Chapter 7

Risk and Return

Before You Go On Questions and Answers

(Note to instructor: There are no questions for Section 7.1.)

Section 7.2
1. What are the two components of a total holding period return?

Capital appreciation and income. This can be seen in Equation 7.1.

2. How is the expected return on an investment calculated?

The expected return is calculated as a weighted-average of the possible returns on an

investment (outcomes) where the weights are the probabilities that each of the possible
returns will be realized.

Section 7.3
1. What is the relation between the variance and the standard deviation?

The standard deviation is the square root of the variance. Alternatively, the variance
equals the standard deviation squared.

2. What relation do we generally observe between risk and return when we examine
historical returns?
 Investments with higher risks tend to have higher returns. This is illustrated in Exhibit
7.3.

3. How would we expect the standard deviation of the return on an individual stock to
compare with the standard deviation of the return on a stock index?

We would expect the standard deviation of the return on an individual stock to be greater
than the standard deviation of the return on a stock index. For an illustration, see Exhibit
7.4.

Section 7.4
1. What does the coefficient of variation tell us and how is it related to the Sharpe Ratio?

The coefficient of variation is a measure of risk per unit of return. It tells us the amount
of risk, defined as the standard deviation of returns, associated with each 1 percent of
expected return for an asset. A larger coefficient of variation indicates greater risk for
each 1 percent of return.

The Sharpe ratio differs from the coefficient of variation in two ways. First, instead of
using the total return in the calculation, with the Sharpe ratio we use the difference
between the total return and the risk free rate. Second, the Sharpe ratio is the inverse of
the coefficient of variation ratio that would be calculated using this adjusted return.
Computing the inverse of the coefficient of variation yields a measure return per unit of
risk, which some investors find more intuitive than a measure of risk for each 1 percent
of return.

2. What are the two components of total risk?

The two components of total risk are unique risk and systematic risk. Unique risk is risk
that is unique to a particular asset. This is the risk that can be eliminated through
 diversification. Systematic risk is risk that is common to all assets and cannot be
diversified away.

3. Why does the total risk of a portfolio not approach zero as the number of assets in a
portfolio becomes very large?

Because the systematic risk associated with the individual assets cannot be diversified
away. With a very large number of assets, the total risk of a portfolio will approach the
weighted average (where the weights are the fractions of total portfolio value represented
by each asset) of the systematic risks associated with each asset.

Section 7.5
1. Why are returns on the stock market used as a benchmark in measuring systematic risk?

Because the stock market portfolio is the most diversified portfolio for which good return
data are available, it is the portfolio that both comes closest to eliminating all unique risk
and has good return data. This makes the returns on the stock market a practical choice as
a benchmark for measuring the systematic risk of individual assets.

2. How is beta estimated?

Beta is estimated using regression analysis in which returns on an individual asset are
regressed against returns on the market. Beta is the slope of the regression line. This is
illustrated in Exhibit 7.11.

1. How would you interpret a beta of 1.5 for an asset? A beta of 0.75?

A beta of 1.5 indicates that the asset has 1.5 times as much systematic risk as the market.
A beta of 0.75 indicates that the asset has 75 percent as much systematic risk as the
market.
(Note to instructor: There are no questions for Section 7.6.)

Section 7.7
1. How is the expected return on an asset related to its systematic risk?

CAPM tells us that there is a linear relation between expected return and systematic risk.
With zero systematic risk, the expected return equals the risk-free rate. For systematic risk
greater than zero, the expected return on an asset increases as its systematic risk increases
and this increase is linear. This relation is illustrated in Equation 7.9.

2. What name is given to the relation between risk and expected return implied by the
CAPM?

This plot is called the Security Market Line, or SML, and is illustrated in Exhibit 7.11.

3. If an asset’s expected return does not plot on the line in question 2 above, what does that
imply about its price?

If the expected return on an asset does not plot on the SML, then this indicates that the
expected return on the asset is either too low or too high in view of its systematic risk. If
the asset plots below the SML, the expected return is too low and the price is too high. If
the asset plots above the SML, the expected return is too high and its price is too low.

Self-Study Problems

7.1 Kaaran made a friendly wager with a colleague that involves the result from flipping a
coin. If heads comes up, Kaaran must pay her colleague $15; otherwise, her colleague will
pay Kaaran $15. What is Kaaran’s expected cash flow, and what is the variance of that
cash flow if the coin has an equal probability of coming up heads or tails? Suppose
 Kaaran’s colleague is willing to handicap the bet by paying her $20 if the coin toss results
in tails. If everything else remains the same, what are Kaaran’s expected cash flow and the
variance of that cash flow?

Solution:
Part 1: E(cash flow) = (0.5 × –$15) + (0.5 × $15) = 0
σ2cash flow = [0.5 × (–$15 - $0)2] + [0.5 × ($15 – $0)2] = $225

Part 2: E(cash flow) = (0.5 × –$15) + (0.5 × $20) = $2.50

σ2cash flow = [0.5 × (–$15 – $2.50)2] + [0.5 × ($20 – $2.50)2] = $306.25

7.2 You know that the price of CFI, Inc., stock will be $12 exactly one year from today. Today
the price of the stock is $11. Describe what must happen to the price of CFI, Inc., today in
order for an investor to generate a 20 percent return over the next year. Assume that CFI
does not pay dividends.

