Chapter Eleven

Risk and return in capital markets

Answers to Review Questions
3. What is the intuition behind using the average annual return as a measure of expected
return?

If we believe that the distribution of possible returns for a share does not change over time, then
the historical average return is a good estimate of what to expect in the future.

4. How does standard deviation relate to the general concept of risk?

The risk of an investment is the potential for an investment’s return to be different from the
expected. Standard deviation of returns is the measure of how volatile returns have been over a
period of time. Thus, standard deviation is a good measure for how much a share’s return may
differ from its expected return.

6. Consider two local banks. Bank A has 100 loans outstanding, each for $1 million, which it
expects will be repaid today. Each loan has a 5% probability of default, in which case the
bank is not repaid anything. The chance of default is independent across all the loans.
Bank B has only one loan of $100 million outstanding that it also expects will be repaid
today. It also has a 5% probability of not being repaid. Explain the difference between the
type of risk each bank faces. Assuming you are averse to risk, which bank would you
prefer to own?

The two banks face the same probability of default on each individual loan, but in the case of
Bank A, the risk of default is spread among 100 different loans. Thus, Bank A can diversify the
risk of default among its 100 loans. Bank B has no diversification of its risk because there is only
one loan. Thus they face the same systematic risk, but Bank B faces higher unsystematic risk. If
you are risk averse, you would prefer to own Bank A.

9. What is the difference between systematic and unsystematic risk?

Systematic risk is the risk that cannot be diversified away, while unsystematic risk is the risk that
is diversifiable.

11. If you randomly select 10 shares for a portfolio and 20 other shares for a different
portfolio, which portfolio is likely to have the lower standard deviation? Why?

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 The portfolio with 20 randomly selected shares is likely to have a lower standard deviation of
returns than the portfolio with 10 randomly selected shares. The additional 10 shares should
decrease the standard deviation of returns by increasing the diversification of unsystematic risk.

13. Your spouse works for Qantas and you work for Woolworths. Is your company or your
spouse’s company likely to be more exposed to systematic risk?

Qantas Airlines is more exposed to systematic risk. Systematic risk describes the movement of
the share relative to the market. Grocery stores will perform about the same in a recession and
a boom, as consumers do not alter their purchases of groceries much. But air travel is more
sensitive to market swings, so an airline will be exposed to more systematic risk.

Answers to Problems
Note: All problems in this chapter are available in MyLab Finance. An asterisk (*) indicates problems
with a higher level of difficulty.

5. The following table contains prices and dividends for a share. All prices are after the
dividend has been paid. If you bought the share on 1 January and sold it on 31 December,
what is your realised return?

Plan: Compute each period’s return as the price change + dividend divided by the initial price
(see Eq. 11.1). Then compute the annual realised return as the product of 1 + each period’s
return and then subtract the 1 (see Eq. 11.2):

Execute:
0.20   11  10  0.20   10.50  11 
R1   12% R2   2.7%
10 11
0.20   11.10  10.50  0.20   11  11.10 
R3   7.6% R4   0.9%
10.50 11.10
R = (1 + 0.12)(1 – 0.027)(1 + 0.076)(1 + 0.009) –1 = 1.183 –1 = 18.3%

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 Evaluate: The annual realised return is the compound return of the quarterly returns, taking
into account both the dividends and price changes.

7. Ten annual returns are listed in the following table.

a. What is the arithmetic average return over the 10-year period?

b. *What is the geometric average return over the 10-year period?

c. If you invested $100 at the beginning, how much would you have at the end?

Plan: For part (a), to compute the arithmetic average, use Eq.11.3. For part (b), to compute the
geometric average, take the product of 1 + each return and then take the 10th root of that
product (see ‘Finance in Focus’ on page 334). For part (c), realise that the total return computed
in part (b) before taking the average can be applied directly to the $100.

Execute:
1
a. R 
T 1
 R  R2  ...  Rn 
1

10
 19.9  16.6  18.0  50.0  43.3  1.2  16.5  45.6  45.2  3.0 
 8.05%

 0.801  1.166   1.180   0.500   1.433  

1/10

*b. R     1  3.19%
 1.012   0.835   1.456   1.452   0.970  

c. In part (b) we computed the total realised return as the product of 1 + each year’s return.
We would have earned that return on the $100, so the answer is $100(1.3683) = $136.83.

