CHAPTER 4: Risk and Return: An Overview of Capital Market Theory

Problem 1

Purchase price of L&T’s share 212

Number of shares purchased –
1 Jan. 2004 100
Share price on sale after one year –
31 Dec. 2004 215
Total dividend received 700
Capital gain per share: 215 ⫺ 212 3
Total capital gain: 3 ⫻ 100 300
Total return: 700 ⫹ 300 1000
Percentage return: 1,000/(212 ⫻
100) 4.72%

Problem 2

Closing price last year, Rs 50

Dividend per share, Rs 5
Closing price current year, Rs 57
Dividend yield: 5/50 10%
Capital gain percentage: (57 –
50)/50 14%
Percentage total share return: 5/50
⫹ (57 – 50)/50 24%

Problem 3

Purchase price, Rs 87
Number of shares purchased 200
Total price paid for shares, Rs 17,400
Par value of Telco’s share, Rs 10
Dividend rate 15%
Dividend per share (Rs): 10 ⫻ 15% 1.5
Total dividend (Rs): 1.50 ⫻ 200 300
Realised amount from sale of
shares after one year, Rs 18,500
Capital gain: 18,500 – 17,400 1,100
Dividend yield: 1.50/87 or
300/17,400 1.72%
Capital gain percentage:
1,100/17,400 6.32%
Total rupee return: 300 ⫹ 1,100 1,400
Total percentage return: 1,400/17,
400 or 1.72% ⫹ 6.32% 8.05%
 Chapter 4
Problem 4

90 125 + 4,535
4, 250 = +
(1 + r )1 (1 + r ) 2

By trial and error = 5.8%

Problem 5

Nominal rate of return 17%

Inflation rate 5.50%
Real rate of return:1.17 ⫽ (1 ⫹
real rate) ⫻ (1.055)
Real rate ⫽ 1.17/1.055 ⫺ 1 10.90%

Problem 6

Share price – Hind & Nirmala -

two years ago, Rs 100
Fall in Hind price-after one year ⫺12%
Increase in Hind price after two
years 12%
Hind’s share price after two years,
Rs: 100 ⫻ 0.88 ⫻ 1.12 98.56
Fall in Nirmala’s price – after
one year 12%
Increase in Nirmala’s price after
two years ⫺12%
Nirmala’s share price after two
years, Rs: 100 ⫻ 1.12 ⫻ 0.88 98.56

Problem 7

7-year holding period return:

(1.153 ⫻ 0.945 ⫻ 1.173 ⫻1.25 ⫻ 1.168 ⫻1.095 ⫻ 1.288) ⫺1 ⫽ 1.63 or 163% 1.63 1.63
Compound rate of return:
1.15 1.15
= 7 1.153 × 0.945 × 1.173 ×1.25 × 1.168 ×1.095 × 1.288 −1 = 1.15 or 115%

Problem 8

Year Return, r (ri ⫺ 9.7%)2

1 5.30% 0.19%
2 15.60% 0.35%
3 ⫺7.30% 2.88%
4 15.00% 0.28%
5 19.80% 1.02%
Sum 48.40% 4.73%
Average 9.68%
Variance 0.0118317
Stdev 0.108773618 10.88%
 Risk and Return: An Overview of Capital Market Theory

Problem 9

(ri
⫺12.73%)2
Year Return, r Prob. r ⫻ prob. ⫻ Prob
Rapid growth 19.50% 0.15 2.93% 0.07%
Moderate growth 14.00% 0.55 7.70% 0.01%
Recession 7.00% 0.3 2.10% 0.10%
Expected return 12.73%
Variance 0.18%
Stdev 4.20%

Problem 10

Expected Square of
Return, ER Deviation Deviation Product
Return, Ri Probability,p Rip (Ri ⫺ ER) (Ri ⫺ ER) (Ri - ER)2p
2

20 0.10 2.0 8.1 65.61 6.56

18 0.45 8.1 6.1 37.21 16.74
8 0.30 2.4 ⫺3.9 15.21 4.56
0 0.05 0.0 ⫺11.9 141.61 7.08
⫺6 0.1 ⫺0.6 ⫺17.9 320.41 32.04
å(Ri ⫺ ER) 2

ER 11.9 p 66.99
STDEV, s 66.99 = 8.18 8.18

Problem 11

Security X

Return Probability Sq.

p Exp. Return Deviation Deviation Product
Rx ER ⫽ Rxp (Rx - ER) (Rx - ER) (Rx - ER)2p 2

30 0.1 3 19 361 36.1

20 0.2 4 9 81 16.2
10 0.4 4 ⫺1 1 0.4
5 0.2 1 ⫺6 36 7.2
⫺10 0.1 ⫺1 ⫺21 441 44.1
å
(Rx ⫺ ERx)2
ER 11 å(Rx ⫺ ER)2 p
920 104
STDEV, s 104 = 10.2 10.20
 Chapter 4

Security Y

Return Probability Sq.

p Exp. Return Deviation Deviation Product
Ry ER ⫽ Ryp (Ry - ER) (Ry - ER) (Ry- ER)2p 2