Solution:
The expected return for CFI based on today’s stock price is ($12 – $11)/$11 = 9.09 percent,
which is lower than 20 percent. Since the stock price one year from today is fixed, then the
only way that you will generate a 20 percent return is if the price of the stock drops today.
Consequently, the price of the stock today must drop to $10. It is found by solving the
following: 0.2 = ($12 – x)/ x, or x = $10.

7.3 The expected value of a normal distribution of prices for a stock is $50. If you are 90
percent sure that the price of the stock will be between $40 and $60, then what is the
variance of the prices for the stock?

Solution:
Since you know that 1.645 standard deviations around the expected return captures 90
percent of the distribution, you can set up either of the following equations:
 $40 = $50 – 1.645σ or $60 = $50 + 1.645σ

and solve for σ. Doing this with either equation yields

σ = $6.079 and σ2 = 36.954

7.4 You must choose between investing in stock A and stock B. You have already used CAPM
to calculate the rate of return you should expect to receive for each stock given their
systematic risk and decided that the expected return for both exceeds that predicted by
CAPM by the same amount. In other words, both are equally attractive investments for a
diversified investor. However, since you are still in school and do not have a lot of money,
your investment portfolio is not diversified. You have decided to invest in the stock that
has the highest expected return per unit of total risk. If the expected return and standard
deviation of returns for stock A are 10 percent and 25 percent, respectively, and the
expected return and standard deviation of returns for stock B are 15 percent and 40 percent,
respectively, which should you choose? Assume that the risk free rate is 5 percent.

Solution: A comparison of the Sharpe ratios for the two stocks will tell you which has the
highest expected return per unit of total risk.

Stock B has the highest expected return per unit of risk.

7.5 CSB, Inc., has a beta of 1.35. If the expected market return is 14.5 percent and the risk-free
rate is 5.5 percent, what is the appropriate required return of CSB (using the CAPM)?

Solution:
 E(RCSB) = Rrf + CSB[E(RM) - Rrf] = 0.055 +1.35 × (0.145 - 0.055)] = 0.1765 or, 17.65%

Critical Thinking Questions

7.1 Given that you know the risk as well as the expected return for two stocks, discuss what
process you might utilize to determine which of the two stocks is a better buy. You may
assume that the two stocks will be the only assets held in your portfolio.

You should be looking to maximize your expected return on an investment given the
level of risk that such an investment requires the investor to bear. Therefore, you should
compare the expected return and risk associated with each of the two stocks. If the stocks
have the same expected return, then choose the stock with the lower risk. If the stocks
have the same risk, then choose the stock with the greatest expected return. If the
expected return and risk of the two assets have no common level, perhaps you should
compare the ratio of the risk/expected return to see which stock contains the least risk per
unit of expected return.

7.2 What is the difference between the expected rate of return and the required rate of return?
What does it mean if they are different for a particular asset at a particular point in time?

The required rate of return is the rate of return that investors require to compensate them
for the risk associated with an investment. The expected return will not necessarily equal
the required rate of return. The expected return can be lower, in which case the return will
not be sufficient to compensate the investor for the risk associated with the investment if
the expected return is realized. It can also be higher, in which case the expected return
will be greater than that necessary to compensate the investor for the riskiness of the
asset.
7.3 Suppose that the standard deviation of the returns on the shares of stock at two different
companies is exactly the same. Does this mean that the required rate of return will be the
same for these two stocks? How might the required rate of return on the stock of a third
company be greater than the required rates of return on the stocks of the first two
companies even if the standard deviation of the returns of the third company’s stock is
lower?

No. Because some risk can be diversified away, it is possible that two stocks with the
same standard deviation of returns can have different required rates of return. One of these
stocks can have a higher systematic risk than the other stock and, therefore, a higher
required rate of return. The third stock can have a higher required rate of return if its
systematic risk is greater than the systematic risk of the stock in the other two companies.

7.4 The correlation between stocks A and B is 0.50, while the correlation between stocks A
and C is –0.5. You already own stock A and are thinking of buying either stock B or stock
C. If you want your portfolio to have the lowest possible risk, would you buy stock B or
C? Would you expect the stock you choose to affect the return that you earn on your
portfolio?

You would buy stock C because it would result in your portfolio having a lower beta. If
you buy stock C, the required return for your portfolio would be lower than the required
return would be if you bought stock B. If the expected returns on stocks C and B equal
their required returns, then you would expect your portfolio to earn less with stock C.

7.5 The model where we know the return on a security for each possible outcome is overly
simplistic in many ways. However, even though we cannot possibly predict all possible
outcomes, this fact has little bearing on the risk-free return. Explain why.
 The risk-free security delivers the same return in all states of the world. Even though we
do not know all of the possible states of the world in future periods, we do know that the
U.S. government will be able to repay its borrowing in every state of the world. Therefore,
the shortcoming of the model does not affect the risk-free security’s return.

