10.

Returns and Standard Deviations [LO1] Consider the following information:

State of Economy Prob of state of Rate of return if state occurs

Economy Stock A Stock B Stock C
Boom .15 .30 .45 .33
Good .45 .12 .10 .15
Poor .35 .01 -.15 -.05
Bust .05 -.06 -.30 -.09

a. Your portfolio is invested 30 percent each in A and C, and 40 percent in B. What is the expected
return of the portfolio?

b. What is the variance of this portfolio? The standard deviation?

a.

Stock A: EA = 0.15 *0.3 +0.45 *0.12 + 0.35*0.01 + 0.05*(-0.06)= 0.0995 = 9.995%

Stock B: EB = 0.15 *0.45 + 0.45*0.1 - 0.35*0.15 - 0.05*0.3 = 0.045 = 4.5%

Stock C: Ec = 0.15 *0.33 + 0.45*0.15 - 0.35*0.05 - 0.05*0.09 = 0.095 = 9.5%

 EP = 0.3 * 0.0995 + 0.4 * 0.045 + 0.3 * 0.095 = 0.07635 = 7.635%

b.

State of Prob of state Rate of return if state occurs Portfolio

Economy of Economy Stock A Stock B Stock C

Boom .15 .30 .45 .33 0.369

Good .45 .12 .10 .15 0.121
Poor .35 .01 -.15 -.05 -0.072
Bust .05 -.06 -.30 -.09 -0.165

Variance = 0.15 * (0.369 -0.076)2 + 0.45 *(0.121 - 0.076)2+0.35 * (-0.072 - 0.076)2 +0.05 *(-0.165 -0.076)2
= 0.02435905
S.D = 0.1560 = 15.6%

15. Using CAPM [LO4] A stock has an expected return of 13.5 percent, its beta is 1.17, and the risk-free
rate is 5.5 percent. What must the expected return on the market be?

E(RA ) = Rf + A (E(RM) – Rf ) = 5.5% +1.17 (EM – 5.5%) = 13.5%

 EM = 12.34%
19. Reward-to-Risk Ratios [LO4] Stock Y has a beta of 1.3 and an expected return of 18.5 percent.
Stock Z has a beta of .70 and an expected return of 12.1 percent. If the risk-free rate is 8 percent and
the market risk premium is 7.5 percent, are these stocks correctly priced?

Stock Y: E(RY ) = Rf + Y (E(RM) – Rf ) = 8% + 1.3 * 7.5% = 17.75%

Stock Z: E(RZ ) = Rf + Z (E(RM) – Rf ) = 8% + 0.7 * 7.5% = 13.25%

These stocks are not correctly priced