Corporate Financial Strategy Tutorial 3

Risk and Return, Portfolio Theory, and the CAPM

1. A game of chance offers the following odds and payoffs. Each play of the
game costs $100, so the net profit per play is the payoff less $100.

Probability Payoff Net Profit

0.10 $500 $400
0.50 100 0
0.40 0 -100

What are the expected cash payoff and expected rate of return? Calculate the
variance and standard deviation of this rate of return.

2. What is the beta of each of the shares show in the table?

Share return if market return is:

Share -10% +10%
A 0 +20
B -20 +20
C -30 0
D +15 +15
E +10 -10

3. True or false?
(a) Investors prefer diversified companies because they are less risky.
(b) If shares were perfectly positively correlated, diversification would not reduce
risk.
(c) Diversification over a large number of assets completely eliminates risk.
(d) Diversification works only when assets are uncorrelated.
(e) A share with a low standard deviation always contributes less to portfolio risk
than a share with a higher standard deviation.
(f) The contribution of a share to the risk of a well-diversified portfolio depends on
its market risk.
(g) A well-diversified portfolio with a beta of 2.0 is twice as risky as the market
portfolio.
(h) An undiversified portfolio with a beta of 2.0 is less than twice as risky as the
market portfolio.
4. Hyacinth Macaw invests 60% of her funds in share I and the balance in share
J. The standard deviation of returns on I is 10%, and on J it is 20%. Calculate the
variance of portfolio returns assuming that:

(a) The correlation between the returns is 1.0.

(b) The correlation is 0.5.

(c) The correlation is 0.

5. For each of the following pairs of investments, state which would always be
preferred by a rational investor (assuming that these are the only investments
available to the investor):
(a) Portfolio A r = 18% σ = 20%
Portfolio B r = 14% σ = 20%
(b) Portfolio C r = 15% σ = 18%
Portfolio D r = 13% σ = 8%
(c) Portfolio E r = 14% σ = 16%
Portfolio F r = 14% σ = 10%

6. True or false?

(a) The CAPM implies that if you could find an investment with a negative beta,
its expected return would be less than the interest rate.

(b) The expected return on an investment with a beta of 2.0 is twice as high as
the expected return on the market.

(c) If a share lies on the security market line, it is undervalued.

7. Consider a three-factor APT model. The factors and associated risk premiums
are:

Factor Risk premium

Change in GNP 5%
Change in energy prices -1
Change in long-term interest rates +2

Calculate expected rates of return on the following shares. The risk-free rate is
7%.

(a) A share whose return is uncorrelated with all three factors.

(b) A share with average exposure to each factor (i.e. with b = 1 for each).

(c) A pure-play energy share with high exposure to the energy factor (b = 2) but
zero exposure to the other two factors.

(d) An aluminium company share with average sensitivity to changes in interest

rates and GNP, but negative exposure of b = -1.5 to the energy factor.