Dr/ Ahmed Ghanim

MBA
Finance

Final Revision
Part 3
(Chapters 4)

Prepared by:
Dr/ Ahmed Ghanim
01018025552

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Theoretical,
Practical,
T & F,
And
MCQ
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Chapter 4
Risk & Return
RULES

Standard Deviation of a Portfolio Returns (correlation)

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Essay Questions
Q1: Define risk, return, and briefly discuss the basic risk preferences.

Risk: is the chance of suffering a financial loss, as measured by the

variability of expected returns associated with a given asset.

Return: represents the total gain or loss on an investment, is the change

in value plus any cash distributions over a defined time period.

Risk Preferences

The risk-averse financial manager requires an increase in return for a

given increase in risk.

The risk-indifferent manager requires no change in return for an

increase in risk.

The risk-seeking manager accepts a decrease in return for a given

increase in risk.

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Q2: What are the main measurements to compute the risk?

1. Sensitivity analysis:
Evaluates asset risk by using more than one possible set of returns to
obtain a sense of the variability of outcomes.
The range is found by subtracting the pessimistic (Minimum)
outcome from the optimistic (Maximum) outcome. The larger the
range, the more variability of risk associated with the asset.

2. Standard deviation:
The most common statistical indicator of an asset’s risk is the
standard deviation, which measures the dispersion around the
expected value of return. The expression for the standard deviation
of returns is as follows:

3- Coefficient of variation:

The coefficient of variation is another indicator of asset risk, measuring

relative dispersion.

The coefficient of variation may be a better basis than the standard

deviation for comparing risk of assets with differing expected returns.

The coefficient of variation is calculated by using this equation:

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Q3: Define portfolio, efficient portfolio, diversification, and the main

types of portfolio risk.

Portfolio means that the investor invests his money in more than one
asset.

The efficient portfolio is a portfolio that maximizes the return for a

given level of risk or minimizes the risk for a given level of return.

Diversification means combining negatively correlated assets to

diversify risk. In general, the lower the correlation between asset
returns, the greater the potential diversification of risk.

Types of risk:

1- Diversifiable risk (Unsystematic risk) refers to the portion of an

asset's risk attributable to firm-specific, random events that can
be eliminated by diversification.
2- Nondiversifiable risk (Systematic risk) is attributable to market
factors affecting all firms.

Because any investor can create a portfolio of assets that will eliminate
virtually all diversifiable risk, the only relevant risk is nondiversifiable
risk.

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Q4: Discuss CAPM and identify its main advantage and disadvantage.

CAPM is the basic theory model to calculate the required rate of return

The required return for all assets: is composed of two parts, the risk-
free rate and risk premium. The risk-free rate (RF) is usually estimated
from the return on US T-bills. The risk premium is a function of both
market conditions and the asset itself, it is composed of two parts.

The Market Risk Premium which is the return required for investing in
any risky asset rather than the risk-free rate.

Beta, a risk coefficient which measures the sensitivity of the particular

stock’s return to changes in market conditions.

Portfolio Betas: The beta of a portfolio can be easily estimated by using

the betas of the individual assets it includes.

If B= 1 RRR = Rm

B>1 RRR > Rm

B<1 RRR < Rm

Advantages:

1- Easy used by investors

2- Most wide used model in asset pricing

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Disadvantages:

1- Based on the concept of efficient market which is not exist in

reality.
2- Based on the Beta which is the only factor that determine the RRR
and Beta is calculated based on historical data and hard to be
calculated.

If the investor depends on this CAPM to evaluate buy or not to buy the
asset, the higher the RRR, the higher the risk, and then the lower the
market value of the asset.

So, invest in asset to be accepted only and only if RRR calculated is less
than or equal the expected return.

Q5: Write short essay on Security Market Line (SML) and the major
forces causing shifts in the SML. (Graphs are required)

SML is the representation of the CAPM as a graph that reflects the RRR
in the marketplace for each level of nondiversifiable risk (beta).

The (SML) is not stable over time, and as a result of shifting in SML, the
required rate of return will be changed.

The main two major forces affecting the position and the slope of the
SML are:

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A) Change in inflationary expectations:

Changes in inflationary expectations result in parallel shifts in the SML, in

direct response to the magnitude and direction of the change. The
following figure shows this effect.

