Sami Al-Najjar Tutorial (4) _Fin220 Ch(8): Risk & Rates of Return

Tutorial 4 Chapter 8: Risk & Rates of Return

Easy Problems
Problem 8-1 EXPECTED RETURN ( EASY )
A stock’s returns have the following distribution:
Demand for the Probability of This Rate of Return If This
Company’s Products Demand Occurring Demand Occurs
Weak 0.10 (50%)
Below average 0.20 (5%)
Average 0.40 +16%
Above average 0.20 +25%
Strong 0.10 +60%
Total 1.00

Calculate the stock’s expected

return, variance, standard deviation,
and coefficient of variation.
Solution:
expected return
r̂ = (0.1) (-50%) + (0.2) (-5%) + (0.4)(16%) + (0.2)(25%) + (0.1)(60%)
= 11.40%.

Variance
2 = (-50% – 11.40%)2(0.1) + (-5% – 11.40%)2(0.2) + (16% – 11.40%)2(0.4)+
(25% – 11.40%)2(0.2) + (60% – 11.40%)2(0.1)
2 = 712.44;
Standard deviation
 =712.44= 26.69%.
Coefficient of variation.
26.69%
CV = 11.40% = 2.34.
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Sami Al-Najjar Tutorial (4) _Fin220 Ch(8): Risk & Rates of Return

Problem 8-2 PORTFOLIO BETA ( EASY )

An individual has $35,000 invested in a stock (Zain) with a beta of 0.8 and
another stock (viva) $40,000 invested in a stock with a beta of 1.4. If these are
the only two investments in her portfolio, what is her portfolio’s beta?

Solution:
Given data:
Stock Investment Beta
Zain $35,000 0.8
Viva $40,000 1.4
Total of portfolio $75,000 ???
Portfolio’s beta:
bp = ($35,000/$75,000)x(0.8) + ($40,000/$75,000)x(1.4) = 1.12.
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Problem 8-3 REQUIRED RATE OF RETURN ( EASY )

Assume that the risk-free rate is 6% and the expected return on the market
is 13%. What is the required rate of return on a stock with a beta of
0.7?
Solution:
Given data:
rRF = 6%; rM = 13%; b = 0.7; r = ?
r = rRF + (rM – rRF) x b
r = 6% + (13% – 6%) x 0.7
r = 10.9%.
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Sami Al-Najjar Tutorial (4) _Fin220 Ch(8): Risk & Rates of Return

Problem 8-4
EXPECTED AND REQUIRED RATES OF RETURN (EASY )
rate is (rRF )5% and the market risk
Assume that the risk-free
premium is (RPM )6%.
Part 1) What is the expected return for the overall stock market?
Part 2) What is the required rate of return on a stock with a beta of 1.2?
Solution:
Problem 8-4
Data given
rRF = 5%; RPM = 6%; rM = ?, beta of overall market= 1.0
Part 1) What is the expected return for the overall stock market?

rM = 5% + (6%)x1.0 = 11%.
Part 2) What is the required rate of return on a stock
with a beta of 1.2?
Find the value of (r) when b = 1.2 = ??%

rstock = 5% + 6%X(1.2) = 12.2%.

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Sami Al-Najjar Tutorial (4) _Fin220 Ch(8): Risk & Rates of Return

Problem 8-5
BETA AND REQUIRED RATE OF RETURN (EASY )
A stock has a required return of 11%, the risk-free rate is 7%, and the market
risk premium is 4%. a. What is the stock’s beta? b. If the market risk
premium increased to 6%, what would happen to the stock’s required rate of
return? Assume that the risk-free rate and the beta remain unchanged.
Solution:
a. What is the stock’s beta?
Data given: r = 11%; rRF = 7%; RPM = 4%.
r= rRF + (rM – rRF)b
11% = 7% + 4%b
4% = 4%x b
Stock’s beta b = 1.
b. what would happen to the stock’s required rate of return?
Data given rRF = 7%; RPM = 6%; b = 1.
r = rRF + (rM – rRF)b
= 7% + (6%)1
= 13%.

