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CHAPTER5:RISKANDRETURN:PASTANDPROLOGUE

1.

iandii.Thestandarddeviationisnonnegative.

11.

a.

Theholdingperiodreturnsforthethreescenariosare:
Boom:

(3525+1)/25=0.44=44.00%

Normal:

(2525+0.50)/25=0.02=2.00%

Recession: (1025+0.25)/25=0.59=59.00%
E(HPR)=[(1/3)44%]+[(1/3)2%]+[(1/3)(59.00%)]=4.33%
2(HPR)=[(1/3)(44(4.33))]2+[(1/3)(2(4.33))]2+(1/3)[(59(4.33))]2
=1788.22
= 1788.22 =42.29%
b.

E(r)=(0.54.33%)+(0.54%)=0.165%
=0.542.29%=21.145%

13.

a.

Meanofportfolio=(1y)rf+yrP=rf+(rPrf)y=6+9y
Iftheexpectedrateofreturnfortheportfoliois12%,then,solvingfory:
12=6+9yy=

12 6
=0.667
9

Therefore,inordertoachieveanexpectedrateofreturnof12%,theclient
mustinvest66.7%oftotalfundsintheriskyportfolioand33.3%inTbills.
b.
Security
TBills
StockA
StockB
StockC
c.

Investment
Proportions
33.3%
0.66727%=
18.0%
0.66733%=
22.0%
0.66740%=
26.7%

P=0.66725%=16.7%peryear

14.

a.

Portfoliostandarddeviation=P=y25%
Iftheclientwantsastandarddeviationof20%,then:
y=(20%/25%)=0.80=80.0%intheriskyportfolio.

15.

b.

Expectedrateofreturn=6+9y=6+(0.809)=13.20%

a.

SlopeoftheCML=

b.

Myfundallowsaninvestortoachieveahigherexpectedrateofreturnforany
givenstandarddeviationthanwouldapassivestrategy,i.e.,ahigherexpected
returnforanygivenlevelofrisk.

14 6
=0.333
24

28.
Average Rate of Return, Standard Deviation
and Reward-to-Variability Ratio of the Risk Premiums
for Small Common Stocks over One Month Bills
for 1926-2003 and Various Sub-Periods
1926-1943
1944-1963
1964-1983
1984-2003
1926-2003

Mean
SD
18.40
60.00
17.84
29.86
13.61
35.30
9.08
25.69
14.64
38.72

Table 5.5 (for comparison)

1926-1943
1944-1963
1964-1983
1983-2003
1926-2003

a.

b.

7.15
14.74
2.76
9.08
8.46

SD
29.07
18.38
17.29
16.79
20.80

Reward-toVariability Ratio
0.3066
0.5975
0.3855
0.3535
0.3780

Reward-toVariability Ratio
0.2460
0.8018
0.1596
0.5408
0.4071

variabilityratio(0.3780)thanlargestocks(0.4071).However,intwoofthe
foursubperiods,smallstocksperformedbetterthanlargestocks.
Ingeneral,yes.

CHAPTER6:EFFICIENTDIVERSIFICATION
1.

E(rP)=(0.516%)+(0.410%)+(0.106%)=12.6%

13.
Year
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Average:
Std. deviation:

Annualized %
Large Stocks
L-t T-Bonds
6.46
15.29
32.00
32.68
18.40
23.96
5.34
-2.65
16.86
8.40
31.34
19.49
-3.20
7.13
30.66
18.39
7.71
7.79
9.87
15.48
1.29
-7.18
37.71
31.67
23.07
-0.81
33.17
15.08
28.58
13.52
21.04
-8.74
-9.10
20.27
-11.89
4.21
-22.10
16.79
28.69
2.38
14.30
11.66
17.12
11.61

Large Stocks
Large Stocks
L-t T-Bonds

L-t T-Bonds

1
0.284892829

Minimum Variance Portfolio

Portfolio Proportions
ABC
XYZ
0.00
1.00
0.10
0.90
0.20
0.80
0.30
0.70
0.40
0.60
0.50
0.50
0.60
0.40
0.70
0.30
0.80
0.20
0.90
0.10
1.00
0.00
0.2485
0.7515

Mean
11.66
11.92
12.19
12.45
12.71
12.98
13.24
13.50
13.77
14.03
14.30
12.31

Portfolio
Std.Dev.
11.61
11.06
10.78
10.78
11.08
11.63
12.42
13.40
14.53
15.78
17.12
10.74

18.

