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You are on page 1of 11

line.

from

-∞ to +∞.

its negative correlation with other stocks. In a single-asset

portfolio, Security A would be more risky because σ A > σ B and CVA > CVB.

5-3 a. No, it is not riskless. The portfolio would be free of default risk

and liquidity risk, but inflation could erode the portfolio’s

purchasing power. If the actual inflation rate is greater than that

expected, interest rates in general will rise to incorporate a

larger inflation premium (IP) and--as we shall see in Chapter 7--the

value of the portfolio would decline.

expect to “roll over” the Treasury bills at a constant (or even

increasing) rate of interest, but if interest rates fall, your

investment income will decrease.

purchasing power (that is, an indexed bond) would be close to

riskless. The U.S. Treasury currently issues indexed bonds.

for a common stock. Each outcome is multiplied by its probability

of occurrence, and then these products are summed. For example,

suppose a 1-year term policy pays $10,000 at death, and the

probability of the policyholder’s death in that year is 2 percent.

Then, there is a 98 percent probability of zero return and a 2

percent probability of $10,000:

Generally, the premium will be larger because of sales and

administrative costs, and insurance company profits, indicating a

negative expected rate of return on the investment in the policy.

life insurance policy and the returns on the policyholder’s human

capital. In fact, these events (death and future lifetime earnings

capacity) are mutually exclusive.

pay a premium to decrease the uncertainty of their future cash

flows. A life insurance policy guarantees an income (the face value

of the policy) to the policyholder’s beneficiaries when the policy-

holder’s future earnings capacity drops to zero.

If risk aversion increases, the slope of the SML will increase, and so

will the market risk premium (kM - kRF). The product (kM - kRF)bj is the

risk premium of the jth stock. If b j is low (say, 0.5), then the

product will be small; RPj will increase by only half the increase in

RP M .

However, if bj is large (say, 2.0), then its risk premium will rise by

twice the increase in RPM.

beta will increase a company’s expected return by an amount equal to

the market risk premium times the change in beta. For example, assume

that the risk-free rate is 6 percent, and the market risk premium is 5

percent. If the company’s beta doubles from 0.8 to 1.6 its expected

return increases from 10 percent to 14 percent. Therefore, in general,

a company’s expected return will not double when its beta doubles.

it may be impossible to find individual stocks that have a nonpositive

beta. In this case it would also be impossible to have a stock

portfolio with a zero beta. Even if such a portfolio could be

constructed, investors would probably be better off just purchasing

Treasury bills, or other zero beta investments.

5-8 No. For a stock to have a negative beta, its returns would have to

logically be expected to go up in the future when other stocks’ returns

were falling. Just because in one year the stock’s return increases

when the market declined doesn’t mean the stock has a negative beta. A

stock in a given year may move counter to the overall market, even

though the stock’s beta is positive.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

(0.1)(60%)

= 11.40%.

11.40%)2(0.4)

+ (25% - 11.40%)2(0.2) + (60% - 11.40%)2(0.1)

σ 2

= 712.44; σ = 26.69%.

26.69%

CV = = 2.34.

11.40%

$35,000 0.8

40,000 1.4

Total $75,000

kM = 5% + (6%)1 = 11%.

k when b = 1.2 = ?

k = 5% + 6%(1.2) = 12.2%.

= 6% + (13% - 6%)0.7

= 10.9%.

11% = 7% + 4%b

4% = 4%b

b = 1.

b. kRF = 7%; RPM = 6%; b = 1.

k = 7% + (6%)1

k = 13%.

5-6 a. k̂ = ∑ Pk

i=1

i i .

= 14% versus 12% for X.

b. σ = ∑ (k

i=1

i

− k̂)2 Pi .

+ (20% - 12%)2(0.2) + (38% - 12%)2(0.1) = 148.8%.

then it might have a lower beta than Stock X, and hence be

less risky in a portfolio sense.

c. 1. kM increases to 16%:

2. kM decreases to 13%:

$142,500 $7,500

5-8 Old portfolio beta = (b) + (1.00)

$150,000 $150,000

1.12 = 0.95b + 0.05

1.07 = 0.95b

1.1263 = b.

Alternative Solutions:

(0.05)b20

∑b i = 1.12/0.05 = 22.4.

1.16.

- 1.0 =

21.4, so the beta of the portfolio excluding this stock is b =

21.4/19 = 1.1263. The beta of the new portfolio is:

$400,000 $600,000

5-9 Portfolio beta = (1.50) + (-0.50)

$4,000,000 $4,000,000

$1,000,000 $2,000,000

+ (1.25) + (0.75)

$4,000,000 $4,000,000

bp = (0.1)(1.5) + (0.15)(-0.50) + (0.25)(1.25) + (0.5)(0.75)

= 0.15 - 0.075 + 0.3125 + 0.375 = 0.7625.

= 6% + (14% - 6%)(0.7625) = 12.1%.

using the CAPM equation [kRF + (kM - kRF)b], and then calculate the

weighted average of these returns.