B) Changes in risk aversion:

Changes in risk aversion, and shifts in the SML result from changing
preferences of investors. Increasing risk aversion results in a steepening
in the slope of SML. Decreasing risk aversion results in reducing the
slope of SML. The following figure shows this effect:

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Q7: Discuss the importance of correlation.

Correlation: The correlation between asset returns is important when

evaluating the effect of a new asset on the portfolio's overall risk.

Returns on different assets moving in the same direction are positively

correlated, while those moving in opposite directions are negatively
correlated.

Assets with high positive correlation increase the variability of portfolio

returns (risk), while assets with high negative correlation reduce the
variability of portfolio returns (risk).

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MSQ
1- If a personʹs required return does not change when risk increases, that
person is said to be
A) risk-seeking.
B) risk-indifferent.
C) risk-averse.
D) risk-aware.
Answer: B
2- If a personʹs required return decreases for an increase in risk, that
person is said to be
A) risk-seeking.
B) risk-indifferent.
C) risk-averse.
D) risk-aware.
Answer: A
3- ________ is the chance of loss or the variability of returns associated
with a given asset.
A) Return
B) Value
C) Risk
D) Probability
Answer: C
4- The ________ of an asset is the change in value plus any cash
distributions expressed as a percentage of the initial price or amount
invested.
A) return
B) value
C) risk
D) probability
Answer: A
Risk aversion is the behavior exhibited by managers who require a (n)
________.
A) increase in return, for a given decrease in risk
B) increase in return, for a given increase in risk
C) decrease in return, for a given increase in risk
D) decrease in return, for a given decrease in risk
Answer: B

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5- If a person requires greater return when risk increases, that person is

said to be
A) risk-seeking.
B) risk-indifferent.
C) risk-averse.
D) risk-aware.
Answer: C

6- Last year Mike bought 100 shares of Dallas Corporation common

stock for $53 per share.
During the year he received dividends of $1.45 per share. The stock is
currently selling for $60
per share. What rate of return did Mike earn over the year?
A) 11.7 percent.
B) 13.2 percent.
C) 14.1 percent.
D) 15.9 percent.
Answer: D

7- The ________ is the extent of an assetʹs risk. It is found by subtracting

the pessimistic outcome from the optimistic outcome.
A) return
B) standard deviation
C) probability distribution
D) range
Answer: D

8- Since for a given increase in risk, most managers require an increase in

return, they are
A) risk-seeking.
B) risk-indifferent.
C) risk-free.
D) risk-averse.
Answer: D
9- Which asset would the risk-averse financial manager prefer? (See
below.)

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A) Asset A.
B) Asset B.
C) Asset C.
D) Asset D.
Answer: D
10- The expected value and the standard deviation of returns for asset A
is (See below.)

A) 12 percent and 4 percent.

B) 12.7 percent and 2.3 percent.
C) 12.7 percent and 4 percent.
D) 12 percent and 2.3 percent.
Answer: B

11- The ________ the coefficient of variation, the ________ the risk.
A) lower; lower
B) higher; lower
C) lower; higher
D) more stable; higher
Answer: A

12- Given the following expected returns and standard deviations of

assets B, M, Q, and D, which asset should the prudent financial manager
select?

A) Asset B
B) Asset M
C) Asset Q
D) Asset D
Answer: A

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13- The expected value, standard deviation of returns, and coefficient of

variation for asset A are (See below.)

A) 10 percent, 8 percent, and 1.25, respectively.

B) 9.33 percent, 8 percent, and 2.15, respectively.
C) 9.35 percent, 4.68 percent, and 2.00, respectively.
D) 9.35 percent, 2.76 percent, and 0.295, respectively.
Answer: D

14- What is the market risk premium if the risk free rate is 5 percent and
the expected market return is given as follows?

