Financial Management and Policy

Risk and Return

Q No. 1 Two stock prices for six days are given below.

Price Price
A B
25 55
29 60
33 61
29 63
26 61
29 60

Calculate:

1. Average return of both stock (Arithmetic mean &

Geometric mean)
2. Standard deviation of each stock
3. Coefficient of Variation of each stock
4. Covariance
5. Correlation
6. Which stock is less risky based on Standard deviation?
7. Which stock you will select based on Coefficient of
variation?
Q2. Consider the following scenario analysis:

Scenario Probability Stocks Bonds

Recession 0.30 -6 % +15%

Normal Economy 0.30 +14 +7
Boom 0.40 +26 +5

a) Calculate the expected rate of return and standard deviation

for each investment?
b) Which investment would you prefer?

Q3. Use the data in the previous problem and consider a

portfolio with weights of 0.70 in stocks and 0.30 in bonds.

a) What is the rate of return on the portfolio in each scenario?

b) What is the expected rate of return and standard deviation
of the portfolio?
c) Would you prefer to invest in the portfolio, in stocks only,
or in bonds only?
Q4. (Student Practice)

Use the data in the previous problem and consider a

portfolio with weights of 0.60 in stocks and 0.40 in bonds.

a) What is the rate of return on the portfolio in each scenario?

b) What is the expected rate of return and standard deviation
of the portfolio?
c) Would you prefer to invest in the portfolio, in stocks only,
or in bonds only, give reason?

Q5.
a) A share of stock with a beta of .80 now sells for $45.
Investors expect the stock to pay a year-end dividend of
$1.80. The T-bill rate is 4.5 percent, and the market risk
premium is 7 percent. If the stock is perceived to be fairly
priced today, what must be investors’ expectations of the
price of the stock at the end of the year?
b) The following table shows betas for several companies.
Calculate each stock’s expected rate of return using CAPM.
Assume the risk free rate of interest is 9 percent. Use a 6
Percent risk premium for the market portfolio.

Company Beta
Cisco 2.03
CitiGroup 1.63
Merck 0.50
Walt Disney 0.74

c) If the expected rate of return on the market portfolio is 14

percent and T- bills yield is 6 percent, what must be the
beta of a stock that investors expect to return 10 percent?

d) You have equal investment in all four stocks given in part

(b)of this question. What would be your portfolio beta?
 e) Student practice: Suppose you have investment as follows:

Cisco 20%
CitiGroup 20%
Merck 30%
Walt Disney 30%

Take the Beta as given above and calculate your

portfolio beta.

Q No.6

Suppose kRF = 5%, kM = 10% and kA = 12%.

a. Calculate Stock A’s beta.
b. If Stock A’s beta were 2.0, what would be A’s new
required rate of return?

Q No.7

Suppose kRF = 9%, kM = 14%, and bi = 1.3.

a. What is ki, the required rate of return on stock i?
b. Now suppose kRF (1) increases to 10 percent or (2)
decreases to 8 percent. The slope of the SML remains
constant. How would this affect kM and ki?
Q No.8
Suppose you hold a diversified portfolio consisting of a $7500
investment in each of 20 different common stocks. The portfolio
beta is equal to 1.12. Now suppose you have decided to sell one
of the stocks in your portfolio with a beta equal to 1.0 for $7500
and to use these proceeds to buy another stock for your
portfolio. Assume the new stock’s beta is equal to 1.75.
Calculate your portfolio’s new beta.

Q No.9: Student Practice

Market rate of return is 18%, risk free rate of return 8% and beta
is 1.2

Calculate required rate of return

Calculate risk premium

Q No.10: Student Practice

Market rate of return is 14%, beta is 1.5 and required rate of
return is 18.5%. What is risk free rate of return?
Q No.11: Student Practice
Here are stock market and Treasury bill returns between 1997
and 2001

Year Stock return T-Bill return

1997 31.29 5.26
1998 23.43 4.86
1999 23.56 4.68
2000 -10.89 5.89
2001 -10.97 3.83

a. What was the risk premium on common stock in each year?

b. What was the average risk premium?
c. What was the standard deviation of the risk premium?
Q No. 12: Student Practice

ECRI Corporation is a holding company with four main

subsidiaries. The percentage of its business coming from each
subsidiaries, and their respective betas, are as follows:

Subsidiary % of Beta
Business
Electric utility 60% 0.70
Cable company 25 0.90
Real estate 10 1.30
International/special 5 1.50
projects

a. What is the holding company’s beta?

b. Assume that the risk-free rate is 6 percent and the market
risk premium is 5 percent. What is the holding company’s
required rate of return?