρI.45)(.1400 or 14.1800 βI = 1. which is: E(RZ) = Rf + βZ[E(RM) – Rf] E(RZ) = .3465 = .B-264 SOLUTIONS Next.70(. which is: E(RI) = Rf + βI[E(RM) – Rf] E(RI) = 0.10βI βI = 3. Since we know the market risk premium and the risk-free rate.4223) / .07 . we can use the CAPM to find the expected return of the portfolio.M)(σZ) / σM βZ = (.063) E(RZ) = .00(.85 Now.0498)1/2 σM = .45)(.2232 or 22.42) + .32% σZ = (.4223 or 42.M)(σI) / σM βI = (. which is: βZ = (ρZ. First.00 Now we can use the beta of the security in the CAPM to find its expected return.063 + .00% 33. which are: σM = (. we can use the standard deviation of the market portfolio to solve for the beta of a security using the beta equation.40) / .3465 or 34. if we know the expected return of the asset we can use the CAPM to solve for the β of the asset.85(.14 – 0.05) E(RI) = . we need to find the standard deviation of the market and the portfolio.09) + .23% Now we can use the equation for beta to find the beta of the portfolio.65% Using the CAPM to find the β of Stock I. we find: .

so we need to calculate the standard deviation of Stock I.0443 + .30 – . to find the risk-free rate.23 = .15(–.2039 or 20.217 – .3Rf = 1.70(. Now that we have the risk-free rate. it has much less systematic risk.13 = Rf + ..12) + .23 = Rf + 1.15(. and II has more unsystematic and more total risk. Stock I will have a higher risk premium and a greater expected return. we find the expected return to be: E(RII) = . we get: E(RPete Corp. Since unsystematic risk can be diversified away. We can express the returns of the two assets using CAPM.04160)1/2 = .43% .44) = .3Rf.1050 Using the CAPM to find the β of Stock II.3465)2 + . Here we have the expected return and beta for two assets. we find: .30) + .0521 Rf = .15(–.3RM – .3(RM – Rf). and solve the equation for Repete Co.23 = Rf + 1.71% E(RRepete Co.23]/.15(.6(RM – Rf) . and then solve for the risk-free rate.04 + . Going back to Algebra.0443) RM = . . I has more systematic risk.) = .13 = Rf + .1871 or 18.39% Although Stock II has more total risk than I. We will solve the equation for Pete Corp.01477)1/2 = .71% .105)2 + .09 – .1215 or 12. Now we have two equations and two unknowns.3RM – . we find: σI2 = .15% Using the same procedure for Stock II.167Rf = .15(.3465)2 σI2 = .10βII βII = 0.105)2 + . I is actually the “riskier” stock despite the lack of volatility in its returns.105)2 σII2 = .1050 = .12 – .6RM – .3 Rf = [1.04160 σII = (.6 RM = .13 – . to find the expected return of the market.3(. Doing so.3RM – 1.23)/. Thus.65 And the standard deviation of Stock II is: σII2 = .4Rf)/.44 – .0443 or 4.217 – .3465)2 + . 35.70(.3 1.) = .CHAPTER 10 B-265 The total risk of the asset is measured by its standard deviation.1871 or 18. since its beta is much smaller than I’s. we can substitute this into either original CAPM expression and solve for expected return of the market.667Rf) – .42 – . Rf = (1. We next substitute the expected return of the market into the equation for Pete Corp.6(RM – .70(.0443 + 1.0443) RM = . Beginning with the calculation of the stock’s variance.13 = .15(.01477 σI = (.6(RM – Rf) = Rf + .3(RM – . we can solve the two equations.6Rf RM = (.667Rf .26 – .

000625 / (.00163)1/2 = .1750)2 + .03% b. we first need to calculate the variance.3846 .10(.50% 2 2 2 2 σ2 2 =.10 – .40(.25 – .10 – . So.40(. So.2) = . The result is the variance.00163 σ3 = (.2) = .1750)2 + .10) = .1750)2 + .25) = .00163)1/2 = .25) + .10(.40(.10(.10(. The expected return of an asset is the sum of the probability of each return occurring times the probability of that return occurring.50% 2 σ1 =.15) + .25 – .15) + .10 – .10(.B-266 SOLUTIONS 36.2 = . and then add all of these up.15 – .40(.15 – .2) / σ1 σ2 ρ1.1750) + .1750)(. To calculate the standard deviation.10(.10(. To find the variance.40(.1750)(.15 – .1750) + .2 = .20) + .40(.00163)1/2 = .40(.1750) + .0403 or 4.1750) + . the expected return and standard deviation of each stock are: Asset 1: E(R1) = .1750)(. The correlation is the covariance divided by the product of the two standard deviations.10(.0403) ρ1.15 – .10(.1750 or 17.20) + .0403)(.20) + . The sum of these products is the covariance.000625 ρ1.40(.40(.00163 σ1 = (.20 – .20 – .1750)2 = .1750)2 + .20 – .40(.40(.03% Asset 2: E(R2) = . we find the squared deviations from the expected return.1750) + .10) = . We then multiply each possible squared deviation by its probability.25 – .1750) = .10(. we multiply each possible state times the product of each assets’ deviation from the mean in that state.10(.10(.10(.25 – .10) + .40(.03% Asset 3: E(R3) = .40(.10(. To find the covariance.10 – .00163 σ2 = (. a.0403 or 4.1750 or 17.25 – .10 – .20 – .1750)2 + .40(.20 – .15 – .1750)2 = .1750) Cov(1.1750) + .1750)(.15) + .25) + .1750)2 + .50% 2 σ3 =.0403 or 4.1750 or 17. the covariance and correlation between each possible set of assets are: Asset 1 and Asset 2: Cov(1.2 = Cov(1.