Theprobabilitydistributionis:
Probability
0.6
0.4

RateofReturn
100%
50%

Expectedreturn=(0.6100%)+0.4(50%)=40%
Variance=[0.6(10040)2]+[0.4(5040)2]=5400
Standarddeviation= 5400 =73.48%
19.

20.

a.

Theriskofthediversifiedportfolioconsistsprimarilyofsystematicrisk.Beta
measuressystematicrisk,whichistheslopeofthesecuritycharacteristicline
(SCL).Thetwofiguresdepictthestocks'SCLs.StockB'sSCLissteeper,and
henceStockB'ssystematicriskisgreater.TheslopeoftheSCL,andhencethe
systematicrisk,ofStockAislower.Thus,forthisinvestor,stockBistheriskiest.

b.

Theundiversifiedinvestorisexposedprimarilytofirmspecificrisk.StockA
hashigherfirmspecificriskbecausethedeviationsoftheobservationsfromthe
SCLarelargerforStockAthanforStockB.Deviationsaremeasuredbythe
verticaldistanceofeachobservationfromtheSCL.StockAisthereforeriskiest
tothisinvestor.

Monthlyratesofreturn,excessreturnsandmeansforthefiveyearperiodMay
2000throughApril2005areshowninthetableonthenextpage.Thecalculation
ofbetaforGMisshownonthefollowingpage.

Month
May-00
Jun-00
Jul-00
Aug-00
Sep-00
Oct-00
Nov-00
Dec-00
Jan-01
Feb-01
Mar-01
Apr-01
May-01
Jun-01
Jul-01
Aug-01
Sep-01
Oct-01
Nov-01
Dec-01
Jan-02
Feb-02
Mar-02
Apr-02
May-02
Jun-02
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
Aug-03
Sep-03
Oct-03
Nov-03
Dec-03
Jan-04
Feb-04
Mar-04
Apr-04
May-04
Jun-04
Jul-04
Aug-04
Sep-04
Oct-04
Nov-04
Dec-04
Jan-05
Feb-05

Monthly rates of return

GM
S&P500
-24.57
-2.19
-17.79
2.39
-1.94
-1.63
22.94
6.07
-7.14
-5.35
-4.42
-0.49
-20.32
-8.01
2.90
0.41
5.42
3.46
-0.71
-9.23
-2.76
-6.42
5.71
7.68
3.81
0.51
13.09
-2.50
-1.17
-1.07
-13.92
-6.41
-21.64
-8.17
-3.68
1.81
20.28
7.52
-2.21
0.76
5.23
-1.56
3.60
-2.08
14.10
3.67
6.12
-6.14
-3.12
-0.91
-14.00
-7.25
-12.91
-7.90
2.81
0.49
-18.72
-11.00
-14.52
8.64
19.40
5.71
-7.15
-6.03
-1.44
-2.74
-7.05
-1.70
-0.44
0.84
7.23
8.10
-2.00
5.09
1.90
1.13
3.97
1.62
9.80
1.79
-0.41
-1.19
4.25
5.50
0.26
0.71
24.82
5.08
-6.97
1.73
-3.14
1.22
-1.81
-1.64
0.36
-1.68
-4.28
1.21
2.64
1.80
-7.41
-3.43
-4.24
0.23
2.83
0.94
-9.25
1.40
0.10
3.86
3.81
3.25
-8.11
-2.53
-3.15
1.89

