Realized Rates of Returns:

Stocks A and B have the following historical returns:

Year Stock A's Returns, Stock B's

rA Returns, rB
2x15 -24.25% 5.50%
2x16 18.50% 26.73%
2x17 38.67% 48.25%
2x18 14.33% -4.50%
2x19 39.13% 43.86%
a. Calculate the average rate of return for each stock during the period 2x15 through 2x19. Assume
that someone held a portfolio consisting of 50% of Stock A and 50% of Stock B. What would have
been the realized rate of return on the portfolio in each year from 2x15 through 2x19? What
would have been the average return on the portfolio during that period?

b. Calculate the standard deviation of returns for each stock.

Year Stock A's Returns, rA Stock B's Returns, rB Portfolio AB

2x15 -24.25% 5.50% -9.38%
2x16 18.50% 26.73% 22.62%
2x17 38.67% 48.25% 43.46%
2x18 14.33% -4.50% 4.92%
2x19 39.13% 43.86% 41.50%
Average return 17.28% 23.97% 20.62%
Standard Dev. 25.84% 23.15% 22.96%

c. Assume the risk-free rate during this time was 3.5%. What are the Sharpe ratios for Stocks A and
B over this time period using their average returns?

Sharpe= (Return – Risk free rate)

Standard dev.

Stock A Stock B

Sharpe= (17.28% - 3.5%) Sharpe= (23.97% - 3.5%)

25.84% 23.15%

Sharpe= 0.53 Sharpe= 0.88

Beta and the Required Rate of Return:
ECRI Corporation is a holding company with four (4) main subsidiaries. The percentage of its capital
invested in each of the subsidiaries (and their respective betas) is as follows:
 Subsidiary Percentage of Beta
Capital
Electric Utility 60% 0.70
Cable Company 25% 0.90
Real Estate Development 10% 1.30
International/Special Projects 5% 1.50

a. What is the holding company’s beta?

Company’s beta= (60% x 0.70) + (25% x 0.90) + (10% x 1.30) + (5% x 1.50) = 0.85

b. If the risk-free rate is 4% and the market risk premium is 5%, what is the holding company’s
required rate of return?

Required rate return= Risk free rate + market risk premium x company’s beta

Required rate return= 4% + (5%) x 0.85= 8.25%

c. ECRI is considering a change in its strategic focus; it will reduce its reliance on the electric utility
subsidiary, so the percentage of its capital in this subsidiary will be reduced to 50%. At the same
time, it will increase its reliance on the international/special projects division, so the percentage of
its capital in that subsidiary will rise to 15%. What will the company’s required rate of return be
after these changes?

Company’s new beta= (50% x 0.70) + (25% x 0.90) + (10% x 1.30) + (15% x 1.50) = 0.93

Required rate of return after these changes= 4% + (5%) x 0.93 = 8.65%