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Sami Al-Najjar Tutorial (4) _Fin220 Ch(8): Risk & Rates of Return
Intermediate Problems
8-6 EXPECTED RETURNS
Stocks X and Y have the following probability distributions of expected future returns:
Probability stock(X) stock(Y)
0.1 (10%) (35%)
0.2 2% 0%
0.4 12% 20%
0.2 20% 25%
0.1 38% 45%
a. Calculate the expected rate of return, ER(Y) for Stock Y , ( ER(X) = 12%).
b. Calculate the standard deviation of expected returns, X, for Stock X (Y = 20.35%).
Now calculate the coefficient of variation for Stock Y. Is it possible that most investors
will regard Stock Y as being less risky than Stock X? Explain.

Probability Stock (X) Pi X Ri (Dev.)2 = (Dev.)2 x Prob

state (1) (2) (3) = 1*2
(Dev.) = 4
5 = (4)2 6 = 1* 5
Recession 0.10 -10% -1 -22 484 48.4
Below AVG 0.20 2 0.4 -10 100 20
AVG 0.40 12 4.8 0 0 0
Above AVG 0.20 20 4 8 64 12.8
Boom 0.10 38 3.8 26 676 67.6
SUM 1.00 12 148.4

Expected Return: 12%

Variance (Var) 148.4
Standard Deviation (Var^0.5) =: 12.198
Coefficient of Variation = STD / E(R) =: 1.017

Probability Stock (Y) Pi X Ri (Dev.)2 = (Dev.)2 x Prob

state (1) (2) (3) = 1*2
(Dev.) = 4
5 = (4)2 6 = 1* 5
Recession 0.10 -35% -3.5 -49 2401 240.1
Below AVG 0.20 0 0 -14 196 39.2
AVG 0.40 20 8 6 36 14.4
Above AVG 0.20 25 5 11 121 24.2
Boom 0.10 45 4.5 31 961 96.1
SUM 1.00 14 414

Expected Return: 14%

Variance (var) 414
Standard Deviation (Var^0.5) = : 20.347
Coefficient of Variation = STD / E(R) = : 1.453
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Sami Al-Najjar Tutorial (4) _Fin220 Ch(8): Risk & Rates of Return

8-7 PORTFOLIO REQUIRED RETURN

Suppose you are the money manager of a $4 million investment fund. The fund consists
of four stocks with the following investments and betas:
Stock Investment Beta
A $ 400,000 1.50
B $ 600,000 (0.50)
C $ 1,000,000 1.25
D $ 2,000,000 0.75
If the market’s required rate of return is 14% and the risk-free rate is 6%, what is the
fund’s required rate of return?

8-7 rRF = 6% and (rM – rRF) = 8%.

Method 1
Wi X Bi
stock Investment weight (1) beta (2)
(3) = 1 x 2
A $400,000 .10 1.50 0.15
B $600,000 .15 -0.50 -0.075
C $1,000,000 .25 1.25 0.3125
D $2,000,000 .50 0.75 0.375
$4,000,000 1.00 0.7625
$400,000 $600,000 $1,000,000 $2,000,000
Portfolio beta = (1.50) + (-0.50) + (1.25) + (0.75)
$4,000,000 $4,000,000 $4,000,000 $4,000,000
bp = (0.1)(1.5) + (0.15)(-0.50) + (0.25)(1.25) + (0.5)(0.75)
= 0.15 – 0.075 + 0.3125 + 0.375 = 0.7625.

rp = rRF + (rM – rRF)(bp) = 6% + (14% – 6%)(0.7625) = 12.1%.

Method 2
Alternative solution: First, calculate the return for each stock using the CAPM
equation
[rRF + (rM – rRF)b], and then calculate the weighted average of these returns.
Ri = rRF + (rM – rRF)b Wi X Ri
stock Investment Weight (1)
Return for each stock (2) (3) = 1x2
A $400,000 .10 18.00% 1.8
B $600,000 .15 2.00% 0.3
C $1,000,000 .25 16.00% 4
D $2,000,000 .50 12.00% 6
$4,000,000 1.00 12.10

rp = 18%(0.10) + 2%(0.15) + 16%(0.25) + 12%(0.50) = 12.1%.