T-bills
0.50
0.49
0.51
0.52
0.52
0.52
0.53
0.50
0.44
0.42
0.38
0.33
0.31
0.30
0.30
0.29
0.22
0.18
0.16
0.14
0.14
0.15
0.15
0.15
0.15
0.14
0.14
0.14
0.14
0.13
0.10
0.10
0.10
0.10
0.10
0.10
0.09
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.09
0.11
0.11
0.13
0.14
0.15
0.18
0.19
0.20
0.22

Excess Returns
GM
S&P500
-25.07
-2.69
-18.28
1.91
-2.45
-2.15
22.42
5.55
-7.66
-5.86
-4.95
-1.02
-20.85
-8.54
2.41
-0.09
4.98
3.02
-1.13
-9.65
-3.14
-6.80
5.38
7.35
3.50
0.20
12.80
-2.80
-1.46
-1.37
-14.20
-6.70
-21.87
-8.40
-3.87
1.63
20.12
7.36
-2.36
0.61
5.09
-1.70
3.45
-2.22
13.95
3.52
5.97
-6.29
-3.26
-1.05
-14.14
-7.39
-13.05
-8.04
2.68
0.35
-18.86
-11.14
-14.66
8.51
19.29
5.60
-7.25
-6.13
-1.54
-2.84
-7.15
-1.80
-0.54
0.74
7.13
8.01
-2.09
5.00
1.82
1.05
3.90
1.55
9.72
1.71
-0.49
-1.27
4.17
5.42
0.18
0.63
24.75
5.00
-7.04
1.65
-3.22
1.14
-1.89
-1.72
0.28
-1.76
-4.37
1.12
2.54
1.69
-7.52
-3.54
-4.37
0.10
2.69
0.80
-9.40
1.25
-0.07
3.68
3.62
3.06
-8.31
-2.73
-3.37
1.68

Mar-05
Apr-05
Average:

-17.56
-12.15
-1.58

-1.91
-3.65
-0.31

0.23
0.24
0.21

-17.79
-12.38
-1.79

-2.15
-3.88
-0.51

COVARIANCE MATRIX:
GM
GM
107.9826597
S&P500
26.78817906

S&P500
20.24856691

SUMMARY OUTPUT OF EXCEL REGRESSION:

SUMMARY OUTPUT
Regression Statistics
Multiple R
0.572887092
R Square
0.32819962
0.316616855
Standard Error
8.662809438
Observations
60
ANOVA
df
Regression
Residual
Total

Intercept
S&P500

1
58
59
Coefficients
-1.10680279
1.322966666

SS
MS
2126.392076 2126.392076
4352.567507 75.04426736
6478.959583

F
28.33517004

Std Error
1.125626727
0.248534103

P-value
0.329555203
1.72383E-06

t Stat
-0.983276927
5.323079

Significance
F
1.72383E-06

CHAPTER7:CAPITALASSETPRICING
ANDARBITRAGEPRICINGTHEORY
1.

a,candd.

2.

a.

E(rX)=5%+0.8(14%5%)=12.2%
X=14%12.2%=1.8%
E(rY)=5%+1.5(14%5%)=18.5%
Y=17%18.5%=1.5%

b.