7.6 Which investment category has shown the greatest degree of risk in the United States since
1926? Explain why that makes sense in a world where the price of a small stock is likely to
be more adversely affected by a particular negative event than the price of a corporate
bond. Use the same type of explanation to help explain other investment choices since
1926.

Small stocks have generally been riskier than large stocks, long-term corporate bonds,
long-term government bonds, intermediate government bonds, and short-term government
bonds. The explanation for this can be best understood if we realize that small stocks will
be affected to a greater extent than the list of investments above by either good or bad
states of the world. These good and bad effects translate into a distribution with greater
spread or greater risk than the other investments.

7.7 You are concerned about one of the investments in your fully diversified portfolio. You
just have an uneasy feeling about the CFO, Iam Shifty, of that particular firm. You do
believe, however, that the firm makes a good product and that it is appropriately priced by
the market. Should you be concerned about the effect on your portfolio if Shifty embezzles
a portion of the firm’s cash?

The risk of Shifty embezzling is a nonsystematic risk that will most likely be offset by a
more fortunate event affecting another holding in your portfolio. Therefore, Shifty’s
actions should not affect the risk that you bear by investing in your diversified portfolio
(systematic risk).
7.8 The CAPM is used to price the risk in any asset. Our examples have focused on stocks, but
we could also price the expected rate of return for bonds. Explain how debt securities are
also subject to systematic risk.

A firm’s ability to repay its debt obligations will be affected in a very similar, and yet
lessened, way than the firm’s stock will be affected. That is, systematic and nonsystematic
factors will also affect returns for debt securities. However, if held in a diversified
portfolio, then only the systematic risk component will be borne and then compensated for
bearing. Therefore, we can use the CAPM to price debt securities.

7.9 In recent years, investors have correctly agreed that the market portfolio consists of more
than just a group of U.S. stocks and bonds. If you are an investor who only invests in U.S.
stocks, describe the effects on the risk in your portfolio.

If the market portfolio is composed of all assets, then the U.S.-only portfolio will probably
have a small amount of nonsystematic risk that is not providing return compensation for
that risk. Therefore, the portfolio is bearing too much risk given its expected returns.

7.10 You may have heard the statement that you should not include your home as an asset in
your investment portfolio. Assume that your house will comprise up to 75 percent of your
assets in the early part of your investment life. Evaluate omitting it from your portfolio
when calculating the risk of your overall investment portfolio.

From a systematic risk measurement perspective, omitting the beta of your real estate
investment, which does not have a beta equal to zero, could have a serious impact on your
portfolio’s perceived systematic risk. In a volatile real estate market, you could be
understating the risk in your portfolio, and in a flat real estate market, you could be
overestimating the risk in your portfolio.
Questions and Problems

BASIC

7.1 Returns: Describe the difference between a total holding period return and an expected
return.
LO 2, LO3

Solution:
The holding period return is the total return over some investment or “holding” period. It
consists of a capital appreciation component and an income component. The holding
period return reflects past performance. The expected return is a return that is based on
the probability-weighted average of the possible returns from an investment. It describes
a possible return (or even a return that may not be possible) for a yet- to-occur investment
period.

7.2 Expected returns: John is watching an old game show on rerun television called Let’s
Make a Deal in which you have to choose a prize behind one of two curtains. Behind one
of the curtains is a gag prize worth $ 150, and behind the other is a round-the-world trip
worth $7,200. The game show has placed a subliminal message on the curtain containing
the gag prize, which makes the probability of choosing the gag prize equal to 75 percent.
What is the expected value of the selection, and what is the standard deviation of that
selection?
LO 3

Solution:
E(prize) = (0 .75 × $150) + (0.25 × $7,200) = $1,912.50
σ2prize = (0.75 × ($150 – $1,912.50)2) + (0.25 × ($7,200 – $1,912.50)2 )
= $9,319,218.75

σprize = ($9,319,218.75)1/2 = $3,052.74

7.3 Expected returns: You have chosen biology as your college major because you would
like to be a medical doctor. However, you find that the probability of being accepted into
medical school is about 10 percent. If you are accepted into medical school, then your
starting salary when you graduate will be $300,000 per year. However, if you are not
accepted, then you would choose to work in a zoo, where you will earn $40,000 per year.
Without considering the additional educational years or the time value of money, what is
your expected starting salary as well as the standard deviation of that starting salary?
LO 3

Solution:
E(salary) = 0.9($40,000) + (0.1) ($300,000) = $66,000
σ2salary = 0.9($40,000 – $66,000)2 + (0.1) ($300,000 – $66,000)2 = $
$5,476,208,400σsalary = ($5,476,208,400)1/2 = $74,002.74

7.4 Historical market: Describe the general relation between risk and return that we observe
in the historical bond and stock market data.
LO 3, LO4

