FIN702 Corporate Financial Management 1

Tutorial 4 – Risk and Return

Discussion Questions
1. Explain the concept of “risk” and how it is measured in financial management

2. Explain what we mean by “total risk” of a portfolio and how it is measured

3. Identify each of the following risks as most likely to be systematic risk or diversifiable risk:
a. The risk that your main production plant is shut down due to a tornado.
b. The risk that the economy slows, decreasing demand for your firm’s products.
c. The risk that your best employees will be hired away.
d. The risk that the new product you expect your R&D division to produce will not
materialize.

4. Consider the following two, completely separate, economies. The expected return and volatility
of all stocks in both economies is the same. In the first economy, all stocks move together—in
good times all prices rise together and in bad times they all fall together. In the second
economy, stock returns are independent—one stock increasing in price has no effect on the
prices of other stocks. Assuming you are risk-averse and you could choose one of the two
economies in which to invest, which one would you choose? Explain.
5. Explain why the risk premium of a stock does not depend on its diversifiable risk
6. Assume the risk-free rate is 4%. You are a financial advisor, and must choose one of the funds
below to recommend to each of your clients. Whichever fund you recommend, your clients will
then combine it with risk-free borrowing and lending depending on their desired level of risk.

Which fund would you recommend without knowing your client’s risk preference?

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Problem – Solving

1. You bought a stock one year ago for $50 per share and sold it today for $55 per share. It paid a $1 per
share dividend today.
a. What was your realized return?
b. How much of the return came from dividend yield and how much came from capital gain?

2. The following table shows the one-year return distribution of Startup, Inc.

Calculate
a. The expected/average return.
b. The standard deviation of the return.

3. The last four years of returns for a stock are as follows:

a. What is the average annual return?

b. What is the variance of the stock’s returns?
c. What is the standard deviation of the stock’s returns?

4. Consider an economy with two types of firms, S and I. S firms all move together. I firms move
independently. For both types of firms, there is a 60% probability that the firms will have a 15%
return and a 40% probability that the firms will have a −10% return. What is the volatility
(standard deviation) of a portfolio that consists of an equal investment in 20 firms of (a) type S, and
(b) type I?

5. An investor puts 40% of her funds in company A’s shares and the remainder in company B’s
shares. The standard deviation of the returns on A is 20% and on B is 10%. Calculate the
variance of returns on the portfolio, assuming that the correlation between the returns on the
two securities is: (a) +1.0 (b) +0.5 (c) 0 (d) -0.5 ( e) -1.0

6. Levy Jones has invested one-third of his funds in share 1 and two-thirds in share 2. His
assessment of each investment is as follows:

Item Share 1 Share 2

E(Ri) in % 15 21

S.D in % 18 25
Correlation between the returns = 0.5

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 (a) What are the expected return and standard deviation of return on Levy’s portfolio

(b) Recalculate the expected return and standard deviation where the correlation between the
returns is -0.5

(c) Is Levy better or worse off as a result of investing in two securities rather than one security?

7. You have $100,000 to invest. You choose to put $150,000 into the market by borrowing $50,000.
a. If the risk-free interest rate is 5% and the market expected return is 10%, what is the expected
return of your investment?
b. If the market volatility is 15%, what is the volatility of your investment?

8. Suppose the risk-free return is 4% and the market portfolio has an expected return of 10% and a volatility
of 16%. Merck & Co. (Ticker: MRK) stock has a 20% volatility and a correlation with the market of
0.06.
a. What is Merck’s beta with respect to the market?
b. Under the CAPM assumptions, what is its expected return?

9. Suppose Autodesk stock has a beta of 2.16, whereas Costco stock has a beta of 0.69. If the risk-free interest
rate is 4% and the expected return of the market portfolio is 10%, what is the expected return of a
portfolio that consists of 60% Autodesk stock and 40% Costco stock, according to the CAPM?

10. Consider a portfolio consisting of the following three stocks:

The volatility of the market portfolio is 10% and it has an expected return of 8%. The risk-free rate
is 3%.
a. Compute the beta and expected return of each stock.
b. Using your answer from part a, calculate the expected return of the portfolio.
c. What is the beta of the portfolio?
d. Using your answer from part c, calculate the expected return of the portfolio and verify that it
matches your answer to part b.