A) 10.5%
B) 11.0%
C) 16.0%
D) 16.5%
Answer: B

15- Nico bought 100 shares of Cisco Systems stock for $24.00 per share
on January 1, 2002. He received a dividend of $2.00 per share at the end
of 2002 and $3.00 per share at the end of 2003. At the end of 2004, Nico
collected a dividend of $4.00 per share and sold his stock for $18.00 per
share. What was Nicoʹs realized holding period return?
A) -12.5%
B) +12.5%
C) -16.7%
D) +16.7%
Answer: B
16- A collection of assets is called a(n)
A) grouping.
B) portfolio.
C) investment.
D) diversity.
Answer: B

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17- An efficient portfolio is one that

A) maximizes risk for a given level of return.
B) maximizes return for a given level of risk.
C) minimizes return for a given level of risk.
D) maximizes return at all risk levels.
Answer: B

18- The ________ is a statistical measure of the relationship between

series of numbers.
A) coefficient of variation
B) standard deviation
C) correlation
D) probability
Answer: C

19- The goal of an efficient portfolio is to

A) maximize risk for a given level of return.
B) maximize risk in order to maximize profit.
C) minimize profit in order to minimize risk.
D) minimize risk for a given level of return.
Answer: D

20- Perfectly ________ correlated series move exactly together and have
a correlation coefficient of ________, while perfectly ________
correlated series move exactly in opposite directions and have a
correlation coefficient of ________.
A) negatively; -1; positively; +1
B) negatively; +1; positively; -1
C) positively; -1; negatively; +1
D) positively; +1; negatively; -1
Answer: D

21- Combining negatively correlated assets having the same expected

return results in a portfolio with ________ level of expected return and
________ level of risk.
A) a higher; a lower
B) the same; a higher
C) the same; a lower
D) a lower; a higher
Answer: C

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22- An investment advisor has recommended a $50,000 portfolio

containing assets R, J, and K; $25,000 will be invested in asset R, with an
expected annual return of 12 percent; $10,000 will be invested in asset J,
with an expected annual return of 18 percent; and $15,000 will be
invested in asset K, with an expected annual return of 8 percent. The
expected annual return of this portfolio is
A) 12.67%.
B) 12.00%.
C) 10.00%.
D) unable to be determined from the information provided.
Answer: B

23- Combining two negatively correlated assets to reduce risk is known

as
A) diversification.
B) valuation.
C) liquidation.
D) risk aversion.
Answer: A

24- In general, the lower (less positive and more negative) the correlation
between asset returns,
A) the less the potential diversification of risk.
B) the greater the potential diversification of risk.
C) the lower the potential profit.
D) the less the assets have to be monitored.
Answer: B

25- Combining two assets having perfectly negatively correlated returns

will result in the creation
of a portfolio with an overall risk that
A) remains unchanged.
B) decreases to a level below that of either asset.
C) increases to a level above that of either asset.
D) stabilizes to a level between the asset with the higher risk and the asset
with the lower risk.
Answer: B

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26- Combining two assets having perfectly positively correlated returns

will result in the creation of a portfolio with an overall risk that
A) remains unchanged.
B) decreases to a level below that of either asset.
C) increases to a level above that of either asset.
D) lies between the asset with the higher risk and the asset with the lower
risk.
Answer: D
27- Systematic risk is also referred to as
A) diversifiable risk.
B) economic risk.
C) nondiversifiable risk.
D) not relevant.
Answer: C

28- The purpose of adding an asset with a negative or low positive beta is
to
A) reduce profit.
B) reduce risk.
C) increase profit.
D) increase risk.
Answer: B

29- The beta of the market

A) is greater than 1.
B) is less than 1.
C) is 1.
D) cannot be determined.
Answer: C

30- Risk that affects all firms is called

A) total risk.
B) management risk.
C) nondiversifiable risk.
D) diversifiable risk.
Answer: C

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31- The relevant portion of an assetʹs risk attributable to market factors

that affect all firms is called
A) unsystematic risk.
B) diversifiable risk.
C) systematic risk.
D) none of the above.
Answer: C

32- ________ risk represents the portion of an assetʹs risk that can be
eliminated by combining assets with less than perfect positive correlation.
A) Diversifiable
B) Nondiversifiable
C) Systematic
D) Total
Answer: A

33- Unsystematic risk is not relevant, because

A) it does not change.
B) it can be eliminated through diversification.
C) it cannot be estimated.
D) it cannot be eliminated through diversification.
Answer: B

34- An investment banker has recommended a $100,000 portfolio

containing assets B, D, and F. $20,000 will be invested in asset B, with a
beta of 1.5; $50,000 will be invested in asset D, with a beta of 2.0; and
$30,000 will be invested in asset F, with a beta of 0.5. The beta of the
portfolio is
A) 1.25.
B) 1.33.
C) 1.45.
D) unable to be determined from the information provided.
Answer: C