Stock Investment Beta k = kRF + (kM - kRF)b Weight

A $ 400,000 1.50 18% 0.10

B 600,000 (0.50) 2 0.15

C 1,000,000 1.25 16 0.25

D 2,000,000 0.75 12 0.50

Total $4,000,000 1.00

kR = 7% + 6%(1.50) = 16.0%

kS = 7% + 6%(0.75) = 11.5

4.5%

k̂ Y = 12.5%; bY = 1.2; σ Y = 25%.

kRF = 6%; RPM = 5%.

beta. Therefore, the stock with the higher beta is more

risky. Stock Y has the higher beta so it is more risky than

Stock X.

c. kX = 6% + 5%(0.9)

kX = 10.5%.

kY = 6% + 5%(1.2)

kY = 12%.

d. kX = 10.5%; k̂ X = 10%.

kY = 12%; k̂Y = 12.5%.

since its expected return of 12.5% is greater than its

required return of 12%.

e. bp = ($7,500/$10,000)0.9 + ($2,500/$10,000)1.2

= 0.6750 + 0.30

= 0.9750.

kp = 6% + 5%(0.975)

kp = 10.875%.

f. If RPM increases from 5% to 6%, the stock with the highest beta

will have the largest increase in its required return.

Therefore, Stock Y will have the greatest increase.

Check:

kX = 6% + 6%(0.9)

= 11.4%. Increase 10.5% to 11.4%.

kY = 6% + 6%(1.2)

= 13.2%. Increase 12% to 13.2%.

ks = 6% + (6.5%)1.7 = 17.05%.

9% = kRF + (kM – kRF)bX

9% = 5.5% + (kM – kRF)0.8

(kM – kRF) = 4.375%.

5-14 In equilibrium:

kJ = k̂J = 12.5%.

kJ = kRF + (kM - kRF)b

12.5% = 4.5% + (10.5% - 4.5%)b

b = 1.33.

kLRI = 4.5% + (10.5% - 4.5%)0.6 = 4.5% + 6%(0.6) = 8.1%

Difference 7.2%

(given in the problem) and the risk-free rate is 5 percent, you

can calculate the market risk premium (RPM) calculated as kM - kRF

as follows:

k = kRF + (RPM)b

12.5% = 5% + (RPM)1.0

7.5% = RPM.

Now, you can use the RPM, the kRF, and the two stocks’ betas to

calculate their required returns.

Bradford:

kB = kRF + (RPM)b

= 5% + (7.5%)1.45

= 5% + 10.875%

= 15.875%.

Farley:

kF = kRF + (RPM)b

= 5% + (7.5%)0.85

= 5% + 6.375%

= 11.375%.

15.875% - 11.375% = 4.5%.

5-17 Step 1: Determine the market risk premium from the CAPM:

0.12 = 0.0525 + (kM - kRF)1.25

(kM - kRF) = 0.054.

The beta of the new portfolio is ($500,000/$5,500,000)

(0.75) + ($5,000,000/$5,500,000)(1.25) = 1.2045.

The required return on the new portfolio is:

5.25% + (5.4%)(1.2045) = 11.75%.

5-18 After additional investments are made, for the entire fund to have an

expected return of 13%, the portfolio must have a beta of 1.5455 as

shown below:

b = 1.5455.

the individual investments, we can calculate the required beta on

the additional investment as follows:

($20,000,0

00)(1.5) $5,000,000X

1.5455 = +

$25,000,00

0 $25,000,00

0

1.5455 = 1.2 + 0.2X

0.3455 = 0.2X

X = 1.7275.

c. Risk averter.

d. 1. ($1.15 million)(0.5) + ($0)(0.5) = $575,000, or an expected

profit of $75,000.

2. $75,000/$500,000 = 15%.

were perfectly positively correlated. Otherwise, the stock

portfolio would have the same expected return as the single

stock (15 percent) but a lower standard deviation. If the

correlation coefficient between each pair of stocks was a

negative one, the portfolio would be virtually riskless.

Since r for stocks is generally in the range of +0.6 to

+0.7, investing in a portfolio of stocks would definitely

be an improvement over investing in the single stock.

b. First, determine the fund’s beta, bF. The weights are the

percentage of funds invested in each stock.

A = $160/$500 = 0.32

B = $120/$500 = 0.24

C = $80/$500 = 0.16

D = $80/$500 = 0.16

E = $60/$500 = 0.12

= 0.16 + 0.48 + 0.64 + 0.16 + 0.36 = 1.8.

16 percent required rate of return on an investment with a

risk of b = 2.0. Since kN = 16% > k̂ N = 15%, the new stock

should not be purchased. The expected rate of return that

would make the fund indifferent to purchasing the stock is 16

percent.

5-21 The answers to a, b, c, and d are given below:

kA kB Portfolio

1998 (18.00%) (14.50%) (16.25%)

1999 33.00 21.80 27.40

2000 15.00 30.50 22.75

2001 (0.50) (7.60) (4.05)

2002 27.00 26.30 26.65

Std. Dev. 20.79 20.78 20.13

Coef. Var. 1.84 1.84 1.78

Stock A or Stock B alone, since the portfolio offers the same

expected return but with less risk. This result occurs

because returns on A and B are not perfectly positively

correlated (rAB = 0.88).

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