CHAPTER13 RETURN, RISK, AND THE SECURITY MARKET LINE

Learning Objectives LO1 LO LO! LO" The calculation for expected returns and standard deviation for individual securities and portfolios. The principle of diversification and the role of correlation. Systematic and unsystematic risk. Beta as a measure of risk and the security market line.

Ans#ers t$ C$nce%ts Revie# an& Critica' T(in)ing *+esti$ns 1, -LO!. 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 ords, systematic risk can be controlled, but only by a costly reduction in expected returns. -LO!. If the market expected the gro th rate in the coming year to be ! percent, then there ould be no change in security prices if this expectation had been fully anticipated and priced. "o ever, if the market had been expecting a gro th rate different than ! percent and the expectation as incorporated into security prices, then the government#s announcement ould most likely cause security prices in general to change$ prices ould drop if the anticipated gro th rate had been more than ! percent, and prices ould rise if the anticipated gro th rate had been less than ! percent. (LO3) a. systematic b. unsystematic c. both$ probably mostly systematic d. unsystematic e. unsystematic f. systematic (LO3) a. a change in systematic risk has occurred$ market prices in general ill most likely decline. b. no change in unsystematic risk$ company price ill most likely stay constant. c. no change in systematic risk$ market prices in general ill most likely stay constant. d. a change in unsystematic risk has occurred$ company price ill most likely decline. e. no change in systematic risk$ market prices in general ill most likely stay constant.

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",

S$'+ti$ns t$ *+esti$ns an& /r$b'e0s NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. ue to space and readability constraints! when these intermediate steps are included in this solutions manual! rounding may appear to have occurred. "owever! the final answer for each problem is found without rounding during any step in the problem. Basic 11, (LO1, 4) a. %gain e have a special case here the portfolio is equally eighted, so e can sum the returns of each asset and divide by the number of assets. The expected return of the portfolio is&

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*+,p- . +.'/ 0 .123-4! . .'121 or '1.215

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b.

6e need to find the portfolio eights that result in a portfolio ith a of 1.78. 6e kno the of the risk)free asset is 9ero. 6e also kno the eight of the risk)free asset is one minus the eight of the stock since the portfolio eights must sum to one, or '11 percent. So& p . 1.78 . S+'.(8- 0 +' : 1.78 . '.(8 S 0 1 : 1 S S . 1.784'.(8 S . .;1(;
S

-+1-

%nd, the eight of the risk)free asset is&

,f

. ' : .;1(; . .!7/(

c.

6e need to find the portfolio eights that result in a portfolio ith an expected return of 3 percent. 6e also kno the eight of the risk)free asset is one minus the eight of the stock since the portfolio eights must sum to one, or '11 percent. So& *+,p- . .13 . .'/ S 0 .123+' : .13 . .'/ S 0 .123 : .123 S .1(! . .''! S S . .!38; So, the of the portfolio ill be& p . .!38;+'.(8- 0 +' : .!38;-+1- . 1.(3/
S

d.

Solving for the of the portfolio as e did in part a, e find& p . !.;1 .

S S

+'.(8- 0 +' :

-+1-

. !.;14'.(8 . ! . ' : ! . :'

,f

The portfolio is invested !115 in the stock and :'115 in the risk)free asset. This represents borro ing at the risk)free rate to buy more of the stock. 12, -LO1, ". <irst, e need to find the of the portfolio. The of the risk)free asset is 9ero, and the eight of the risk)free asset is one minus the eight of the stock, the of the portfolio is& =p . 6+'.!8- 0 +' : 6-+1- . '.!8 6 So, to find the of the portfolio for any eight of the stock, e simply multiply the eight of the stock times its . *ven though e are solving for the and expected return of a portfolio of one stock and the risk)free asset for different portfolio eights, e are really solving for the S>?. %ny combination of this stock, and the risk)free asset ill fall on the S>?. <or that matter, a portfolio of any stock and the risk)free asset, or any portfolio of stocks, ill fall on the S>?. 6e kno the slope of the S>? line is the market risk premium, so using the @%A> and the information concerning this stock, the market risk premium is& *+,6- . .'8! . .18( 0 >,A+'.!8>,A . .1774'.!8 . .1;7! or ;.7!5

So, no

e kno the @%A> equation for any stock is&

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*+,p- . .18( 0 .1;7(p The slope of the S>? is equal to the market risk premium, hich is 1.1;7!. Bsing these equations to fill in the table, e get the follo ing results& *+,p8.(15 ;.;35 '1.!85 '!.;(5 '8.!15 ';./35 !1.'85 =p 1.111 1.('( 1./!8 1.7(3 '.!81 '.8/( '.3;8

