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BUS 328
Homework-Week 4
1) Concepts review

Question 3/ 407 We have seen that over long periods, stock investments have tended to
substantially outperform bond investments. However, it is common to observe investors
with long horizons holding entirely bonds. Are such investors irrational?

Long-term investors holding bonds while stocks tend to do well are irrational. Because
Stocks offer greater return opportunities than bonds, but stocks carry a higher risk of market
volatility. and these investors don't like high risk so even the extra return from the stock will
not attract them, and bonds used by them as a safe alternative.

3/ 442 Systematic versus Unsystematic Risk [LO3] Classify the following events as
mostly systematic or mostly unsystematic. Is the distinction clear in every case?

a. Short-term interest rates increase unexpectedly. (systematic) => this is regarded as a

systematic risk because it affects not just one business, but all enterprises.
b. The interest rate a company pays on its short-term debt borrowing is increased by its
bank.(unsystematic) => because it only affects the company's short-term debt
c. Oil prices unexpectedly decline. (systematic )=> because oil price decrease are associated
with stock market increase.
d. An oil tanker ruptures, creating a large oil spill. (unsystematic ) => because it is
Operational Risk of a particular oil company
e. A manufacturer loses a multi million-dollar product liability suit. (unsystematic )=>
because this is business risk of a specific company
f. A Supreme Court decision substantially broadens producer liability for injuries suffered
by product users.-(systematic ) => => because this case is market risk that affects the overall
market.

5. Expected Portfolio Returns [LO1] If a portfolio has a positive investment in every

asset, can the expected return on the portfolio be greater than that on every asset in the
portfolio? Can it be less than that on every asset in the portfolio? If you answer yes to
one or both of these questions, give an example to support your answer.

My answer is no. because if the expected return is less than that on every asset in the
portfolio, the business's investment will fail. According to the information I find out, "the
expected return on investment must be the average return from the assets". that means the
expected return on the portfolio must be greater than the asset with the smallest investment
value, and less than the asset with the largest value. rather than larger or smaller on every
property.

7.Portfolio Risk [LO2] If a portfolio has a positive investment in every asset, can
the standard deviation on the portfolio be less than that on every asset in the portfolio?
What about the portfolio beta?

The portfolio's standard deviation could be lower than the standard deviation of each
assets.Beta is an average whose number must be at least one greater than the Beta of each
asset.

8. Beta and CAPM [LO4] Is it possible that a risky asset could have a beta of zero?
Explain. Based on the CAPM, what is the expected return on such an asset? Is it
possible that a risky asset could have a negative beta? What does the CAPM predict
about the expected return on such an asset? Can you give an explanation for your
answer?

Beta information regarding a single stock can only give an investor a rough idea of how much
risk the stock will add to a diversified portfolio. In the CAPM, beta is utilized to compute the
value of the asset's expected return. A risky asset, in my opinion, can have a zero beta if its
specific risk (asset specific and uncorrelated with the market) is non-zero. If the beta and
particular risk of a risk-free asset are both zero, and the return variance is not zero, the asset is
risky.

2) Questions and problems

1/ 407 Investment Selection [LO4] Given that IDT Corporation was up by about
429 percent for 2010, why didn’t all investors hold this stock?

All investors do not hold this stock because when the stock price goes up they sell and they
are afraid when the stock price goes up the risk is bigger

2/407 Investment Selection [LO4] Given that First Bancorp was down by 80 percent for
2010, why did some investors hold the stock? Why didn’t they sell out before the price
declined so sharply?

they think the stock price will go up again in a short time and they hold the stock like that
because they are afraid of selling at a loss and not finding a buyer

7/ 408 Calculating Returns and Variability [LO1] Using the following returns, calculate
the arithmetic average returns, the variances, and the standard deviations for X and Y.
We have: Arithmetic average return = Sum of annual returns / Number of years

