Foundations of Corporate Finance

Solutions to end-of-chapters Problems

Chapter 2

Important Remark: In this chapter, you will be computing measures like variances
and covariances, which are expressed in percentage square. It is important to be consistent
in your computations. If you want to get rid of the percentage totally, you should do that
for all your calculations. Otherwise, you will have wrong values. For instance, if 12 = 10
percentage square and 1 = 2 percent and 2 = 10 percent, then the correlation coe¢ cient
is simply
12 10
corr (r1 ; r2 ) = = = 0:5:
1 2 2 10
Here, I kept the percentage, i.e., the unit of measurement pertaining to the covariance and
the standard deviation without any change. A di¤erent strategy would be to get rid of the
percentage totally. In this case, we have: 12 = 0:0010, 1 = 0:02 and 2 = 0:1: Notice, I
did not write any percentage sign. Then,
12 0:0010
corr (r1 ; r2 ) = = = 0:5:
1 2 0:02 0:1

Chapter 2: Problems 1-4

1. Notice here that the returns are given already. Most of the time you have prices.
In such case, you need to convert them into returns before your proceed to compute
expectations.

(a) The Expected rate of return formula for asset 1 is

or
X
n
or
Er1 = 1 = pi r1i = p1 r11 + p2 r12 + + pn r1n ;
i=1

where r1i denote the realization (or the rate of return) on asset 1 in state i. Notice
here than the number of states n = 5: You can verify that

Er1 = 9% and (similarly) Er2 = 5%

(b) The total volatility or total risk is measured by the standard deviation of returns,
q q
2 2
1 = 1 (for asset 1) and 2 = 2 (for asset 2),

which is calculated from the variance using the formula:

or
X
n
2 2
var(r1 ) = 1 = pi (r1i 1) (for asset 1)
i=1

and
or
X
n
2 2
var(r2 ) = 2 = pi (r2i 2) (for asset 1),
i=1

1
 where the subscripts 1 and 2 denote assets 1 and 2, respectively, and the subscript
i, as usual, denote state i, with n = 5: You can verify that
2
1 = 28 (or 0.0028) and 1 = 5:29%
2
2 = 51 (or 0.0051) and 2 = 7:13%.
Remark: Notice here that the variance is measured in percentage square. You
can either write it as 28 or 51, or equivalently, you can just write without any
% sign as 0.0028 or 0.0051. The standard deviation, however, must always be
reported in percentage.

Explanation of results: For asset 1 the expected return is 9%, however, the
risk is that the actual return could be more or less than the average by 5.29%.
Similarly, for asset 2, actual return could be more or less than the expected return
by 7.13%.
(c) In general, the correlation coe¢ cient is unit free and describes the direction of
association between two variables as well as the strength of that relationship,
whereas the covariance only describes the direction of association. For more details
see Page 42 in your text book.
(d) Notice the portfolio return and standard deviation formulas given. In addition,
you will need to calculate the covariance using the following formula:

or
X
n
cov(r1 ; r2 ) = 12 = pi (r1i 1) (r2i 2 ):
i=1

Verify that
12 = 1:2 percentage square (or 0:00012)
Allocation 1 (equal weights)

Erp = 7%; var(rp ) = 19 (or 0.0019), sd(rp ) = 4:37%:

(e) Allocation 2 (80% asset 1 and 20% asset 2)

Erp = 8:2%; var(rp ) = 20 (or 0.0020), sd(rp ) = 4:42%:

Comparing the allocations: The expected rate of return per unit of risk for each
allocation is:
7%
Allocation 1 : = 1:6
4:37%
8:2%
Allocation 1 : = 1:86
4:42%
Thus, allocation 2 provides better return for each unit of risk.

2. For Questions 2-4, below are the …nal answers. Detailed solutions will be presented in
tutorials.

2
 (a) ErAAA = 8:33%
(b) sd(rAAA ) = AAA = 41:67%
(c) Erp = 5:17% and p = 25:91%

3. See detailed solutions in tutorials.

or
(a) ErA = B = 1%
or
(b) ErB = B = 2%
or
(c) sd(rB ) = A = 1%
or
(d) sd(rB ) = B = 1:22%
or
(e) cov(rA ; rB ) = AB = 1 percentage square or ( 0:0001)
or
(f) corr(rA ; rB ) = AB = 0:82
or or
(g) Erp = p = 1:44% and sd(rp ) = p = 0:33%

4. You should verify, using the marginal expected return per unit of risk, that both
investors have same degree of risk aversion.