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35- Given the information in Table 5.2, what is the expected annual
return of this portfolio?
A) 11.4%
B) 10.0%
C) 11.0%
D) 11.7%
Answer: C

36- The beta of the portfolio in Table 5.2, containing assets X, Y, and Z,
is
A) 1.5.
B) 2.4.
C) 1.6.
D) 2.0.
Answer: C

37- The beta of the portfolio in Table 5.2 indicates this portfolio
A) has more risk than the market.
B) has less risk than the market.
C) has an undetermined amount of risk compared to the market.
D) has the same risk as the market.
Answer: A

38- As randomly selected securities are combined to create a portfolio,

the ________ risk of the portfolio decreases until 10 to 20 securities are
included. The portion of the risk eliminated is ________ risk, while that
remaining is ________ risk.
A) diversifiable; nondiversifiable; total
B) relevant; irrelevant; total
C) total; diversifiable; nondiversifiable
D) total; nondiversifiable; diversifiable
Answer: C

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39- Nicole holds three stocks in her portfolio: A, B, and C. The portfolio
beta is 1.40. Stock A comprises 15 percent of the dollar value of her
holdings and has a beta of 1.0. If Nicole sells all of her investment in A and
invests the proceeds in the risk-free asset, her new portfolio beta will be:
A) 0.60.
B) 0.88.
C) 1.00.
D) 1.25.
Answer: D
40- Nico owns 100 shares of stock X which has a price of $12 per share
and 200 shares of stock Y which has a price of $3 per share. What is the
proportion of Nicoʹs portfolio invested in stock
X?
A) 77%
B) 67%
C) 50%
D) 33%
Answer: B

41- Which asset (X or Y) in Table 5.3 has the least total risk? Which has
the least systematic risk?
A) X; X.
B) X; Y.
C) Y; X.
D) Y; Y.
Answer: B
42- Using the data from Table 5.3, what is the systematic risk for a
portfolio with two -thirds of the funds invested in X and one-third
invested in Y?
A) 0.88
B) 1.17
C) 1.33
D) 1.67
Answer: C

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43- Using the data from Table 5.3, what is the portfolio expected return
and the portfolio beta if you invest 35 percent in X, 45 percent in Y, and
20 percent in the risk -free asset?
A) 12.5%, 0.975
B) 12.5%, 1.975
C) 15.0%, 0.975
D) 15.0%, 1.975
Answer: A

44- Using the data from Table 5.3, what is the portfolio expected return if
you invest 100 percent of your money in X, borrow an amount equal to
half of your own investment at the risk free rate and invest your
borrowings in asset X?
A) 15.0%
B) 22.5%
C) 25.0%
D) 27.5%
Answer: D
45- What is the expected return for asset X if it has a beta of 1.5, the
expected market return is 15 percent, and the expected risk-free rate is 5
percent?
A) 5.0%
B) 7.5%
C) 15.0%
D) 20.0%
Answer: D

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True & False

1- For the risk-seeking manager, no change in return would be
required for an increase in risk.

Answer: FALSE

Comment risk-seeking managers can accept a lower level of return for

an increase in risk. They accept this lower level of return because they are
risky lovers.

2- The return on an asset is the change in its value plus any cash
distribution over a given period of time, expressed as a
percentage of its ending value.

Answer: FALSE

Comment The return on an asset is the change in its value plus any
cash distribution over a given period of time, divided by the value of the
asset at the beginning. This can be shown in the following equation:

CF + Pt – Pt-1
R=
Pt-1
3- Investment A guarantees its holder $100 return. Investment B
earns $0 or $200 with equal chances (i.e., an average of $100) over
the same period. Both investments have equal risk.

Answer: FALSE

Comment investment A is less risky than investment B, in investment

A there is no variability in return while in investment B there is a
variability in return, and as long as the higher the variability the higher
the risk so investment B is more risky than investment A.

4- Financial risk is the chance that the firm will be unable to cover its
operating costs and is affected by a firm's revenue stability and the
structure of its operating costs (fixed vs. variable).

Answer: FALSE

Comment This is the Business Risk.

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5- The real utility of the coefficient of variation is in comparing assets

that have equal expected returns.