 Arithmetic average return for X = (17%+ 22% + 8% - 15% + 10% ) /5 = 0.084= 8.4%

 Arithmetic average return for Y = (23% + 34 % +11 % - 32 % + 21 %) /5 =0.114=

11.4%

Variance for X

year (n) Returns (ri) ri - rm (ri - rm)2

1 0.17 0.086 0.007396
2 0.22 0.136 0.018496
3 0.08 -0.004 0.000016
4 -0.15 -0.234 0.054756
5 0.10 0.016 0.000256
Sum ∑ ri 0.42 ∑(ri - rm)2 0.08092
Variance for X = ∑(ri - rm)2/(n-1) = 0.08092 / (5-1) =0.02023

Variance for Y:

year (n) Returns (ri) ri - rm (ri - rm)2

1 0.23 0.116 0.013456
2 0.34 0.226 0.051076
3 0.11 -0.004 0.000016
4 -0.32 -0.434 0.188356
5 0.21 0.096 0.009216
Sum ∑ ri 0.57 ∑(ri - rm)2 0.26212
Variance for Y = ∑(ri - rm)2/(n-1)= 0.26212/ (5-1)=0.06553

Standard deviation for X=√ Variance for X = √0.02023 = 0.14223

Standard deviation for Y=√ Variance for Y = √0.06553 =0.2560

13/409 Calculating Investment Returns [LO1] You bought one of Great White Shark
Repellant Co.’s 8 percent coupon bonds one year ago for $1,030. These bonds make
annual payments and mature 14 years from now. Suppose you decide to sell your bonds
today, when the required return on the bonds is 7 percent. If the inflation rate was 4.2
percent over the past year, what was your total real return on investment?

We have :

Market Price of the Bond

Face Value of the bond = $1,000

Annual Coupon Amount = 0.08 x 1000 = $80

Annual Yield to Maturity = 7%

Maturity Period = 14 Years

The Market Price of the Bond = Present Value of the Coupon Payments + Present Value of
the face Value

= $80 x [1 - (1 / (1 + r)n / r] + $1000 x 1 / (1 + r)n

=$80 x( 1 - (1 / (1 + 7%)14 / 7%) + $1000 x ( 1 - (1 / (1 + 7%)14 )

= ($80 x 8.745) + ($1000 x 0.612) = $ 1311.6

Nominal Rate of Return on the Bond

Nominal Rate of Return on the Bond = [(Annual Coupon Amount + (Change in Bond Price))
/ Current Price] x 100

= [($80 + ($1311.6 - $1,030) / $1,030] x 100

= [($80 + $281.6) / $1,030] x 100

= 35.1068 %

Real Rate of Return on Investment

Real Rate of Return on Investment = [(1+Nominal Rate of Return)/(1+Inflation Rate)] - 1

= [(1 + 0.351068) / (1 + 0.0420)] – 1

= [1.351068 / 1.0420] – 1

= 0.297 = 29.7%

1/ 443 Determining Portfolio Weights [LO1] What are the portfolio weights for a
portfolio that has 145 shares of Stock A that sell for $45 per share and 110 shares of
Stock B that sell for $27 per share?

We have: the portfolio weights for asset = total investment in that asset / total portfolio value
Total value = 145 x ($45)+ 110 x ($27) = $ 9,495

the portfolio weights for A = 145 x ($45)/ $ 9,495 =0.6872

the portfolio weights for B = 110 x ($27)/ $ 9,495 = 0.3128

2/ 444 Portfolio Expected Return [LO1] You own a portfolio that has $2,950 invested in
Stock A and $3,700 invested in Stock B. If the expected returns on these stocks are
8 percent and 11 percent, respectively, what is the expected return on the portfolio?

We have : the expected return of a portfolio = the weight of each asset times + the expected
return of each asset.

Total value = invested in Stock A + invested in Stock B = $2,950 + $3,700 = $6,650

the expected return of a portfolio = ($2,950/$6,650)x(0.08) + ($3,700/$6,650)x (0.11) = 0.096

( 9.6% )

5/444 Calculating Expected Return [LO1] Based on the following information, calculate
the expected return:

Expected return=Respective return x Respective probability

Expected return =(0.30 x (-14)) + (0.70 x 22) = 11.2%

7/ 444 Calculating Returns and Standard Deviations [LO1] Based on the following in
formation, calculate the expected return and standard deviation for the two stocks:

We have : Expected Return = [Probability(i) x Return(i)]