1750)(.50 (.3 = Cov(2.3 = –.1750 or 17.10 – .50% .3846) σ2 P = .40(.20 – .40(.0403 ) + 2(.3 = Cov(1.0403)(.1750) + .0403) ρ2. The expected return of the portfolio is the sum of the weight of each asset times the expected return of each asset.10 – .25 – .1750) + .0403)(. for a portfolio of Asset 1 and Asset 2: E(RP) = w1E(R1) + w2E(R2) E(RP) = .3) / σ2 σ3 ρ2.000625 / (.1750)(.15 – .3846 c.1750) + .3) / σ1 σ3 ρ1.35% d.10(. so.50(.10(.10(.40(.3) = –.1750)(. The expected return of the portfolio is the sum of the weight of each asset times the expected return of each asset.1750) + .3 = –1 Asset 2 and Asset 3: Cov(2.25 – .20 – .50(.15 – .1750)(.1750) + .CHAPTER 10 B-267 Asset 1 and Asset 3: Cov(1.001125 And the standard deviation of the portfolio is: σP = (.10 – .3 = –.1750) E(RP) = .50)(.1750)(.50% The variance of a portfolio of two assets can be expressed as: 2 2 2 2 σ2 P = w 1 σ 1 + w 2 σ 2 + 2w1w2σ1σ2ρ1.1750) + .3) = .1750) Cov(2.15 – .2 2 2 2 2 σ2 P = .000625 ρ2.0403)(.15 – .0403)(.50(.20 – .1750) E(RP) = . for a portfolio of Asset 1 and Asset 3: E(RP) = w1E(R1) + w3E(R3) E(RP) = .001125)1/2 σP = .50(.25 – .1750)(.0403 ) + .20 – .0335 or 3.50)(.50 (.3) = .1750)(.25 – .1750 or 17.0403) ρ1.3 = –.10(.1750) Cov(1.40(.1750) + .3) = –.1750)(.10 – .001625 / (. so.1750) + .001625 ρ1.

0403)(.1750 or 17.000500)1/2 σP = .24% f.000000 Since the variance is zero.50 (.30) + . for a portfolio of Asset 1 and Asset 3: E(RP) = w2E(R2) + w3E(R3) E(RP) = .3 2 2 2 2 σ2 P = .50(.0403 ) + .25(–.25(–. there is a benefit to diversification.25(.50(.50 (.50)(.50)(.0403 ) + 2(. holding the expected return on each stock constant. The expected return of an asset is the sum of the probability of each return occurring times the probability of that return occurring. so.50)(. a.000500 And the standard deviation of the portfolio is: σP = (.20) = .25(. A portfolio with negatively correlated stocks can achieve greater risk reduction than a portfolio with positively correlated stocks.0500 or 5.3 2 2 2 2 σ2 P = .0403 ) + 2(. Applying proper weights on perfectly negatively correlated stocks can reduce portfolio variance to 0.05) + .50 (.0403)(–1) σ2 P = . So.40) = .50(.50 (.50(.0403 ) + .3846) σ2 P = . the standard deviation is also zero.00% 37.1750) E(RP) = . The expected return of the portfolio is the sum of the weight of each asset times the expected return of each asset.B-268 SOLUTIONS The variance of a portfolio of two assets can be expressed as: 2 2 2 2 σ2 P = w 1 σ 1 + w 3 σ 3 + 2w1w3σ1σ3ρ1.1750) + . the expected return of each stock is: E(RA) = .0224 or 2.0403)(–.50% The variance of a portfolio of two assets can be expressed as: 2 2 2 2 σ2 P = w 2 σ 2 + w 3 σ 3 + 2w2w3σ2σ3ρ1.0403)(.10) + .50)(. e.50% E(RB) = . . As long as the correlation between the returns on two securities is below 1.10) + .0750 or 7.