Evaluate: The geometric average return is a better representation of what actually happened.
However, the arithmetic average is a better estimate of what you can expect to happen in any
given year (if you were trying to forecast the return for next year, for example).

Diversification in share portfolios

18. You are a risk-averse investor who is considering investing in one of two economies. The
expected return and volatility of all shares in both economies is the same. In the first
economy, all shares move together—in good times all prices rise together and in bad
times they all fall together. In the second economy, share returns are independent—one

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 share increasing in price has no effect on the prices of other shares. Which economy
would you choose to invest in? Explain.
A risk-averse investor would choose the economy in which share returns are independent
because this risk can be diversified away in a large portfolio.

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Chapter Twelve
Systematic risk and the equity risk
premium

Answers to Review Questions

1. What information do you need to compute the expected return of a portfolio?

To compute the expected return of a portfolio, one needs the expected returns of each asset
in the portfolio and the weight of each asset in the portfolio.

2. What does correlation tell us?

Correlation tells us how the returns of two assets move relative to one another. A correlation
of 1 tells us that when Share A goes up, Share B always goes up. A correlation of –1 tells us
that when Share A goes up, Share B always goes down.

Answers to Problems
Note: All problems in this chapter are available in MyLab Finance. An asterisk ( * ) indicates problems
with a higher level of difficulty.

The expected return of a portfolio

4.You have $70 000. You put 20% of your money in a share with an expected return of
12%, $30 000 in a share with an expected return of 15% and the rest in a share with an
expected return of 20%. What is the expected return of your portfolio?

Plan: Compute the weights on each investment and then, matching those weights to the
expected returns, compute the expected return of the portfolio using Eq. 12.3.

Execute:

$30,000/$70,000 = 42.86%, which is the weight on the second share. Since the weights must
sum to 1, the weight on the final share is (1 – 0.4286 – 0.20), or 37.14%.

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 E[R] = (0.2)(0.12) + (0.4286)(0.15) + (0.3714)(0.2) = 0.1626 = 16.26%

Evaluate: The expected return of the portfolio is a weighted average of the expected returns
of the share. The biggest weight on any individual share in this case is the 42.86% on the share
with a 15% return.

5. There are two ways to calculate the expected return of a portfolio: either calculate the
expected return using the value and dividend stream of the portfolio as a whole, or
calculate the weighted average of the expected returns of the individual shares that
make up the portfolio. Which return is higher?

Both calculations of expected return of a portfolio give the same answer.

The volatility of a portfolio

6. If the returns of two shares have a correlation of 1, what does this imply about the
relative movements in the share prices?

If the price of one share goes up, the other share price always goes up as well. Similarly, if one
goes down, the other will also be going down.

10. The following spreadsheet contains monthly returns for Cola Corporation and Gas
Corporation for 2016. Using these data, estimate the average monthly return and
volatility for each share (see MyLab Finance for the data in Excel format).

Plan: Calculate the average monthly return and volatility for the shares of Cola Corporation
and Gas Corporation.

Execute: The mean for Cola Corp. is 2.02%; the mean for Gas Corp. is 0.79%. The standard
deviation (i.e., volatility) for Cola Corp. is 8.24%; the standard deviation for Gas Corp. is 4.25%.

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 Evaluate: Cola Corp. has a higher mean return (2.02%) than Gas Corp. (0.79%). However, Cola
Corp. has more volatility (8.24%) than Gas Corp. (4.25%). This is consistent with finance theory
– higher risk is associated with higher average return.

11. Using the spreadsheet from Problem 10 and the fact that Cola Corporation and Gas
Corporation have a correlation of 0.6083, calculate the volatility (standard deviation) of
a portfolio that is 55% invested in Cola Corporation shares and 45% invested in Gas
Corporation shares. Calculate the volatility by:

a. using Eq. 12.4; and

b. calculating the monthly returns of the portfolio and computing its volatility directly.

c. How do your results compare?

Plan: Use Eqs. 12.4 (taking the square root of the variance to find the standard deviation) and
12.3, respectively, to compute the volatility of the indicated portfolio, and compare the results.