portfolio,KayshouldrecommendStockXbecauseofitspositivealpha,while
StockYhasanegativealpha.Ingraphicalterms,StockXsexpected
return/riskprofileplotsabovetheSML,whileStockYsprofileplotsbelow
theSML.Also,dependingontheindividualriskpreferencesofKaysclients,
StockXslowerbetamayhaveabeneficialimpactonoverallportfoliorisk.
ii.Foraninvestorwhowantstoholdthisstockasasinglestockportfolio,
KayshouldrecommendStockY,becauseithashigherforecastedreturnand
lowerstandarddeviationthanStockX.StockYsSharperatiois:
(0.170.05)/0.25=0.48
StockXsSharperatioisonly:
(0.140.05)/0.36=0.25
ThemarketindexhasanevenmoreattractiveSharperatio:
(0.140.05)/0.15=0.60
However,giventhechoicebetweenStockXandY,Yissuperior.Whena
stockisheldinisolation,standarddeviationistherelevantriskmeasure.For
assetsheldinisolation,betaasameasureofriskisirrelevant.Although
holdingasingleassetinisolationisnottypicallyarecommendedinvestment
strategy,someinvestorsmayholdwhatisessentiallyasingleassetportfolio
(e.g.,thestockoftheiremployercompany).Forsuchinvestors,therelevance
ofstandarddeviationversusbetaisanimportantissue.

3.

a.

b.

Thebetaisthesensitivityofthestock'sreturntothemarketreturn.Callthe
aggressivestockAandthedefensivestockD.Thenbetaisthechangeinthe
stockreturnperunitchangeinthemarketreturn.Wecomputeeachstock's
betabycalculatingthedifferenceinitsreturnacrossthetwoscenariosdivided
bythedifferenceinmarketreturn.
A

1 33
2.00
4 20

6 10
0.25
4 20

eachstockifthemarketreturnisequallylikelytobe4%or20%?]
Withthetwoscenariosequallikely,theexpectedrateofreturnisanaverage
ofthetwopossibleoutcomes:
E(rA)=0.5(1%+33%)=17.0%
E(rD)=0.5(6%+10%)=8.0%

c.TheSMLisdeterminedbythefollowing:Tbillrate=6%withabetaequaltozero,
betaforthemarketis1.0,andtheexpectedrateofreturnforthemarketis:
0.5(20%+4%)=12.0%
Theequationforthesecuritymarketlineis:
E(r)=6%+(12%6%)
Seethefollowinggraph.

E(r)
SML
18.0%

17.0%
M

12.0%
8.0%
7.5%
6.0%

.25

d.

1.0

2.0

Theaggressivestockhasafairexpectedrateofreturnof:
E(rA)=6%+2.0(12%6%)=18.0%
Thesecurityanalystsestimateoftheexpectedrateofreturnis17%.Thus
thealphafortheaggressivestockis:
A=actualexpectedreturnrequiredreturnpredictedbyCAPM
=17%18%=1.0%
Similarly,therequiredreturnforthedefensivestockis:
E(rD)=6%+0.25(12%6%)=7.5%
ThesecurityanalystsestimateoftheexpectedreturnforDis8%,andhence:
D=8%7.5%=0.50%
Thepointsforeachstockareplottedonthegraphabove.

e.

Thehurdlerateisdeterminedbytheprojectbeta(i.e.,0..25)notbythefirms
beta.Thecorrectdiscountrateistherefore7.50%,thefairrateofreturnon
stockD.
10

22.

a.

Sincethemarketportfolio,bydefinition,hasabetaof1.0,itsexpectedrate
ofreturnis12%.

b.

=0meansthestockhasnosystematicrisk.Hence,theportfolio's
expectedrateofreturnistheriskfreerate,5%.

c.

UsingtheSML,thefairrateofreturnforastockwith=0.5is:
E(r)=5%+(0.5)(12%5%)=1.5%
Theexpectedrateofreturn,usingtheexpectedpriceanddividendfornextyear:
E(r)=(\$44/\$40)1=0.10=10%
Becausetheexpectedreturnexceedsthefairreturn,thestockmustbe
underpriced.

23.

a.

BoththeCAPMandAPTrequireameanvarianceefficientmarket
portfolio.Thisstatementisincorrect.TheCAPMrequiresthemean
varianceefficientportfolio,butAPTdoesnot.

b.

TheCAPMassumesthatonespecificfactorexplainssecurityreturnsbut
APTdoesnot.Thisstatementiscorrect.

11

12

13