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Sami Al-Najjar Tutorial (4) _Fin220 Ch(8): Risk & Rates of Return
8-19 EVALUATING RISK AND RETURN
Stock X has a 10% expected return, a beta coefficient of 0.9, and a 35% standard deviation of
expected returns. Stock Y has a 12.5% expected return, a beta coefficient of 1.2, and a 25%
standard deviation. The risk-free rate is 6%, and the market risk premium is 5%.
a. Calculate each stock’s coefficient of variation.
b. Which stock is riskier for a diversified investor?
c. Calculate each stock’s required rate of return.
d. On the basis of the two stocks’ expected and required returns, which stock would be more
attractive to a diversified investor?
e. Calculate the required return of a portfolio that has $7,500 invested in Stock X and $2,500
invested in Stock Y.
f. If the market risk premium increased to 6%, which of the two stocks would have the larger
increase in its required return?

8-19 r̂X = 10%; bX = 0.9; X = 35%.

r̂Y = 12.5%; bY = 1.2; Y = 25%.

rRF = 6%; RPM = 5%.

a. CVX = 35%/10% = 3.5. CVY = 25%/12.5% = 2.0 .

b. For diversified investors the relevant risk is measured by beta. Therefore, the stock with the higher
beta is more risky. Stock Y has the higher beta so it is more risky than Stock X.

c. rX = 6% + 5%(0.9) rX = 10.5%.
rY = 6% + 5%(1.2) rY = 12%.
d. rX = 10.5%; r̂ X = 10%.
rY = 12%; r̂ Y = 12.5%.

Stock Y would be most attractive to a diversified investor since its expected return of 12.5% is
greater than its required return of 12%.

e. bp = ($7,500/$10,000)0.9 + ($2,500/$10,000)1.2 = 0.6750 + 0.30 = 0.9750.

rp = 6% + 5%(0.975) = 10.875%.

f. If RPM increases from 5% to 6%, the stock with the highest beta will have the largest increase in its
required return. Therefore, Stock Y will have the greatest increase.
Check:
rX = 6% + 6%(0.9) = 11.4%. Increase 10.5% to 11.4%. Diff = 0.9%

rY = 6% + 6%(1.2) = 13.2%. Increase 12% to 13.2%. Diff = 1.2%

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Sami Al-Najjar Tutorial (4) _Fin220 Ch(8): Risk & Rates of Return
8-21 You plan to invest in the Kish Hedge Fund, which has total capital of $500 million invested in five
stocks:
Stock Investment Stock’s Beta Coefficient
A $160 million 0.5
B $120 million 1.2
C $80 million 1.8
D $80 million 1.0
E $60 million 1.6

Kish’s beta coefficient can be found as a weighted average of its stocks’ betas. The risk-free rate is 6%,
and you believe the following probability distribution for future market returns is realistic:
Probability Market Return
0.10 -28%
0.20 0%
0.40 12%
0.20 30%
0.10 50%
a. What is the equation for the Security Market Line (SML)? (Hint: First, determine the expected market
return.)
b. Calculate Kish’s required rate of return.
c. Suppose Rick Kish, the president, receives a proposal from a company seeking new capital. The
amount needed to take a position in the stock is $50 million, it has an expected return of 15%, and its
estimated beta is 1.5. Should Kish invest in the new company? At what expected rate of return should
Kish be indifferent to purchasing the stock?
8-21 a. r̂M = 0.1(-28%) + 0.2(0%) + 0.4(12%) + 0.2(30%) + 0.1(50%) = 13%.
rRF = 6%. (given)
Therefore, the SML equation is:
ri = rRF + (rM – rRF)bi = 6% + (13% – 6%) bi = 6% + (7%)bi.
b. First, determine the fund’s beta, bF.
Wi X Bi
stock Investment Weight (1) beta (2)
(3) = 1x2
A $160 .32 0.50 0.16
B $120 .24 1.20 0.288
C $80 .16 1.80 0.288
D $80 .16 1.00 0.16
E $60 .12 1.60 0.192
$500 1.00 1.0880
Next, use bF = 1.088 in the SML determined in Part a:
r̂F = 6% + (13% – 6%)1.088 = 6% + 7.616% = 13.616%.

c. rN = Required rate of return on new stock = 6% + (7%)1.5 = 16.5%.

An expected return of 15% on the new stock is below the 16.5% required rate of return on an investment with a
risk of b = 1.5. Since rN = 16.5% > r̂N = 15%, the new stock should not be purchased. The expected rate of
return that would make the fund indifferent to purchasing the stock is 16.5%.
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Sami Al-Najjar Tutorial (4) _Fin220 Ch(8): Risk & Rates of Return