Execute:

 0.55  0.0824    0.45   0.0425 

2 2 2 2

 
SD Rp   5.89%
2  0.55  0.45   0.6083   0.0824   0.0425 
a.
b.Monthly portfolio returns, using Eq. 12.3, based on portfolio weights of 55% for Cola Corp.
and 45% for Gas Corp.:

Date Cola return Gas return Portfolio return

Jan -10.84 -6.00 -8.662
Feb 2.36 1.28 1.874
Mar 6.60 -1.86 2.793
Apr 2.01 -1.90 0.2505
May 18.36 7.40 13.428
Jun -1.22 -0.26 -0.788
Jul 2.25 8.36 4.9995
Aug -6.89 -2.46 -4.8965
Sep -6.04 -2.00 -4.222
Oct 13.61 0.00 7.4855
Nov 3.51 4.68 4.0365
Dec 0.54 2.22 1.296
The standard deviation of these monthly portfolio returns is 5.89%.

Evaluate:

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 c.The volatility of the returns on the portfolio is the same using either method.

12. Suppose Sonic Health Care and Healthscope have the expected returns and volatilities
shown below, with a correlation of 22%.

For a portfolio that is equally invested in Sonic Health Care and Healthscope shares,
calculate:

a. the expected return;

b. the volatility (standard deviation)

Plan: Use Eqs. 12.3 and 12.4 to compute the expected return and volatility of the indicated
portfolio.

Execute: In this case, the portfolio weights are xSonic = xHealthscope = 0.50.
From Eq. 12.3: E[Rp] = (0.07)(0.5) + (0.10)(0.5) = 0.085 = 8.5%
We can take the square root of the portfolio variance equation (Eq. 12.4), to get the standard
deviation.

 0.5  0.16    0.5  0.20 

2 2 2 2

 
SD Rp   14.1%
2  0.5  0.5  0.22   0.16   0.20 

Evaluate: The portfolio would have an expected return of 8.5% and a standard deviation of
14.1%. The relatively low correlation coefficient helps reduce the risk of the portfolio.
Putting it all together: The Capital Asset Pricing Model

21. Suppose the risk-free return is 4% and the market portfolio has an expected return of
10% and a standard deviation of 16%. If CSL shares have a beta of 0.6, what is its
expected return?

Plan: Compute the expected return for CSL.

E Ri   rf   i  e  RMkt   rf   0.04  0.6  0.10  0.04   7.6%

Execute:
Evaluate: The expected return for CSL is 7.6%.

24. Suppose News Corporation shares have a beta of 1.7, whereas CBA shares have a beta
of 1. If the risk-free interest rate is 4% and the expected return of the market portfolio
is 10%, according to the CAPM:

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 a. what is the expected return of News Corp shares?

b. what is the expected return of CBA shares?

c. what is the beta of a portfolio that consists of 60% News Corp shares and 40% CBA
shares?

d. what is the expected return of a portfolio that consists of 60% News Corp shares and
40% CBA shares? (Show both ways to solve this.)

Plan: Compute the expected returns of News Corp and CBA as well as the portfolio beta. Then
compute the expected return of the portfolio.

Execute:
0.04  1.7  0.10  0.04   14.2%
a.News Corp’s expected return =
0.04  1  0.10  0.04   10%
b.CBA’s expected return =
c. Portfolio beta = (0.6)(1.7) + (0.4)(1) = 1.42
0.04  1.42  0.10  0.04   12.52%
d.Portfolio’s expected return =
or Portfolio’s Expected Return = (0.6)(14.2) + (0.4)(10) = 12.52

Evaluate: News Corp’s expected return is 14.2%, CBA’s expected return is 10%, the portfolio
beta is 1.42 and the expected return of the portfolio is 12.52%.

26. *You are analysing a share that has a beta of 1.2. The risk-free rate is 5% and you
estimate the market risk premium to be 6%. If you expect the share to have a return
of 11% over the next year, should you buy it? Why or why not?

*Plan: Compute what the expected return for a share with a beta of 1.2 should be. You should
buy the share if the expected return is 11% or less.

E Ri   0.05  1.2  0.06   12.2%

Execute:
Evaluate: No, you should not buy the share. You should expect a return of 12.2% for taking on
an investment with a beta of 1.2. But since this share only returns 11%, it does not fully
compensate you for the risk of the share, and you can find other investments that will return
11% with less risk.

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Corporate Finance/3e