Solution:
The general axiom that the greater the risk, the greater the return describes the historical
returns of the bond and stock market. If we look at Exhibit 7.4 in the text, we see that
small stocks have averaged the greatest returns but that they also have the greatest
standard deviation for the returns. When compared to large stocks, the average return and
standard deviation of the small stocks are greater. Large stock average returns and
standard deviation numbers are larger than those of long-term government bonds, which
are larger than those of intermediate-term government bonds, which in turn are larger
than those of U.S. Treasury bills. The comparison shows that the riskier the investment
category, the greater the average return as well as standard deviation of returns.
7.5 Single-asset portfolios: Stocks A, B, and C have expected returns of 15 percent, 15
percent, and 12 percent, respectively, while their standard deviations are 45 percent, 30
percent, and 30 percent, respectively. If you were considering the purchase of each of
these stocks as the only holding in your portfolio and the risk free rate is 0 percent, which
stock should you choose?
LO 4

Solution:
Since the holding will be made in a completely undiversified portfolio, then we can
calculate the risk per unit of return for each stock, the coefficient of variation, and choose
the stock with the lowest value.
CV(RA) = 0.45/0.15 = 3.0
CV(RB) = 0.30/0.15 = 2.0
CV(RC) = 0.30/0.12 = 2.5 ===> Choose B
Alternatively, we could have noted that the expected return for A and B was the same,
with A having a greater degree of risk. B and C have the same degree of risk, but B has a
greater expected return. This would lead you to the conclusion, just as our coefficient of
variation calculations did, that Stock B is superior.

7.6 Diversification: Describe how investing in more than one asset can reduce risk through
diversification.
LO 5

Solution:
An investor can reduce the risk of his or her investments by investing in two or more
assets whose values do not always move in the same direction at the same time. This is
because the movements in the values of the different investments will partially cancel
each other out.

7.7 Systematic risk: Define systematic risk.

LO 6
Solution:
Risk that cannot be diversified away is called systematic risk. It is the only type of risk
that exists in a diversified portfolio, and it is the only type of risk that is rewarded in asset
markets.

7.8 Measuring systematic risk: Susan is expecting the returns on the market portfolio to be
negative in the near term. Since she is managing a stock mutual fund, she must remain
invested in a portfolio of stocks. However, she is allowed to adjust the beta of her
portfolio. What kind of beta would you recommend for Susan’s portfolio?
LO 6

Solution:
If we confine our analysis to portfolios with positive beta values, and since beta describes
how much and what direction our portfolio is expected to vary with the market portfolio,
then Susan should construct a very low beta portfolio. In that case, Susan’s portfolio is
not expected to have losses quite as large as that of the market portfolio. A large beta
portfolio would have larger losses than that of the market portfolio. If Susan could
construct a negative beta portfolio, then she would like to construct as negative a
portfolio beta as possible.

7.9 Measuring systematic risk: Describe and justify what the value of the beta of a U.S.
Treasury bill should be.
LO 6

Solution:
Since the beta of any asset is the slope of the line of best fit for the plot of an asset against
that of the market return, then we can use that logic to help us understand the beta of a T-
bill. If we purchased a T-bill five years ago and held the same T-bill through each of the
last 60 months, then the return for each of those 60 months would be exactly the same.
Therefore, the vertical axis coordinates of each of the monthly returns would have the
 same value and the slope (beta) of the line of best fit would be zero. The meaning of a
beta of zero means that our T-bill has no systematic risk. That is logical given that we
know that a T-bill has no risk at all since it is a riskless asset.

7.10 Measuring systematic risk: If the expected rate of return for the market is not much
greater than the risk-free rate of return, what is the general level of compensation for
bearing systematic risk?
LO 6

Solution:
Such a situation suggests that return compensation for investing in an asset is determined
more by the risk-free return than by the market’s compensation for bearing systematic
risk. This means that the price for bearing systematic risk is very low. This may be caused
by a very low perceived level of risk in the market or by an abundance of funds in the
market seeking to be invested in risky assets.

7.11 CAPM: Describe the Capital Asset Pricing Model (CAPM) and what it tells us.
LO 7

Solution:
The CAPM is a model that describes the relation between systematic risk and the
expected return. The model tells us that the expected return on an asset with no
systematic risk equals the risk-free rate. As systematic risk increases, the expected return
increases linearly with beta. The CAPM is written as E(Ri) = Rrf + i(E(Rm) – Rrf) .

7.12 The Security market line: If the expected return on the market is 10 percent and the
risk-free rate is 4 percent, what is the expected return for a stock with a beta equal to 1.5?
What is the market risk premium for the set of circumstances described?
LO 7

Solution:
 Following the CAPM prediction:
(Rcs) = Rrf + β (E(RM) – Rrf) = 0.04 + 1.5 × (0.1 – 0.04) = 0.13

The market risk premium is (E(RM) – Rrf) = 0.06

INTERMEDIATE

7.13 Expected returns: Jose is thinking about purchasing a soft drink machine and placing it
in a business office. He knows that there is a 5 percent probability that someone who
walks by the machine will make a purchase from the machine, and he knows that the
profit on each soft drink sold is $0.10. If Jose expects a thousand people per day to pass
by the machine and requires a complete return of his investment in one year, then what is
the maximum price that he should be willing to pay for the soft drink machine? Assume
250 working days in a year and ignore taxes.
LO 3

Solution:
E(Revenue) = 1,000 × 0.05 x $.10 × 250 days = $1,250
Therefore, the most Jose should pay for the machine is $1,250.

