Group Members:

Ababao, Ralph Adamm

Bernus, Lush Jehmar
Bustamante, Kizzeah
Lecaros, Eric
Answer:

a. ri = rRF + (rM – rRF)bi = 9% + (14% – 9%)1.3 = 15.5%.

15.5% is the required rate of return on Stock i.

b(1). rRF increases to 10%:

rM
ri = increases
rRF + (rMby 1 percentage
– rRF) bi point, from 14% to 15%.
= 10% + (15% – 10%)1.3
= 16.5%

b(2). rRF decreases to 8%:

rM
ri = decreases byrRF)bi
rRF + (rM – 1%, from 14% to 13%.
= 8% + (13% – 8%)1.3
= 14.5%

c(1). ri
rM =increases to –16%:
rRF + (rM rRF)bi
= 9% + (16% – 9%)1.3
= 18.1%

c(2) rM
ri =decreases
rRF + (rMto–13%:
rRF)bi
= 9% + (13% – 9%)1.3
= 14.2%
PROBLEM 8-13 CAPM, PORTFOLIO RISK, AND RETURN:Consider the following information for Stocks X, Y, and
The returns on the three stocks are positively correlated, but they are not perfectly correlated. (That is, each of the
coefficients is between 0 and 1.)

Answer:
a. With the use of Stock X (or any stock):
9% = rRF + (rM – rRF)bX
9% = 5.5% + (rM – rRF)0.8
(rM – rRF)= 4.375% or 4.38%

b. bQ = 1/3(0.8) + 1/3(1.2) + 1/3(1.6)

bQ = 0.2667 + 0.4000 + 0.5333
bQ = 1.2.

c. rQ = 5.5% + 4.375%(1.2)
rQ = 10.75%.

d. I would expect that the portfolio's standard deviation of Fund Q should be less than 15%.
It is because the returns on the three stocks in Portfolio Q are not perfectly positively correlated
ation for Stocks X, Y, and Z.
ed. (That is, each of the correlation

e less than 15%.

ly positively correlated
Portfolio Beta
Suppose you are the manager of a mutual fund and hold a $10 million stock portfolio with a beta of
and the risk-free rate is 4%. You expect to invest an additional fund of $5 million in a number of sto
aggregated fund is expected to be 16%. What should be the average beta of the new stocks added

Given:
Risk Premium = 7% 16% = 4% + (7%) Beta
Risk-free = 4% Beta = 1.7143
Final required return = 16%
Portfolio = $10 million $10 million + $5 million = $15 million
Beta of 10 million = 1.3
Expected investment in additional fund = $5 million
1.7143 =

1.7143 =
X=
million stock portfolio with a beta of 1.3. The required market risk premium is 7%
und of $5 million in a number of stocks and the final required return of the
erage beta of the new stocks added to the portfolio?

% = 4% + (7%) Beta

million + $5 million = $15 million

$ 10,000,000 (1.3) + $ 5,000,000 (X)

$15,000,000 $15,000,000
0.867 + 0.333X
2.544
8-18
Suppose you won the lottery and had two options: (1) receiving $ 0.5 million or (2)
taking a gamble in which, at the flip of a coin, you receive $1 million if a head comes
up but receive zero if a tail comes up.
a. What is the expected value of the gample?
b. would you take the sure 0.5 million or the gample?
c. If you chose the sure $ 0.5 million, would tht indicate that you are a risk averter or a risk seeker?

d. Suppose the payoff was actually $ 0.5 million- that was the only choice. you now face the choice
investing it in a U.S. Treasury bond that will return $537,500 at the end of a year or a common stoc
that has a 50-50 chance of being worthless or worth $ 1,150,000 at the end of the year.

Answers:
A. $ 0.5 Million
B. I would take the $ 0.5 Million
C. That would make me a risk averter

D. Given: Treasury bond = $537,500

Common stock= $1,150,000

1) what is the expected dollar profit on the stock investment?

(1,150,000) x(0.5) + (0) x (0.5) = 575,000 or $ 75,000 expected dollar profit

2) What is the expected rate of return on the stock investment?

expected dollar profit / initial investment

75,000 / 500,000 = 0.15 or 15%

3) Would you invest in the bond or the stock? why?

I would invest on the T bonds rather than the stock choice because i would only
expect a 15% increase on my investment with a 50/50 risk of none of it to comeback.
I would rather choose the t bonds that can grant me a 7.5% increase and a more safer
option of investing. But for others and for some, it depends on risk aversion of person.

4) For me, the expected return needs to be at least 25%, with risk premium that isn't included in the
25%. I need the investment to be exceeding the expected rate of return to match the 50/50 risk I am
gambling. Yet, for some it depends on them.