E (RA) = .20 x(.05) + .55 x (.08) + .25 x (.13) = 0.0865 = 8.65%

E (RB) =.20 x (-17) + .55 x (.12) + .25 x(.29) = 0.1045 =10.45%

We have : Standard Deviation = [ (Probability(i) x (Expected Return - Return(i))2)]1/2

Standard Deviation of A2 = .20x (.05- 0.0865)2 +.55 x (.08- 0.0865)2 + .25 x (.13 - 0.0865)2

= 0.00076 = (0.00076)1/2 = 0.0276 = 2.76%

Standard Deviation of B2 = .20 x (-17- 0.1045)2 + .55 x (.12 - 0.1045)2 + .25 x (.29 - 0.1045)2

= 0.2380 = (0.2380)1/2= 0.1543 = 15.43%

10/445 Returns and Standard Deviations [LO1] Consider the following information:

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/

Expected return of Boom =(30% x 0.35)+ (40% x 0.45) + (30% x 0.27) =36.60%

Expected return of Good =(30% x 0.16)+(40% x 0.10)+(30% x 0.08) =11.20%

Expected return of Boom =(30% x -0.01) + (40% x -0.06) + (30%x -0.04) = -3.90%

Expected return of Boom =(30% x -0.12) +(40%x -0.20) + (30% x -0.09) = -14.30%

Expected Return of the portfolio =0.15 x 36.60%+0.55x11.20%+0.25x-3.90%+0.05x-14.30%

=.0996 =9.96%

b. Variance of this portfolio

=0.15x(36.60%-9.96%)2+0.55x(11.20%-9.96%)2+0.25x(-3.90%-9.96%)2+0.05x(-14.30%-9.9

6%)2 =0.01848

Standard Deviation = (0.01848)1/2 =0.1359 =13.59%

11/445 Calculating Portfolio Betas [LO4] You own a stock portfolio invested 35 percent
in Stock Q, 25 percent in Stock R, 30 percent in Stock S, and 10 percent in Stock T. The
betas for these four stocks are .84, 1.17, 1.11, and 1.36, respectively. What is the
portfolio beta?

Portfolio beta=Respective beta x Respective weight

Portfolio beta =(0.35x 0.84)+(0.25x1.17)+(0.30x 1.11)+(0.10x1.36) =1.06

13/445 Using CAPM [LO4] A stock has a beta of 1.05, the expected return on the
market is 10 percent, and the risk-free rate is 3.8 percent. What must the expected
return on this stock be?

E(Ri) = 0.038 + (0.10 - 0.038) x (1.05) = 0.1031 = 10.31 %

16/445 Using CAPM [LO4] A stock has an expected return of 13.3 percent, its beta
is 1.45, and the expected return on the market is 10.5 percent. What must the risk-free
rate be?
Return on Stock =Risk free rate+ [Beta x (Market return -risk free rate ) ]

<=> 0.133 = Risk free rate + [1.45 x (.105- Risk free rate)]

<=> 0.133 =Risk free rate + 0.15225 - 1.45 Risk free rate

<=> 0.133 - 0.15225 = Risk free rate - 1.45 Risk free rate

<=> -0.09125 = -1.45 Risk free rate

=> Risk free rate = 0.01328 =1.328%

25/ 447 Analyzing a Portfolio [LO2, 4] You have $100,000 to invest in a portfolio
containing Stock X and Stock Y. Your goal is to create a portfolio that has an expected
return of 17 percent. If Stock X has an expected return of 14.8 percent and a beta of
1.35, and Stock Y has an expected return of 11.2 percent and a beta of .90, how much
money will you invest in Stock Y? How do you interpret your answer? What is the beta
of your portfolio?

We have : E(Rp)= Wx*Rx + Wy*Ry

<=>0.17= Wx* 0.148 + (1 - Wx)* 0.112

<=>0.17= 0.148Wx +0.112 - 0.112Wx

<=>0.17 - 0.112= 0.148Wx- 0.112Wx

<=>0.058= 0.036 Wx

=> Wx= 1.6111

=> Wy= 1 - 1.6111 = -0.6111

Money invested in stock Y= -0.6111 x ($100,000) = -$ 61,110

Beta of the portfolio = 1.6111 x (1.35) + (-0.6111) x(0.90) = 1.625