Answer: FALSE

Comment The real utility of the coefficient of variation is in

comparing assets that have different expected returns as in this case the
coefficient of variation will give us an additional information about the
real value of risk associated with each asset.

6- The larger the difference between an asset's worst outcome from

its best outcome, the higher the risk of the asset.

Answer: TRUE

Comment because this difference represent the range, which reflect

the variability of returns, so the higher the range the higher the variability
of returns and therefore the higher the risk.

7- An approach for assessing risk that uses a number of possible

return estimates to obtain a sense of the variability among
outcomes is called sensitivity analysis.

Answer: TRUE

Comment because both sensitivity analysis and probability

distribution are two techniques used to assess the level of risk; they
provide only indication about the level of risk. Sensitivity analysis refers
to the range (difference between highest and lowest possible outcomes)
and the higher the range the higher the variability of outcomes so the
higher the level of risk.

8- The higher the coefficient of variation, the greater the risk and
therefore the higher the expected return.

Answer: TRUE

Comment coefficient of variation measure the risk associated with 1%

of return, so the higher the coefficient of variation the higher the risk, and
since the return is the price of risk so the greater the risk the higher the
expected return.

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9- New investments must be considered in light of their impact on the

risk and return of the portfolio of assets because the risk of any
single proposed asset investment is not independent of other assets.

Answer: TRUE

Comment because the portfolio risk mainly depends on the degree of

correlation that exists between the group of assets from which the
portfolio is formed, the higher the degree of correlation the higher the
level of risk and vice versa.

10- Two assets whose returns move in the same direction and have a
correlation coefficient of +1 are each very risky assets.

Answer: FALSE

Comment because there is no direct relationship between the degree

of correlation of the two assets and the risk of each individual asset.
However, there is a direct relationship between the degree of correlation
of the two assets and the risk of the portfolio, the higher the degree of
correlation the higher the level of portfolio risk and vice versa.

11- The standard deviation of a portfolio is a function of the standard

deviations of the individual securities in the portfolio, the
proportion of the portfolio invested in those securities, and the
correlation between the returns of those securities.

Answer: TRUE

Comment because the standard deviations of the individual securities

in the portfolio is not only the factor that affect the portfolio risk,
however the portfolio risk is a function of the standard deviations of the
individual securities in the portfolio, the proportion of the portfolio
invested in those securities, and the degree of correlation between the
returns of those securities. This can be shown in the following equation:

12- Combining negatively correlated assets can reduce the overall

variability of returns.

Answer: TRUE

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Comment because there is a positive relationship between the degree

of correlation and the overall variability of returns, so the higher the
degree of correlation the higher the risk (variability of returns), and the
lower the degree of correlation the lower the risk (variability of returns).

13- Most investors are risk averse, since for a given increase in return
they require an increase in risk.

Answer: FALSE

Comment Most investors are risk averse, they demand (ask for) more
return to accept more risk.

14- In general, the lower the correlation between asset returns, the
greater the potential diversification of risk.

Answer: TRUE

Comment because there is a positive relationship between the degree

of correlation and the overall level of risk.

15- Even if assets are not negatively correlated, the lower the positive
correlation between them, the lower the resulting risk.

Answer: TRUE

Comment because there is a positive relationship between the degree

of correlation and the overall level of risk.

16- A portfolio of two negatively correlated assets has less risk than
either of the individual assets.

Answer: TRUE

Comment because the degree of correlation between the two assets

from which the portfolio is formed is negative, so the correlation
coefficient will be negative, so the overall portfolio risk will be lower
than the risk of riskless asset. This can be shown in the following
equation; the last term will be negative so the overall portfolio risk will
be less than the riskless asset.

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17- Combining uncorrelated assets can reduce risk not as effectively

as combining negatively correlated assets, but more effectively
than combining positively correlated assets.

Answer: TRUE

Comment because there is a positive relationship between the degree

of correlation and the overall level of risk. A correlation coefficient equal
zero is better than a positive correlation coefficient.

18- Assume your firm produces a good which has high sales when the
economy is expanding and low sales during a recession. This
firm's overall risk will be higher if it invests in another product
which is counter cyclical.

Answer: FALSE

Comment in case of investing in another product which is counter

cyclical the firm's overall risk will not be high as it moves in the same
direction with the market, in other words beta of this firm equal 1 (as
same as the market) so the firm's level of risk will not increase.

