Ch.

4: Risk and Return

CHAPTER 4

RISK AND RETURM:

AN OVERVIEW OF CAPITAL MARKET THEORY

Problem 1

Purchase price of L&T’s share, Rs 212

Number of shares purchased – 1 Jan. 2004 100
Share price on sale after one year – 31 Dec. 2004, Rs 215
Total dividend received, Rs 700
Capital gain per share: 215 – 212, Rs 3
Total capital gain: 3 × 100, Rs 300
Total return: 700 + 300, Rs 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%

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 5.5%
Real rate of return:
1.17 = (1 + real rate) × (1.055)
Real rate = 1.17/1.055 - 1 10.9%

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

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

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%
Compound rate of return:
= 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 =4.73%/(5-1) = 0.011832
Stdev =√0.011832 = 10.9%

Problem 9

Year Return, r Prob. r × prob. (ri - 9.73%)2 × Prob

Rapid growth 19.5% 0.15 2.93% 0.07%
Moderate growth 14.0% 0.55 7.70% 0.01%
Recession 7.0% 0.30 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)2 (Ri - ER)2p
20.00 0.10 2.00 8.10 65.61 6.56
18.00 0.45 8.10 16.90 37.21 16.74
8.00 0.30 2.40 -3.90 15.21 4.56
0.00 0.05 0.00 -11.90 141.61 7.08
-6.00 0.10 -0.60 -17.90 320.41 32.04
1.00 ER = 11.90 ∑(Rj - ER)2 ∑(Ri - ER)2p
= 580.05 = 66.99
STDEV, σ 66.99 = 8.18

Problem 11
Security X
Return Probability Exp. Return Deviation Sq. Deviation Product
Rx p ER = Rxp (Rx - ER) (Rx - ER)2 (Rx - ER)2p
30 0.10 3.00 19.00 361.00 36.10
20 0.20 4.00 9.00 81.00 16.20
10 0.40 4.00 -1.00 1.00 0.40
5 0.20 1.00 -6.00 36.00 7.20
-10 0.10 -1.00 -21.00 441.00 44.10
ER = 11.00 ∑(Rx - ER)2 ∑(Rx - ERx)2p
=920.00 = 104.00

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Ch. 4: Risk and Return

STDEV, σ 104 = 10.2

Security Y
Return Probability Exp. Return Deviation Sq. Deviation Product
Ry p ER = Ryp (Ry - ER) (Ry - ER)2 (Ry- ER)2p
-20 0.05 -1.00 -40.50 1640.25 82.01
10 0.25 2.50 -10.50 110.25 27.56
20 0.30 6.00 -0.50 0.25 0.08
30 0.30 9.00 9.50 90.25 27.08
40 0.10 4.00 19.50 380.25 38.03
ERy = 20.50 ∑(Ry - ER)2 ∑(Ry - ER)2p
= 2221.25 = 174.75
STDEV, σ 174.45 = 13.22

Portfolio of Security XY
Covariance
Probability, X Deviation, X Dev. x Prob. Probability, Deviation, Y Dev. x Prob. (Rx - ERx)p
px (Rx - ERx) (Rx - ERx)p Y (Ry - Ery) (Ry - Ery)2p x (Ry - Er y)2p
py
0.10 19.00 1.90 0.05 -40.50 -2.03 -3.85
0.20 9.00 1.80 0.25 -10.50 -2.63 -4.73
0.40 -1.00 -0.40 0.30 -0.50 -0.15 0.06
0.20 -6.00 -1.20 0.30 9.50 2.85 -3.42
0.10 -21.00 -2.10 0.10 19.50 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 wy2 covxy varxy σxy
104.00 174.75 0.50 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 2x × w 2x + σ 2y × w 2y + 2 w x w y cov arxy
= 104 × 0.25 + 174.75 × 0.25 + 2 × 0.5 × 0.5 × -16.03
= 6167
. = 7.85

Problem 12

Security P
Exp. ret Deviation Deviation sq.
Probability, p Return, RP RP x p P (RP - ERP) (RP - ERP)2 (RP - ERP)2p
0.3 30 9.00 13.00 169 50.7
0.4 20 8.00 3.00 9 3.6
0.3 0 0.00 -17.00 289 86.7
ERP = 17.00 varP = 141
STDEV, σP 11.87

Market portfolio M
Return , RM Exp. ret. Deviation Deviation sq. [(RP - ERP) [(RP - ERP)
RM x pM (RM - ERM) (RM - ERM)2 (RM - ERM)2pM (RM - ERM)] (RM - ERM)]p
-10 -3.00 -24.00 576 172.8 -312.00 -93.6
20 8.00 6.00 36 14.4 18.00 7.2
30 9.00 16.00 256 76.8 -272.00 -81.6
ERM = 14.00 varM = 264 covarPM = -168
σM = 16.25

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

P M
Standard deviation 11.87 16.25
Covariance -168
Correlation corrPM = covarPM/σM σP -0.871
Beta bata = corrPMσPσM / σ2M -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

Economic Treasury Treasury Risk
state Prob. Market Bills Market Bills premium
Growth 0.20 28.50% 9.70% 5.70% 1.94% 3.76%
Decline 0.30 -5.00% 9.50% -1.50% 2.85% -4.35%
Stagnation 0.50 17.90% 9.20% 8.95% 4.60% 4.35%
Average 13.80% 9.47% 4.38% 3.13% 1.25%

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.