20) + . We know that the beta of Stock A is .20 or 20% RNormal = ($55 – 50) / $50 = . the expected return the stock is: E(RA) = .20) = .80(. we need to find the expected return and beta of each of the two securities.10(–.04 0. Therefore. So.08) + .075 – .08 Expected Return 0. For a risk-averse investor holding a well-diversified portfolio. the return for each state of the economy is: RRecession = ($40 – 50) / $50 = –. risk-averse investor seeks high returns and low risks.00% And the variance of the stock is: 2 2 2 σ2 A = .20 or 20% The expected return of an asset is the sum of the probability of each return occurring times the probability of that return occurring. a.06 0.10(. The slope of Security Market Line 0.02 0 Beta the security market line (SML) equals: SlopeSML = Rise / Run SlopeSML = Increase in expected return / Increase in beta SlopeSML = (.075 – .08) + .0096 . A typical. as beta increases by .80(.20 – 0.10(.025 (= . To assess the two stocks. So. We can use the expected returns we calculated to find the slope of the Security Market Line. the slope of the Security Market Line equals the expected market risk premium.25. the expected return on a security increases by .05) / .1000 or 10% Since the market’s beta is 1 and the risk-free rate has a beta of zero.0800 or 8. 38. beta is the appropriate measure of the risk of an individual security. the expected market risk premium must be 10 percent.CHAPTER 10 B-269 b.5). the return on Stock A is simply: (P1 – P0) / P0.25 SlopeSML = .20 – .10(–0.08) σ2 A = 0.25 greater than the beta of Stock B.10 – . Stock A: Since Stock A pays no dividends. So.10 or 10% RExpanding = ($60 – 50) / $50 = .10) + .

784 For Stock B.30(.240 The expected return on Stock B is higher than the expected return on Stock A. The variance of the portfolio is: 2 2 2 2 σ2 P = w A σ A + w B σ B + 2wAwBσAσBρA.00896 And the standard deviation of the portfolio is: σP = (0.70)(.47% .098 or 9.8% Now we can calculate the stock’s beta. so: E(RP) = wAE(RA) + wBE(RB) E(RP) = . is lower than the risk of Stock A.10 βA = . a typical risk-averse investor holding a well-diversified portfolio will prefer Stock B.80)(.12) + 2(. we first need to calculate the variance. b.12)(. Thus.B-270 SOLUTIONS Which means the standard deviation is: σA = (0.30) (.60) σ2 P = .B 2 2 2 2 σ2 P = (.70) (. as measured by its beta. which is: βA = (ρA.20)(. the beta for Stock B is: Stock B: βB = (ρB.083 or 8.M)(σA) / σM βA = (. The expected return of the portfolio is the sum of the weight of each asset times the expected return of each asset.0096)1/2 σA = . Note. this situation implies that at least one of the stocks is mispriced since the higher risk (beta) stock has a lower return than the lower risk (beta) stock.09) E(RP) = .M)(σB) / σM βB = (.098) / .00896)1/2 σP = . So.08) + .30)(.10 βB = .12) / .70(.30% To find the standard deviation of the portfolio.0947 or 9. The risk of Stock B. we can directly calculate the beta from the information provided.098) + (.098)(.

a.102 + .102 + –.70(.8125 wB = .B)] / [σ A + σ B – 2Cov(A.6667 This implies the weight of Stock B is: wB = 1 – wA wB = 1 – . we find the weight of Asset A must be: wA = (. Using the derivative from part a.02) / [. we find the derivative and set the derivative equal to zero.8125 This implies the weight of Stock B is: wB = 1 – wA wB = 1 – .001)] wA = .102 + .202 – 2(–.02)] wA = . setting the derivative equal to zero.30(0. we find: E(RP) = wAE(RA) + wBE(RB) E(RP) = . the weight of each stock in the minimum variance portfolio is: 2 2 wA = [σ 2 B + Cov(A. and solving for the weight of Asset A. The variance of a portfolio of two assets equals: 2 2 2 2 σ2 P = w A σ A + w B σ B + 2wAwBσAσBCov(A.8125(. Finding the derivative of the variance function.B)] wA = (.B) Since the weights of the assets must sum to one.10) E(RP) = 0. So the beta of the portfolio is: βP = . Using the weights calculated in part a.621 39. with the new covariance.784) + .B) To find the minimum for any function. we find: 2 2 wA = [σ 2 B – Cov(A. The beta of a portfolio is the weighted average of the betas of its individual securities.B)] / [σ A + σ B – 2Cov(A.3333 .05) + .6667 wB = . determine the expected return of the portfolio.24) βP = .B)] Using this expression.001) / [. we can write the variance of the portfolio as: 2 2 σ2 P = w A σ A + (1 – wA)σ 2 B + 2wA(1 – wA)σAσBCov(A.202 – .CHAPTER 10 B-271 c.1875 b.202 – 2(.0594 c.1875(0.

.6667)(. The variance of the portfolio with the weights on part c is: 2 2 2 2 σ2 P = w A σ A + w B σ B + 2wAwBσAσBCov(A.20) + 2(.B) 2 2 2 2 σ2 P = (. we can find a portfolio of the two stocks with a zero variance.B-272 SOLUTIONS d.10)(.02) σ2 P = .3333)(.10) + (.0000 Because the stocks have a perfect negative correlation (–1).3333) (.20)(–.6667) (.

Sign up to vote on this title
UsefulNot useful