7.14 Interpreting the variance and standard deviation: The distribution of grades in an
introductory finance class is normally distributed, with an expected grade of 75. If the
standard deviation of grades is 7, in what range would you expect 90 percent of the
grades to fall?
LO 4

Solution:
90% is 1.645 standard deviations from the mean.

Thus, the range can be determined as:

 So, the lower end is:
75 – (1.645 × (7)) = 63.49
And the upper end is:
75 + (1.645 × (7)) = 86.52

So, 90 percent of the grades should fall between 63.49 and 86.52.

7.15 Calculating the variance and standard deviation: Kate recently invested in real estate
with the intention of selling the property one year from today. She has modeled the
returns on that investment based on three economic scenarios. She believes that if the
economy stays healthy, then her investment will generate a 30 percent return. However, if
the economy softens, as predicted, the return will be 10 percent, while the return will be a
=25 percent if the economy slips into a recession. If the probabilities of the healthy, soft,
and recessionary states are 0.4, 0.5, and 0.1, respectively, then what are the expected
return and the standard deviation for Kate’s investment?
LO 4

Solution:
E(Ri) = (0.4)(0.3) + (0.5) (0.1) + (0.1) (–.25) = 0.145

σ2return = (0.4)(0.3 – 0.145)2 + (0.5) (0.1 – 0.145)2 + (0.1) (–0.25 – 0.145)2

= 0.02623

σreturn = (0.02623)1/2 = 0.16194

7.16 Calculating the variance and standard deviation: Barbara is considering investing in a
stock, and is aware that the return on that investment is particularly sensitive to how the
economy is performing. Her analysis suggests that four states of the economy can affect
the return on the investment. Using the table of returns and probabilities below, find the
expected return and the standard deviation of the return on Barbara’s investment.
 Probability Return
Boom 0.1 25.00%
Good 0.4 15.00%
Level 0.3 10.00%
Slump 0.2 -5.00%
LO 4

Solution:
E(Ri) = 0.1 × (0.25) + (0.4) × (0.15) + (0.3) × (0.1) + (0.2) (–0.05) = 0.105

σ2return = 0.1 × (0.25 – 0.105)2 + (0.4) × (0.15 – 0.105)2 + (0.3) × (0.1 – 0.105)2 + (0.2) × (–0.5 –
0.105)2
= 0.00773

σreturn = (0.00773)1/2 = 0.08789

7.17 Calculating the variance and standard deviation: Ben would like to invest in gold and
is aware that the returns on such an investment can be quite volatile. Use the following
table of states, probabilities, and returns to determine the expected return on Ben’s gold
investment.
Probability Return
Boom 0.1 40.00%
Good 0.2 30.00%
OK 0.3 15.00%
Level 0.2 2.00%
Slump 0.2 -12.00%
LO 4

Solution
E(Ri) = 0.1 × (0.4) + (0.2) × (0.3) + (0.3) × (0.15) + (0.2) × (0.02) + (0.2) × (–0.12) = 0.125
 σ2return = 0.1 × (0.4 – 0.125)2 + (0.2) × (0.3 – 0.125)2 + (0.3) × (0.15 – 0.125)2 + (0.2) × (0.02 –
0.125)2 + (0.2) × (–0.12 – 0.125)2
= 0.02809

σreturn = (0.02809)1/2 = 0.16759

7.18 Single-asset portfolios: Using the information from Problems 7.15, 7.16, and 7.17,
calculate the coefficient of variation for each of the investments in these problems.
LO 3, LO 4

Solution:
Coefficient of variation = σReturn / E(Ri)

Problem 15: 0.16194/0.145 = 1.11684 (using the exact values rather than the printed)

Problem 16: 0.08789/0.105 = 0.83707 (using the exact values rather than the printed)

Problem 17: 0.16759/0.125 = 1.34069 (using the exact values rather than the printed)

7.19 Portfolios with more than one asset: Emmy is analyzing a two-stock portfolio that
consists of a Utility stock and a Commodity stock. She knows that the return on the
Utility has a standard deviation of 40 percent, and the return on the Commodity has a
standard deviation of 30 percent. However, she does not know the exact covariance in the
returns of the two stocks. Emmy would like to plot the variance of the portfolio for each
of three cases—covariance of 0.12, 0, and –0.12—in order to understand how the
variance of such a portfolio would react. Do the calculation for all three cases (0.12, 0 and
–0.12), assuming an equal proportion of each stock in the portfolio.
LO 5

Solution:
2 2 2 2
Var( R2 asset port )=x 1 σ 1 +x 2 σ 2 +2 x 1 x 2 σ 12
 Case 1, σ12 = 0.12:
(0.5)2 × (0.4)2 + (0.5)2 × (0.3)2 + 2 × (0.5) × (0.5) × (0.12) = 0.1225

Case 2, ρ = 0.0:
(0.5)2 × (0.4)2 + (0.5)2 × (0.3)2 + 2 × (0.5) × (0.5) × (0.0) = 0.0625

Case 3, σ12 = -0.12:

(0.5)2 × (0.4)2 + (0.5)2 × (0.3)2 + 2 × (0.5) × (0.5) × (-0.12) = 0.0025

7.20 Portfolios with more than one asset: Given the returns and probabilities for the three
possible states listed below, calculate the covariance between the returns of Stock A and
Stock B. For convenience, assume that the expected returns of Stock A and Stock B are
11.75 percent and 18 percent, respectively.