⫺20 0.05 ⫺1.0 ⫺40.5 1640.25 82.0125

10 0.25 2.5 ⫺10.5 110.25 27.5625
20 0.30 6.0 ⫺0.5 0.25 0.075
30 0.30 9.0 9.5 90.25 27.075
40 0.1 4.0 19.5 380.25 38.025
ERy 20.5 å(Ry ⫺ ER)2 å(Ry - ER)2p
2221.25 174.75
STDEV, s 174.45 = 13.22 13.22

Portfolio of Security XY

Covariance
Probability, Deviation, Dev. x Probability, Deviation, Dev. x
X X Prob. Y Y Prob. (Rx ⫺ ERx)p
px (Rx ⫺ ERx) (Rx ⫺ ERx)p py (Ry ⫺ Ery) (Ry ⫺ Ery) p x (Ry⫺Ery)2p
2

0.10 19 1.9 0.05 ⫺40.5 ⫺2.03 ⫺3.85

0.20 9 1.8 0.25 ⫺10.5 ⫺2.63 ⫺4.73
0.40 ⫺1 ⫺0.4 0.30 ⫺0.5 ⫺0.15 0.06
0.20 ⫺6 ⫺1.2 0.30 9.5 2.85 ⫺3.42
0.10 ⫺21 ⫺2.1 0.10 19.5 1.95 ⫺4.10
Covxy ⫺16.03

Var. X Var. Y Weight X Sq. weight X Weight Y Sq weight Y Cov. XY Var XY SD XY

varx vary wx w2x wy w y2 covxy varxy sxy
104 174.75 0.5 0.25 0.5 0.25 ⫺16.03 61.67 7.85

The formula for calculating the standard deviation of portfolio of X and Y securities is as follows:

σ p = σ x2 × wx2 + σ y2 × wy2 + 2 wx wy cov arxy

= 104× 0.25 + 174.75× 0.25 + 2 × 0.5× 0.5×−16.03
= 61.67 = 7.85

Problem 12

Security P

Exp. ret Deviation Deviation sq.

Probability, p Return, RP RP⫻ Pp (RP ⫺ ERP) (RP ⫺ ERP)2 (RP ⫺ ERP)2p
0.3 30 9 13 169 50.7
0.4 20 8 3 9 3.6
0.3 0 0 ⫺17 289 86.7
ER 17 varP 141
STDEV, σP 11.87
 Risk and Return: An Overview of Capital Market Theory

Market portfolio M
Return , RM Exp. ret. Deviation Deviation sq. [(RP⫺ERP) [(RP⫺ERP)

RM ⫻ pM (RM⫺ERM) (RM⫺ERM)2 (RM⫺ERM)2pM (RM⫺ERM)] (RM⫺ERM)]p

⫺10 ⫺3 ⫺24 576 172.8 ⫺312 ⫺93.6

20 8 6 36 14.4 18 7.2
30 9 16 256 76.8 ⫺272 ⫺81.6
ERM 14 varM 264 covarPM ⫺168
σM 16.25

P M
Standard
deviation 11.87 16.25
Covariance ⫺168
Correlation corrPM ⫽ covarPM/sM sP ⫺0.871
Beta bata ⫽ corrPMsPsM / s M
2
⫺0.636

Problem 13

Return
Share Treasury Risk
Year portfolio Bills premium
1 22.50% 11.40% 11.10%
2 ⫺6.80% 9.80% ⫺16.60%
3 26.80% 10.50% 16.30%
4 24.60% 9.90% 14.70%
5 3.20% 9.20% ⫺6.00%
6 15.70% 8.90% 6.80%
7 12.30% 11.20% 1.10%
Average 14.04% 10.13% 3.91%

Realised premium is based on historical data, and as we can see from the above table, in some years it can be negative. The average risk premium
is expected to be positive when a very long period of time, covering various phases of economic cycles, is considered.

Problem 14

Return Expected return

Treasury Treasury Risk
Economic state Prob. Market Bills Market Bills premium
Growth 0.2 28.50% 9.70% 5.70% 1.94% 3.76%
Decline 0.3 ⫺5.00% 9.50% ⫺1.50% 2.85% ⫺4.35%
Stagnation 0.5 17.90% 9.20% 8.95% 4.60% 4.35%
Average 13.80% 9.47% 4.38% 3.13% 1.25%
 Chapter 4

Problem 15

0 − 20.0
S= = −2.0
10.0

S equal to ⫺2 implies that zero return is positioned 2 standard deviations to the left of the expected value of the probability distributions of possible
returns. The probability of being less than 2 standard deviations from the expected value is 0.0228 (see Annexure Table F). This means that there
is 2.28% probability that the return will be zero or less. There is about 67% probability that the return would range between 10% and 30%. There
is 95% chance that the return will be between zero [20% ⫺ 2 ⫻ 10%] and 40% [20% ⫹ 2 ⫻ 10%].

Problem 16
30.0 − 22.0
S= = 0.32
25.0
S equal to 0.32 lies to the right of the expected value. From Annexure Table F, we find that there is about 12.6 % probability that the return will be
30% or more.