1.115 !8.115 81.115 ;8.115 '11.115 '!8.115 '81.115

13, -LO". There are t o ays to correctly ans er this question. 6e ill ork through both. <irst, e can use the @%A>. Substituting in the value e are given for each stock, e find& *+,C- . .13 0 .1;8+'.(1- . .';;8 or ';.;85 It is given in the problem that the expected return of Stock C is '3.8 percent, but according to the @%A>, the return of the stock based on its level of risk, the expected return should be ';.;8 percent. This means the stock return is too high, given its level of risk. Stock C plots above the S>? and is undervalued. In other ords, its price must increase to reduce the expected return to ';.;8 percent. <or Stock D, e find& *+,D- . .13 0 .1;8+1.;1- . .'(!8 or '(.!85 The return given for Stock D is '!.' percent, but according to the @%A> the expected return of the stock should be '(.!8 percent based on its level of risk. Stock D plots belo the S>? and is overvalued. In other ords, its price must decrease to increase the expected return to '(.!8 percent. 6e can also ans er this question using the re ard)to)risk ratio. %ll assets must have the same re ard)to)risk ratio. The re ard)to)risk ratio is the risk premium of the asset divided by its . 6e are given the market risk premium, and e kno the of the market is one, so the re ard)to)risk ratio for the market is 1.1;8, or ;.8 percent. @alculating the re ard)to)risk ratio for Stock C, e find& ,e ard)to)risk ratio C . +.'38 : .13- 4 '.(1 . .1313 The re ard)to)risk ratio for Stock C is too high, hich means the stock plots above the S>?, and the stock is undervalued. Its price must increase until its re ard)to)risk ratio is equal to the market re ard)to)risk ratio. <or Stock D, e find& ,e ard)to)risk ratio D . +.'!' : .13- 4 .;1 . .183/ The re ard)to)risk ratio for Stock D is too lo , hich means the stock plots belo the S>?, and the stock is overvalued. Its price must decrease until its re ard)to)risk ratio is equal to the market re ard)to)risk ratio.

4, -LO". 6e need to set the re ard)to)risk ratios of the t o assets equal to each other, hich is&

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+.'38 : ,f-4'.(1 . +.'!' : ,f-41.;1 6e can cross multiply to get& 1.;1+.'38 : ,f- . '.(1+.'!' : ,fSolving for the risk)free rate, e find& 1.'!78 : 1.;1,f . 1.'8;( : '.(1,f ,f . .12/( or 2./(5 Intermediate 1, -LO1, . <or a portfolio that is equally invested in large)company stocks and long)term bonds& ,eturn . +'1.!(5 0 3.8;5-4! . 7.215 <or a portfolio that is equally invested in small stocks and Treasury bills& ,eturn . +'!.'!5 0 /.225-4! . 7.!35 , -LO". 6e kno that the re ard)to)risk ratios for all assets must be equal. This can be expressed as& E*+,%- : ,fF4% . E*+,B- : ,fF4=B The numerator of each equation is the risk premium of the asset, so& ,A%4% . ,AB4B 6e can rearrange this equation to get& B4% . ,AB4,A% If the re ard)to)risk ratios are the same, the ratio of the betas of the assets is equal to the ratio of the risk premiums of the assets. !, (LO1, 2) a. 6e need to find the return of the portfolio in each state of the economy. To do this, e ill multiply the return of each asset by its portfolio eight and then sum the products to get the portfolio return in each state of the economy. Going so, e get& Boom& *+,p- . .2+.!2- 0 .2+.(/- 0 .!+.88- . .(811 or (8.115 Hormal& *+,p- . .2+.';- 0 .2+.'(- 0 .!+.17- . .'(31 or '(.315 Bust& *+,p- . .2+.11- 0 .2+:.!3- 0 .!+:.28- . :.!1!1 or :!1.!15 %nd the expected return of the portfolio is& *+,p- . .(8+.(8- 0 .81+.'(3- 0 .'8+:.!1!- . .'/'! or '/.'!5 To calculate the standard deviation, e first need to calculate the variance. To find the variance, e find the squared deviations from the expected return. 6e then multiply each possible squared deviation by its probability, than add all of these up. The result is the variance. So, the variance and standard deviation of the portfolio is&

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!p . .(8+.(8 : .'/'!-! 0 .81+.'(3 : .'/'!-! 0 .'8+:.!1! : .'/'!-! !p . .1(!8( p . +.1(!8(-'4! . .'312 or '3.125 b. The risk premium is the return of a risky asset, minus the risk)free rate. T)bills are often used as the risk) free rate, so& ,Ai . *+,p- : ,f . .'/'! : .1(31 . .'!(! or '!.(!5 c. The approximate expected real return is the expected nominal return minus the inflation rate, so& %pproximate expected real return . .'/'! : .1(8 . .'!/! or '!./!5 To find the exact real return, e ill use the <isher equation. Going so, e get& ' 0 *+,i- . +' 0 h-E' 0 e+ri-F '.'/'! . +'.1(81-E' 0 e+ri-F e+ri- . +'.'/'!4'.1(8- : ' . .'!'7 or '!.'75 The approximate real risk premium is the expected return minus the risk)free rate, so& %pproximate expected real risk premium . .'/'! : .1(3 . .'!(! or '!.(!5 The exact expected real risk premium is the approximate expected real risk premium, divided by one plus the inflation rate, so& *xact expected real risk premium . .'!(!4'.1(8 . .''71 or ''.715 ", -LO . Since the portfolio is as risky as the market, the of the portfolio must be equal to one. 6e also kno the of the risk)free asset is 9ero. 6e can use the equation for the of a portfolio to find the eight of the third stock. Going so, e find& p . '.1 .
%

+.38- 0

+'.!1- 0

+'.(8- 0

,f

+1-

Solving for the eight of Stock @, e find&

@

. .(!21;2

So, the dollar investment in Stock @ must be& Invest in Stock @ . .(!21;2+I',111,111- . I(!2,1;2.1; 6e kno the total portfolio value and the investment of t o stocks in the portfolio, so e can find the of these t o stocks. The eights of Stock % and Stock B are&
% B

eight

. I!'1,111 4 I',111,111 . .!'1 . I(!1,1114I',111,111 . .(!1

6e also kno the total portfolio eight must be one, so the eight of the risk)free asset must be one minus the asset eight e kno , or& '.
%

,f

. ' : .!'1 : .(!1 : .(!21;2 :

,f

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,f

. .'287!/

So, the dollar investment in the risk)free asset must be& Invest in risk)free asset . .'287!/+I',111,111- . I'28,7!8.7( Challenge

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