Question Bank on Risk Analysis-

Ques 1 Table below shows standard deviations and correlation coefficients for seven stocks
from different countries. Calculate the variance of a portfolio 40 percent invested in BP, 40
percent invested in KLM, and 20 percent invested in Nestlé

Correlation Coefficient

BP Nestle KLM
BP 1 0.23 0.2
KLM 0.32 1
Nestle 1

Ques 2 Here are some historical data on the risk characteristics of Dell and Microsoft:

Dell Microsoft
Beta 2.21 1.81
Yearly standard deviation of 62.7 50.7
return (%)

Assume the standard deviation of the return on the market was 15 percent.
a. The correlation coefficient of Dell’s return versus Microsoft’s is 0.66. What is the standard
deviation of a portfolio invested half in Dell and half in Microsoft?
b. What is the standard deviation of a portfolio invested one-third in Dell, one-third in
Microsoft, and one-third in Treasury bills?
c. What is the standard deviation if the portfolio is split evenly between Dell and Microsoft
and is financed at 50 percent margin, i.e., the investor puts up only 50 percent of the total
amount and borrows the balance from the broker?
d. What is the approximate standard deviation of a portfolio composed of 100 stocks with
betas of 2.21 like Dell? How about 100 stocks like Microsoft?

Ques 3 It is often useful to know how well your portfolio is diversified. Two measures have
been suggested:
a. The variance of the returns on a fully diversified portfolio as a proportion of the variance
of returns on your portfolio.
b. The number of shares in a portfolio that (i) has the same risk as yours, (ii) is invested in
“typical” shares, and (iii) has equal amounts invested in each share. Suppose that you hold
eight stocks. All are fairly typical; they have a standard deviation of 40 percent a year and the
correlation between each pair is 0.3. Of your fund, 20 percent is invested in one stock, 20
percent is invested in a second stock, and the remaining 60 percent is spread evenly over a
further six stocks. Calculate each measure of portfolio

Ques 4 An analyst predicted last year that the stock of Logistics, Inc., would offer a total
return of at least 10% in the coming year. At the beginning of the year, the firm had a stock
market value of $10 million. At the end of the year, it had a market value of $12 million even
though it experienced a loss, or negative net income, of $2.5 million. Did the analyst’s
prediction prove correct? Explain using the values for total annual return.
Ques 5 Four analysts cover the stock of Fluorine Chemical. One forecasts a 5% return for the
coming year. A second expects the return to be negative 5%. A third predicts a 10% return. A
fourth expects a 3% return in the coming year. You are relatively confident that the return
will be positive but not large, so you arbitrarily assign probabilities of being correct of 35%,
5%, 20%, and 40%, respectively, to the analysts’ forecasts. Given these probabilities, what is
Fluorine Chemical’s expected return for the coming year?

Ques 6 The expected annual returns are 15% for investment 1 and 12% for investment 2. The
standard deviation of the first investment’s return is 10%; the second investment’s return has
a standard deviation of 5%. Which investment is less risky based solely on standard
deviation? Which investment is less risky based on coefficient of variation? Which is a better
measure given that the expected returns of the two investments are not the same?

Ques 7 Your portfolio has three asset classes. U.S. government T-bills account for 45% of
the portfolio, large-company stocks constitute another 40%, and small-company stocks make
up the remaining 15%. If the expected returns are 3.8% for the T-bills,
12.3% for the large-company stocks, and 17.4% for the small-company stocks, what is the
expected return of the portfolio?

Ques 8 You wish to calculate the risk level of your portfolio based on its beta. The five stocks
in the portfolio with their respective weights and betas are shown in the accompanying table.
Calculate the beta of your portfolio.
Stock Portfolio weight% Beta
Alpha 20 1.15
Centauri 10 0.85
Zen 15 1.60
Wren 20 1.35
Yukos 35 1.85

Ques 9 a. Calculate the required rate of return for an asset that has a beta of 1.8, given a risk-
free rate of 5% and a market return of 10%.
b. If investors have become more risk-averse due to recent geopolitical events, and the
market return rises to 13%, what is the required rate of return for the same asset?
c. Use your findings in part a to graph the initial security market line (SML), and then use
your findings in part b to graph (on the same set of axes) the shift in the SML
.
Ques 10 Douglas Keel, a financial analyst for Orange Industries, wishes to estimate the rate
of return for two similar-risk investments, X and Y. Douglas’s research indicates that the
immediate past returns will serve as reasonable estimates of future returns. A year earlier,
investment X had a market value of $20,000; investment Y had a market value of $55,000.
During the year, investment X generated cash flow of $1,500 and investment Y generated
cash flow of $6,800. The current market values of investments X and Y are $21,000 and
$55,000, respectively.
a. Calculate the expected rate of return on investments X and Y using the most
recent year’s data.
b. Assuming that the two investments are equally risky, which one should Douglas
recommend? Why?