5) My decision would not be affected, if the stock return would be perfectly positively correlated,
because the stock portfolio would also have the exact same 15% expected rate of return as the
 1. The expected profit on the T-bond investment is $37,500. what is the expected dollar profit on th
2. The expected rate of return on the T-bond inestment is 7.5%. What is the expected rate of return
verter or a risk seeker? 3. Would you invest in the bond or the stock? why?

ou now face the choice of 4.Exactly how large would the expected profit (or the expected rate of return) have to be on the
year or a common stock stock investment to make you invest in the stock, given the 7.5% return on the bond?
of the year. 5. How might your decision be affected if, rather than buying one stock for $0.5 million, you could c
portfolio consisting of 100 stocks with $5,000 invested in each? Each of these stocks has the same
characteristics as the one stock that is, a 50-50 chance of being worth zero or $11,500 at year end
correlation between return on these stocks matter? explain.

that isn't included in the

match the 50/50 risk I am

positively correlated,
rate of return as the
e expected dollar profit on the stock investment?
s the expected rate of return on the stock investment?

eturn) have to be on the

n on the bond?
for $0.5 million, you could construct a
f these stocks has the same return
zero or $11,500 at year end. Would the
A. Calculate each stock coeffiecient of variation
Coefficient of Variation =Standard Deviation /Expected Return

Coeffecient of Variation X = 35/10 = 3.5

Coeffecient of Variation Y = 25/12.5 = 2.0

B. Which stock is riskier for a diversified investor?

Y is the riskier stock because it has a higher beta of 1.2 > 0.9.

C. Calculate each stocks required rate of return

Required rate of return = riskfree rate +beta (market return - risk free rate) or riskfr

For X
0.06 + 0.9(0.05) = 0.105 = 10.5%

For Y
0.06 1.2 (0.05) = 0.12 = 12%

D. On the basis of the two stocks expected and required return, which stock would be more attract
Expected and requiered return both are large for Y so Y is better

E. Calculate the required return of a protfolia that has $7,500 invested in Stock X and $2.500 Inves

X 7,500 0.75
Y 2,500 0.25
10,000 1

Required return of portfolio= w1r1+ w2r2 = 0.75 * 0.069 +0.25 * 0.072 = 0.05175 + 0.018 = 0.0697
F. If the market risk premium increased to 6% which of the two stocks would have the larger increa

Now market risk premim is 6%

Required rate of return= riskfree rate + beta (markt return-risk free rate) or riskfree rate + beta(mar

for(x) = 0.06 + 0.9(0.06) = 0.114 or 11.4%

for (y) = 0.06 + 1.2 (0.06) = 0.132 or 13.2%

now for X increase to 11.4 from 10.5 that is of 0.9 while for Y increase to 13.2 from 12.0 that is of 1
now for y increase to 13.2 from 12.0 that is of 1.2
turn - risk free rate) or riskfree rate + beta (market risk premium)

stock would be more attractive to a diversified

n Stock X and $2.500 Invested in Stock Y

= 0.05175 + 0.018 = 0.06975 = 6.975%

would have the larger increase in its required return?

) or riskfree rate + beta(markt risk premium)

o 13.2 from 12.0 that is of 1.2 therefore Y is increanse more

 REALIZED RATES OF RETURN Stocks A and B have the following historical returns:

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

2010 -18.00% -14.50%
2011 33.00 21.80
2012 15.00 30.50
2013 -0.50 -7.60
2014 27.00 26.30

a. Calculate the average rate of return for each stock during the period 2010 through 2014.
b. Assume that someone held a portfolio consisting of 50% of Stock A and 50% of Stock B.
What would the realized rate of return on the portfolio have been each year? What would
the average return on the portfolio have been during this period?
c. Calculate the standard deviation of returns for each stock and for the portfolio.
d. Calculate the coefficient of variation for each stock and for the portfolio.
e. Assuming you are a risk-averse investor, would you prefer to hold Stock A, Stock B, or the portfolio? W

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

2010 -18.00% -14.50% -16.25%
2011 33.00 21.80 27.40
2012 15.00 30.50 22.75
2013 -0.50 -7.60 -4.05
2014 27.00 26.30 26.65
Sum 56.50 56.50 56.50

a. Average return 11.30 11.30 11.30 b.

c. Standard deviation of returns 20.79 20.78 20.13
d. Coefficient of variation 1.84 1.84 1.78

e. If I would be a risk-averse investor, I would probably choose the portfolio over either Stock
A and Stock B because as we can see the portfolio is better than the two. Thus, it has a
lesser risk compared to Stock A and B. Moreover, the portfolio offers same expected return
too.
 Calculation for Standard Deviation (c)

Year Stock A's Returns, rA Less Average return (%)

2010 -18.00% 11.30
2011 33.00 11.30
2012 15.00 11.30
2013 -0.50 11.30
2014 27.00 11.30

Sta

ock B, or the portfolio? Why? Year Stock B's Returns, rB Less Average return (%)
2010 -14.50% 11.30
2011 21.80 11.30
2012 30.50 11.30
2013 -7.60 11.30
2014 26.30 11.30

Formula Used:
Sum÷5 years Year Portfolio Less Average return (%)
2010 -16.25% 11.30
Standard deviation ÷ Average return 2011 27.40 11.30
2012 22.75 11.30
2013 -4.05 11.30
2014 26.65 11.30
 (x-x)^2
-29.30 858.49
21.70 470.89
3.70 13.69
-11.80 139.24
15.70 246.49
1,728.80

(x-x)^2
-25.8 665.64
10.50 110.25
19.20 368.64
-18.90 357.21
15.00 225
1,726.74

(x-x)^2
-27.55 759
16.10 259.21
11.45 131.1
-15.35 235.62
15.35 235.62
1,620.55