19- The creation of a portfolio by combining two assets having

perfectly positively correlated returns cannot reduce the
portfolio's overall risk below the risk of the least risky asset. On
the other hand, a portfolio combining two assets with less than
perfectly positive correlation can reduce total risk to a level
below that of either of the components.

Answer: TRUE

Comment because there is a positive relationship between the degree

of correlation and the overall level of risk. positively correlated is better
than perfect positive, uncorrelated is better than positively correlated,
negatively correlated is better then uncorrelated, perfect negative
correlation is better than negatively correlated.

20- Total security risk is the sum of a security's non diversifiable,

diversifiable, systematic, and unsystematic risk.

Answer: FALSE

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Comment Total Risk = Systematic Risk + Unsystematic Risk

(Non diversifiable) + (diversifiable risk)

21- Beta coefficient is an index of the degree of movement of an

asset's return in response to a change in the risk-free asset.

Answer: FALSE

Comment Beta coefficient is an index of the degree of movement of

an asset's return in response to a change in the market return, the higher
the beta the higher the risk.

22- Unsystematic risk can be eliminated through diversification.

Answer: TRUE

Comment Diversifiable risk can be eliminated through diversification

through constructing an efficient portfolio; efficient portfolio is the
portfolio that maximizes return for a given level of risk or minimizes risk
for a given level of return.

23- The beta of a portfolio is a function of the standard deviations of

the individual securities in the portfolio, the proportion of the
portfolio invested in those securities, and the correlation between
the returns of those securities.

Answer: FALSE

Comment The beta of a portfolio is a function of the beta of each

individual asset from which the portfolio is formed in addition to the
proportion of the portfolio invested in those assets (securities). This can
be shown in the following equation:

bp = (W1 X b1) + (W2 X b2) + ……….. + (Wn X bn)

24- The difference between the return on the market portfolio of

assets and the risk-free rate of return represents the premium the
investor must receive for taking the average amount of risk
associated with holding the market portfolio of assets.

Answer: TRUE

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Comment The difference between the return on the market portfolio

of assets and the risk-free rate of return represents the market risk
premium which is the premium the investor must receive for taking the
average amount of risk associated with holding the market portfolio of
assets.

28- Longer-lived assets usually are more risky because it is more

difficult to accurately forecast cash flows that occur far into the
future.

Answer: TRUE

Comment Longer-lived assets are more risky than shorter-term assets,

in general there is a positive relationship between the amount of time
period and the level of risk the longer the time period the higher the level
of risk.

29- Fixed income securities such as bonds or preferred stocks, usually

have betas equal to zero.

Answer: TRUE

Comment because they are fixed income securities, their holders will
receive constant fixed payments periodically, there is no variability in
return exist, so their betas are supposed to be equal to zero.

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Important problems
Problem 1:
Perry purchased 100 shares of Ferro, Inc. common stock for $25 per share
one year ago. During the year, Ferro, Inc. paid cash dividends of $2 per
share. The stock is currently selling for $30 per share. If Perry sells all of
his shares of Ferro, Inc. today, what rate of return would he realize?

Problem 2:
Tim purchased a bounce house one year ago for $6,500. During the year
it generated $4,000 in cash flow. If Time sells the bounce house today, he
could receive $6,100 for it. What would be his rate of return under these
conditions?

Problem 3:
Asset A was purchased six months ago for $25,000 and has generated
$1,500 cash flow during that period. What is the assetʹs rate of return if it
can be sold for $26,750 today?

Problem 4:
Assuming the following returns and corresponding probabilities for asset
A, compute its standard deviation and coefficient of variation.

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Problem 5:
Champion Breweries must choose between two asset purchases. The
annual rate of return and related probabilities given below summarize the
firmʹs analysis.

For each asset, compute

(a) the expected rate of return.
(b) the standard deviation of the expected return.
(c) the coefficient of variation of the return.
(d) Which asset should Champion select?

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Problem 6:
The College Copy Shop is in process of purchasing a high-tech copier. In
their search, they have gathered the following information about two
possible copiers A and B.

(a) Compute expected rate of return for each copier.

(b) Compute variance and standard deviation of rate of return for each
copier.
(c) Which copier should they purchase?