Probability Return(A) Return(B)

Good 0.35 0.30 0.50
OK 0.50 0.10 0.10
Poor 0.15 -0.25 -0.30
LO 5

Solution:

7.21 Compensation for bearing systematic risk: You have constructed a diversified
portfolio of stocks such that there is no nonsystematic risk. Explain why the expected
return of that portfolio should be greater than the expected return of a risk-free security.
LO 6
Solution:
Your portfolio contains no nonsystematic risk but it does in fact contain systematic risk.
Therefore, the market should compensate the holder of this portfolio for the systematic
risk that the investor bears. The risk-free security has no risk and therefore requires no
compensation for risk bearing. The expected return of the portfolio should therefore be
greater than the return of the risk-free security.

7.22 Compensation for bearing systematic risk: Write out the equation for the covariance in
the returns of two assets, Asset 1 and Asset 2. Using that equation, explain the easiest
way for the two asset returns to have a covariance of zero.
LO 6

Solution:

We know that all state probabilities must be greater than zero, and thus the source of a
zero covariance cannot be from the state probabilities. The easiest way for the entire
probability weighted sum to equal zero is for one of the assets, say Number 1(2), to have
a value in all states j that is equal to the expected return of Number 1(2). Another way of
saying that is for one of the assets to have a constant return in all states. If that occurs,
then the second term in the equation will always be equal to zero, causing the sum, or
covariance, to be zero.

7.23 Compensation for bearing systematic risk: Evaluate the following statement: By fully
diversifying a portfolio, such as by buying every asset in the market, we can completely
eliminate all types of risk, thereby creating a synthetic Treasury bill.
LO 6

Solution:
 The statement is false. Even if we could afford such a portfolio and thus completely
diversify our portfolio, we would only be eliminating nonsystematic risk. The systematic
risk generated by the portfolio would remain. Otherwise, the expected rate of return on
the market portfolio would be equal to the risk-free rate of return. We know that to be a
false statement.

7.24 CAPM: Damien knows that the beta of his portfolio is equal to 1, but he does not know
the risk-free rate of return or the market risk premium. He also knows that the expected
return on the market is 8 percent. What is the expected return on Damien’s portfolio?
LO 7

Solution:
Following the CAPM prediction:
(Rcs) = Rrf + β (E(RM) – Rrf) = Rrf + E(RM) – Rrf = E(RM) = 0.08 = 8.0%

7.25 CAPM: In February 2011 the risk free rate was 4.75 percent, the market risk premium
was 6 percent and the beta for Dell stock was 1.31. What is the expected return that was
consistent with the systematic risk associated with the returns on Dell stock?
LO 7

Solution: From Equation 7.10:

E(RDell stock) = Rrf + Dell stock × [E(RM) - Rrf]

E(RDell stock) = 0.045 + 1.31 × [0.060]

E(RDell stock) = 0.045 + 0.079 = 0.124, or 12.4%

7.26 CAPM: The market risk premium is 6 percent and the risk free rate is 5 percent. If the
expected return on a bond is 6.5 percent, what is its beta?
LO 7
 Solution: From Equation 7.10, we can calculate the beta of the bond as:

E(Rbond) = Rrf + bond × [E(RM) - Rrf]

0.065 = 0.050 + bond × 0.060 = 6.0%

bond = (0.065 – 0.050)/0.060 = 0.25

ADVANCED

7.27 David is going to purchase two stocks to form the initial holdings in his portfolio. Iron
stock has an expected return of 15 percent, while Copper stock has an expected return of
20 percent. If David plans to invest 30 percent of his funds in Iron and the remainder in
Copper, then what will be the expected return from his portfolio? What if David invests
70 percent of his funds in Iron stock?
LO 3

Solution:
Part 1: E(Rport) = (0.3) × (0.15) + (0.7) × (0.2) = 0.185 = 18.5%

Part 2: E(Rport) = (0.7) × (0.15) + (0.3) × (0.2) = 0.165 = 16.5%

7.28 Sumeet knows that the covariance in the return on two assets is –0.0025. Without
knowing the expected return of the two assets, explain what that covariance means.
LO 3, LO 5

Solution:
The covariance measure is dependent on the expected return of the two assets in
questions, so without the expected return of the two assets, it is difficult to characterize
the scale of the covariance. However, since the covariance is negative, we can say that
 generally the two assets move in opposite directions, with respect to their own means,
from each other in given states of nature.

