Lahore School of Economics

Financial Management I
Chapter 8
Assignment 11 Solution
Risk and Rates of Return – 3

Class Examples

Q1) r = rRF + (rM – rRF)b

= 6% + (13% – 6%)0.7
= 10.9%.

Q2) r = rRF + (rM – rRF)b

= rRF +RPMb

As market beta = 1,
rM = 5% + (6%)1 = 11%.

when b = 1.2,
r = 5% + 6%(1.2) = 12.2%.

Q3) Total investment = $35,000 + $45,000 = $75,000

bp = ($35,000/$75,000)(0.8) + ($40,000/$75,000)(1.4) = 1.12.

r^
Q4) X = 10%; bX = 0.9; X = 35%.

r^Y = 12.5%; b = 1.2;  = 25%.

Y Y

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) = 10.5%.

rY = 6% + 5%(1.2) = 12%.

r^
d. rX = 10.5%; X = 10%.
r^
rY = 12%; 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.

Q5) a. Using Stock X (or any stock):

9% = rRF + (rM – rRF)bX
9% = 5.5% + (rM – rRF)0.8
(rM – rRF) = 4.375%.

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. Since the returns on the 3 stocks included in Portfolio Q are not perfectly positively correlated, one would
expect the standard deviation of the portfolio to be less than 15%.

$142,500 $7,500
Q6) Old portfolio beta= $150,000 (b) + $150,000 (1.00)
1.12= 0.95b + 0.05
1.07= 0.95b
b = 1.1263

New portfolio beta = 0.95(1.1263) + 0.05(1.75) = 1.1575.

Old portfolio beta = 1.12= (0.05)b1 + (0.05)b2 + ... + (0.05)b20

1.12 = (0.05)(b1 + b2 + …… + b20)
22.4 = (b1 + b2 + …… + b20)
22.4 = (b1 + b2 + …… + b19) + b20
As b20 = 1,
22.4 = (b1 + b2 + …… + b19) + 1
21.4 = (b1 + b2 + …… + b19)

As new b20 = 1.75,

New portfolio beta = (0.05)(b1 + b2 + …… + b19) + (0.05))b20

= (0.05)(21.4) +(0.05)(1.75)
= 1.1575

Problems for Assignment

Q1) r = rRF + (rM – rRF)b

= 4.5% + (5%)(1.2)
= 10.5%.

Q2) a. r = rRF + (rM – rRF)b

11% = 7% + 4%b
4%= 4%b
b = 1.

b.r = rRF + (rM – rRF)b

= 7% + (6%)1
= 13%.

Q3) Total investment = $25,000 + $50,000 = $75,000

 bp = ($25,000/$75,000)(1.5) + ($50,000/$75,000)(0.6) = 0.90.

Q4)
a. No calculation is needed to answer this question. Remember that the standard deviation of a portfolio of
two stocks is less than the weighted average of the individual stocks’ standard deviations, as long as the
correlation between the stocks is less than 1.0. So, in this case because the correlation is 0.4, we know that
the standard deviation of Portfolio P is less than 30%.
b. bp = 0.5(1.2) + 0.5(0.8) = 1.0
The beta of a portfolio is equal to the weighted average of the individual stocks’ betas.
c. The relevant measure of risk to a diversified investor is beta. It follows that a diversified investor would
view the higher beta stock (Stock A) as being more risky.
$400,000 $600,000 $1,000,000 $2,000,000
Q5) Portfolio beta = $4,000,000 (1.50) + $4,000,000 (-0.50) + $4,000,000 (1.25) + $4,000,000 (0.75)
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%.

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.

rRF = 6% and (rM – rRF) = 8%.

Stock Investment Beta r = rRF + (rM – rRF)b Weight

A $ 400,000 1.50 18% 0.10
B 600,000 (0.50) 2 0.15
C 1,000,0001.25 16 0.25
D 2,000,0000.75 12 0.50
Total $4,000,000 1.00

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

Q6) An index fund will have a beta of 1.0.

r= rRF + (RPM)b
12.0%= 5% + (RPM)1.0
7.0%= RPM.

Bradford:
rB = rRF + (RPM)b
= 5% + (7.0%)1.45
= 5% + 10.15%
= 15.15%.

Farley:
rF = rRF + (RPM)b
= 5% + (7.0%)0.85
= 5% + 5.95%
= 10.95%.

The difference in their required returns is = 15.15% – 10.95% = 4.2%.

Q7) rRF = r* + IP = 2.5% + 3.5% = 6%.

 r = 6% + (6.5%)1.7 = 17.05%.

Q8) 0.12= 0.0525 + (rM – rRF)1.25

(rM – rRF) = 0.054.

Calculating the beta of the new portfolio,

($500,000/$5,500,000)(0.75) + ($5,000,000/$5,500,000)(1.25) = 1.2045.

Calculating the required return on the new portfolio,

5.25% + (5.4%)(1.2045) = 11.75%.

Q9) After additional investments are made, for the entire fund to have an expected return of 13%, the portfolio
must have a beta of 1.5455 as shown below:
13% = 4.5% + (5.5%)b
b = 1.5455.
Since the fund’s beta is a weighted average of the betas of all the individual investments, we can calculate
the required beta on the additional investment as follows:
Weight of existing stocks in the new portfolio = $20,000,000/$25,000,000 = 0.8
Weight of new stocks X in the new portfolio = $5,000,000/$25,000,000 = 0.2

($ 20,000 ,000)(1.5) $5 ,000 ,000 X

1.5455 = $25,000 ,000 + $ 25,000,000
1.5455 = 1.2 + 0.2X
0.3455 = 0.2X
X = 1.7275.