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Problem 7:
Akai has a portfolio of three assets. Find the expected rate of return for
the portfolio assuming he invests 50 percent of its money in asset A with
10 percent rate of return, 30 percent in asset B with a rate of return of 20
percent, and the rest in asset C with 30 percent rate of return.

Problem 8:
Metal Manufacturing has isolated four alternatives meeting its need for
increased production capital. The date gathered relative to each of these
alternatives is summarized in the following table.
Alternatives Expected Return Standard Deviation of
Return
A 20% 7.0%
B 2.2 9.5$
C 19 6.0
D 16 5.5

A. Calculate the Coefficient of variation for each alternative.

B. If the firm wishes to minimize risk, which alternative do you
recommend? Why?
Answer
7%
A. 𝐶𝑉 = = 0.3500
20%

79.5%
B. 𝐶𝑉 = = 0.4318
22%

76%
C. 𝐶𝑉 = = 0.3158
19%

5.5%
D. 𝐶𝑉 = = 0.3438
16%

A. Asset C has the lowest coefficient of variation and is the least risky
relative to the other choices.

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Dr/ Ahmed Ghanim

Problem 9:
You have been given the return data shown in the first table on three
assets – F,G and H- over the period 2004 -2007.
Expected returns
Year Asset F Asset G Asset H
2004 16% 17% 14%
2005 17 16 15
2006 18 15 16
2007 19 14 17

Using these assets, you have isolated the three investment alternatives
shown in the following table:
Alternative Investment
1 100% of asset F
2 50% of asset F and 50% of asset G
3 50% of asset F and 50% of asset H

A. Calculate the expected returns over the 4-years period for each of the
three alternatives.
B. Calculate the standard deviation of returns over the 4-years period for
each of the three alternatives.
C. Use your finding in parts A and b to calculate the coefficient of
variation for each of the three alternatives.
D. On the basis of your finding, which of the three alternatives do you
recommend? Why?

A. Expected portfolio return:

Alternatives 1: 100% asset F
16% + 17% + 18% + 19%
rᵨ = = 17.5%
4

Alternatives 2: 50% asset F & 50% asset G

Asset F
Year (WF × rF)
2010 (16% × 0.50 = 8.0%) +
2011 (17% × 0.50 = 8.5%) +
2012 (18% × 0.50 = 9.0%) +
2013 (19% × 0.50 = 9.05%) +
Assets G portfolio returns
+ (WG × rG) = rᵨ
(17% × 0.50 = 8.5%) = 16.5%
(16% × 0.50 = 8.0%) = 16.5%
(15% × 0.50 = 7.5%) = 16.5%
(14% × 0.50 = 7.0%) = 16.5%

16.5% + 16.5% + 16.5% + 16.5%

rᵨ = = 16.5%
4

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Dr/ Ahmed Ghanim

Alternatives 3: 50% asset F + 50% asset H

Asset F
Year (WF × rF)
2010 (16% × 0.50 = 8.0%) +
2011 (17% × 0.50 = 8.5%) +
2012 (18% × 0.50 = 9.0%) +
2013 (19% × 0.50 = 9.05%) +
Assets G portfolio returns
+ (WG × rG) = rᵨ
(14% × 0.50 = 7.0%) = 15.0%
(15% × 0.50 = 7.5%) = 16.0%
(16% × 0.50 = 8.0%) = 17.0%
(17% × 0.50 = 8.5%) = 18.0%

15.0% + 16.0% + 17.0% + 18.0%

rᵨ = = 16.5%
4

B. Standard deviation:
1.

𝐹
(16.0% − 17.5%)2 + (17.0% − 17.5%)2 + (18.0% − 17.5%)2
[ ]
√ +(19.0% − 17.5%)2
=
4−1

(−1.5%)2 + (−0.5%)2 + (0.5%)2

[ ]
√ +(1.5%)2
𝐹 =
3

(0.000225 + 0.000025 + 0.000025 + 0.000225)

𝐹 = √
3

0.0005
𝐹 = √ = √. 000167 = 0.01291 = 1.291%
3

[(16.5%−16.5%)2 +(16.5%−16.5%)2 +(16.5%−16.5%)2 +(16.5%−16.5%)2 ]