7.29 In order to fund her retirement, Glenda requires a portfolio with an expected return of 12
percent per year over the next 30 years. She has decided to invest in Stocks 1, 2, and 3,
with 25 percent in Stock 1, 50 percent in Stock 2, and 25 percent in Stock 3. If Stocks 1
and 2 have expected returns of 9 percent and 10 percent per year, respectively, then what
is the minimum expected annual return for Stock 3 that will enable Glenda to achieve her
investment requirement?
LO 3, LO 5

Solution:
The formula for the expected return of a three-stock portfolio is:
E( R3 asset port ) = x 1 E( R1 ) + x 2 E( R2 )+ x 3 E( R3 )
Therefore, we can solve as in the following:
0.12 = 0.25 × (0.09) + 0.5 × (0.1) + 0.25 × E(R3)
E(R3) = 0.19 or 19.0%

7.30 Tonalli is putting together a portfolio of 10 stocks in equal proportions. What is the
relative importance of the variance for each stock versus the covariance for the pairs of
stocks? For this exercise, ignore the actual values of the variance and covariance terms
and explain their importance conceptually.
LO 4, LO 5

Solution:
The variance of the portfolio will be composed of 10 (n = 10) individual stock variance
terms and 45 ((n2 –n)/2) covariance terms (really 90). Therefore, the vast majority of the
portfolio variance calculation will be determined by the covariance terms of the portfolio
in most cases.
7.31 Explain why investors who have diversified their portfolios will determine the price and,
consequently, the expected return on an asset.
LO 3, LO 5

Solution:
If we assume that all investors will seek to be compensated (generate returns) for the level
of risk that they are bearing, then we can see that undiversified investors will require a
greater return for a given investment than diversified investors will. Given that, we can
see that diversified investors will be willing to pay a greater price for an asset than
undiversified investors. Therefore, the diversified investor is the marginal investor whose
purchase will determine the equilibrium price, and therefore the equilibrium return for an
asset.

7.32 Brad is about to purchase an additional asset for his well-diversified portfolio. He notices
that when he plots the historical returns of the asset against those of the market portfolio,
the line of best fit tends to have a large amount of prediction error for each data point (the
scatter plot is not very tight around the line of best fit). Do you think that this will have a
large or a small impact on the beta of the asset? Explain your opinion.
LO 5

Solution:
It will have no effect on the beta of the asset. The beta measures only the systematic risk
or variation in the returns of the asset. The prediction error reflects the nonsystematic risk
inherent in the returns of the asset and will consequently not affect the beta of the asset.

7.33 The beta of an asset is equal to 0. Discuss what the asset must be.
LO 7

Solution:
Following the CAPM prediction:
(Rcs) = Rrf + β (E(RM) – Rrf) = Rrf + 0 (E(RM) – Rrf) = Rrf
 Therefore, the expected return on the asset is equal to the risk-free rate of return. The only
way an asset could generate a risk-free rate of return is if the asset had no systematic risk
(otherwise the asset would have to compensate an investor for such risk bearing). This
implies that the asset must be the riskless asset, or, practically speaking, it must be a T-
bill.

7.34 The expected return on the market portfolio is 15 percent, and the return on the risk-free
security is 5 percent. What is the expected return on a portfolio with a beta equal to 0.5?
LO 7

Solution:
The beta of the market portfolio is equal to 1. Therefore, we can use the Security Market
Line graph to determine the halfway point between the point (1, 15%) and the point (0,
5%). We can then average the first and second values of the two coordinates to arrive at
((1 + 0)/2, (15% + 5%), 2) or (0.5, 10%), which means that the expected return of a
portfolio with a beta equal to 0.5 is 10 percent.

7.35 Draw the Security Market Line (SML) for the case where the market risk premium is 5
percent and the risk-free rate is 7 percent. Now, suppose an asset has a beta of –1.0 and an
expected return of 4 percent. Plot it on your graph. Is the security properly priced? If not,
explain what we might expect to happen to the price of this security in the market. Next,
suppose another asset has a beta of 3.0 and an expected return of 20 percent. Plot it on the
graph. Is this security properly priced? If not, explain what we might expect to happen to
the price of this security in the market.
LO 7

Solution:
The Security Market Line (SML) shows the relationship between an asset’s expected
return and its beta. We know the market has a beta of one, and we know the risk-free rate
has a beta of zero. The risk-free rate of return is 7 percent, and the market is expected to
return 5 percent more than this. Therefore, the expected rate of return for the market (a
beta one asset) is 12 percent. To draw this SML, we need only connect the dots:

18%

15%
Expected Return

12%

9%

6%

3%

0%
0 1 2
Beta

We can see from the following diagram that an asset with expected return of 4 percent
and a beta of –1.0 is underpriced (its expected return is too high). As the market becomes
aware of this underpricing, investors will purchase the asset, bidding up its price until its
expected return falls on the SML. (Recall that as the initial purchase price of an asset
increases, the expected return from purchasing the asset will decrease because you are
paying a higher initial cost for the asset.)

