Estimating Risk and Return

Part I: Questions

1. Explain why expected return is considered forward-looking. What challenges arise in

using expected return?

Expected return is considered forward-looking because it represents the return investors

expect to receive in the future as compensation for the market risk they’ve taken. The
challenge that can arise is the shear fact that they must strategize that the investment will
act in a specific way. There are several key factors that practitioners utilize to form their
strategies; they include the following: external economic conditions, general demand for
the business’s products/services, the business’s projects, and internal company practices.
The major struggle is that the economy is always considered the unknown part of the
equation. A practitioner could use the probability distribution as a means to determine the
chances of probability there is in the economy acting a certain way to determine the risk.
The sum of the total probability must equal one hundred percent (Sherman, 2011).

2. Explain how differences in allocations between the risk-free security and the market
portfolio can determine the level of market risk.

An investor must decide how much of their portfolio to invest in risk free securities (beta
= 0) when determining how much risk to take and now much to invest into the market
(beta = 1) to accomplish their desired level of risk. An example would be that a more
inclined investor towards risk may invest 80% into the risk free market, and 20% into the
stock market. This allocation would have a beta = .20. While a less risk inclined person
might have allocations on the opposite scale of 20% risk free and 80% invested into the
stock market, which would be beta = .80. If an investors varies their amount of
allocations it allows for the risk free market and market portfolio to vary the amount of
their overall assumed risk (Weston, 2001).

Part II: Problems

1. Based on the probability and percentage of return for the three economic states in the
table below, compute the expected return.
Economic State Probability Percentage of Return
Fast Growth 0.10 60

Slow Growth 0.50 30

Recession 0.40 -23

Expected return = sum of each return x probability of that return

Expected return = (p1 x return) + (p2 x return) + (p3 x return)

(.1 x 60%) + (.5 x 30%) + (.4 x -23%) = 11.8%

2. If the risk-free rate is 7 percent and the risk premium is 4 percent, what is the required
return?

Risk Free Rate = 7%

Risk Premium = 4%

Required return = 7% + 4% = 11%

3. Suppose that the average annual return on the Standard and Poor's 500 Index from 1969
to 2005 was 14.8 percent. The average annual T-bill yield during the same period was 5.6
percent. What was the market risk premium during these 10 years?

Index Return = 14.8%

T-bill Return = 5.6%
Market Risk Premium = 14.8%-5.6% = 9.20%

4. Conglomco has a beta of 0.32. If the market return is expected to be 12 percent and the
risk-free rate is 5 percent, what is Conglomco's required return? Use the capital asset
pricing model (CAPM) to calculate Conglomco's required return.

Beta = 0.32
Market Return = 12%
Risk Free Return = 5%
Required Return= 5% + 0.32*(12%-5%) = 7.24%
5. Calculate the beta of a portfolio that includes the following stocks:
 Conglomco stock, which has a beta of 3.9 and comprises 35 percent of the
portfolio.
 Supercorp stock, which has a beta of 1.7 and comprises 25 percent of the
portfolio.
 Megaorg stock, which has a beta of 0.3 and comprises 40 percent of the portfolio.

The sum of beta is reach by the following formula:

Sum of beta per stock * its weight in the portfolio

Conglomco weight = 0.35

Beta of Conglomco = 3.9

Megaorg weight = 0.40

Beta of Megaorg = 0.3

Supercorp Weight = 0.25

Beta of Supercorp = 1.7

Portfolio Return = 0.35*3.9 + 0.25*1.7 + 0.40*0.3 = 1.91