2.  𝑓𝐺 = √ 4−1

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Dr/ Ahmed Ghanim

[(0)2 + (0)2 + (0)2 + (0)2 ]

 𝑓𝐺 = √
3

 𝑓𝐺 = 0

[(15.5%−16.5%)2 +(16.0%−16.5%)2 +(17.0%−16.5%)2 +(18.0%−16.5%)2 ]

3.  𝑓𝐻 = √ 4−1

[(−1.5%)2 + (−0.5%)2 + (0.5%)2 + (1.5%)2 ]

 𝑓𝐻 = √
3

(0.000225 + 0.000025 + 0.000025 + 0.000225)

 𝑓𝐻 = √
3

0.0005
𝐹𝐻 = √ = √. 000167 = 0.01291 = 1.291%
3

C. Coefficient of variation:

1.291%
𝑐𝑣𝑓 = = 0.0738
17.5%

0
𝑐𝑣𝑓𝐺 = =0
16.5%

1.291%
𝑐𝑣𝑓𝐻 = = 0.0782
16.5%

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Dr/ Ahmed Ghanim

D. Summary:
rᵨ:Expected rp cvp
value
of portfolio
Alternatives 1: F 17.5 1.291% 0.0738
Alternatives 2: FG 16.5 0 0.0
Alternatives 3: FH 16.5 1.291% 0.0782

Since the assets have different expected returns, the coefficient of the
variation should be used to determine the best portfolio. Alternative 3,
with positively correlated assets, has the highest coefficient of variation
and therefore is the riskiest. An alternative 2 is the best choice; it is
perfectly negatively corrected and therefore has the lowest coefficient of
variation.

Problem 10:
Jamie peters invested $100,000 to set up the following portfolio one
year ago:
Asset cost Beta at Yearly Value roday
purchase income
A $20.000 .80 $1.600 $20.000
B 35.000 .95 1.400 36.000
C 30.000 1.50 - 34.500
D 15.000 1.25 375 16.500

A. Calculate the portfolio beta on the basic of the original cost figures.
B. Calculate the percentage return of each asset in the portfolio for
the year.
C. Calculate the percentage return of portfolio on the basis of
original cost, using income and gains during the year.
D. At the time Jamie made his investments, investors were estimating
that the market return for the coming year would be 10%. The
estimate of the risk free rate of return averaged 4% for the coming
year. Calculate an expected rate of return for each stock on the
basis of its beta and the expectations of market risk- free returns.
E. On the basis of the actual results, explain how each stock in the
portfolio performance relative to those CAPM-generated

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Dr/ Ahmed Ghanim

expectations of performance. What factors could explain these

differences?

A.

𝑏ᵨ = (0.02)(0.80) + (0.35)(0.95) + (0.30)(1.50) + (0.15)(1.25)

= 0.16 + 0.3325 + 0.45 + 0.1875 = 1.13

B.
($20,000 − $20,000) + $1,600 $1,600
𝑟𝛼 = = = 8%
$20,000 $20,000

($36,000 − $35,000) + $1,400 $2,600

𝑟𝑏 = = = 6.86%
$35,000 $35,000

($34,500 − $30,000) + 0 $4,500

𝑟𝑐 = = = 15%
$30,000 $30,000

($16,500 − $15,000) + $375 $1,875

𝑟𝑑 = = = 12.5%
$15,000 $15,000

C.
($107,000 − $100,000) + $3,375 $10,375
𝑟ᵨ = = = $10,375
$100,000 $100,000

D. 𝑟𝐴 = 4% + [0.80 × (10% − 4%)] = 8.8%

𝑟𝐴 = 4% + [0.95 × (10% − 4%)] = 9.7%
𝑟𝐴 = 4% + [1.50 × (10% − 4%)] = 13.0%
𝑟𝐴 = 4% + [1.25 × (10% − 4%)] = 11.5%
Of the four investments, only C (15% versus 13%) and D (12.5% versus 11.5%) had
actual returns that exceeded the CAPM expected return (15% versus 13%). The
underperformance could be due to any unsystematic factor that would have caused the
firm not do as well as expected. Another possibility is that the firm’s characteristics
may have changed such that the beta at the time of the purchase overstated the true
value of beta existed during that year. A third explanation is that beta, as a single
measure, may not capture all of the systematic factors that causes the expected return.
In other words, there is error in the beta estimate.

37