18%
Expected Return

15%
The investment
12% will fall here in
this plot
9%

6%

3%

0%
-1 0 1 2

Beta
 As we can see from the following diagram, an asset with a beta of 3.0 should have an
expected return of 7% + (3)(5%) = 22%. The asset only has an expected return of 20
percent. Therefore, this asset is overpriced. Demand for this asset will be low, driving
down its market price, until the asset’s expected return falls on the SML.

28%
Expected Return

23%

18%

14% The investment

will fall here in
9%
this plot
5%

0%
0 1 2 3

Beta

7.36 If the CAPM describes the relation between systematic risk and investment returns, can
both an individual asset and the market portfolio of all risky assets have negative
expected real rates of return? Why or why not?

Solution:

A negative expected real rate of return implies that the expected total rate of return is less
than the risk free rate.

1) It is possible for the beta of an individual stock to be negative. Therefore, from CAPM,
E[Ri] = Rrf + i × [E(RM) - Rrf)], it is also possible for a share of stock to have a negative
expected real rate of return.

2) It is not possible for the market portfolio to have a negative expected real rate of return
since the beta for the market equals 1.

LO 7
7.37 You have been provided the following data on the securities of three firms and the
market:

Security E[Ri] σRi  βi

Stock A 0.15 1.0 1.5

Stock B 0.15 0.18 0.5
Stock C 0.10 0.02 0.5
Market portfolio 0.10 0.04
Treasury-bills 0.05 0

Assume the CAPM and SML are true and fill in the missing values in the table. Would you
invest in the stock of any of the three firms? If so, which one(s) and why?

LO 7

Solution:
1) The missing values in the table are:
2) Using Equation 7.10 you can calculate the expected returns for the different shares:

E(RA) = 0.05 + [1.5 × (0.10 - 0.05)] = 0.125, or 12.5%

E(RB) = 0.05 + [2.25 × (0.10 - 0.05)] = 0.1625, or 16.25%

E(RC) = 0.05 + [0.5 × (0.10 - 0.05)] = 0.075, or 7.5%

A comparison of the expected returns that are given in the table above, with the
returns that CAPM predicts (which are calculated above), indicates that you should
buy stocks A and C and avoid stock B.
.

Sample Test Problems

7.1 Friendly Airlines stock is selling at a current price of $37.50 per share. If the stock does
not pay a dividend and has a 12 percent expected return, then what is the expected price
of the stock one year from today?

Solution:
Using the formula for an asset’s return during a period,
P1−P 0 P1 −$ 37 .50
RT =R CA= ⇒ 0 .12= ⇒ P1 =$ 42. 00
P0 $ 37 .50

7.2. Stefan’s parents are about to invest their nest egg in a stock that he has estimated to have
an expected return of 9 percent over the next year. If the return on the stock is normally
distributed with a 3 percent standard deviation, in what range will the stock return fall 95
percent of the time?

Solution:
Since the return distribution for the stock is normal, then a 95 percent confidence level
corresponds to 1.96 standard deviations. Therefore,

Thus, the range can be determined as:

0.09  (1.96  (0.03))
So, the lower end is:
0.09 – (1.96 × (0.03)) = 0.0312 or 3.12%
And the upper end is:
0.09 + (1.96 × (0.03)) = 0.1488 or 14.88%

So, 95 percent of the time the stock return will fall in the range between 3.12 percent. and
14.88 percent.
7.3 Elaine has narrowed her investment alternatives to two stocks (at this time she is not
worried about diversifying): Stock M, which has a 23 percent expected return, and Stock
Y, which has an 8 percent expected return. If Elaine requires a 16 percent return on her
total investment, what proportion of her portfolio will she invest in each stock?

Solution:
If we let x = the proportion of the portfolio invested in M and (1 – x) = the proportion
invested in Y, then we can solve
0.23(x) + 0.08(1 – x) = 0.16 ==> x = 0.53
or 53 percent of the portfolio is to be invested in M, and therefore, 47 percent of the
portfolio is to be invested in Y.

7.4 You have just prepared a graph similar to Exhibit 7.9 comparing historical data for Pear
Computer Corp. and the general market. When you plot the line of best fit for these data,
you find that the slope of that line is 2.5. If you know that the market generated a return
of 12 percent and that the risk-free rate is 5 percent, then what would your best estimate
be for the return of Pear Computer during that same time period?

Solution:
Since the line of best fit has a slope of 2.5, then we know that the beta of Pear Computer
is also 2.5. This tells us that for every 1 percent change in the return on the market, we
can expect the return on Pear to be 2.5 percent. Therefore, our best estimate for the return
on Pear during this time period is 2.5 x 12% = 30%.

7.5 The CAPM predicts that the return of MoonBucks Tea Corp. is 23.6 percent. If the risk-
free rate of return is 8 percent and the expected return on the market is 20 percent, then
what is MoonBucks’ beta?

Solution:
Using the CAPM, we find
E(RMoonBucks) = Rrf + ßMoonBucks(E[RM] – Rrf)
0.236 = 0.08 + ßMoonBucks(0.20 – 0.08)
ßMoonBucks= 1.3