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CHAPTER 7
The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.
(1 + .2563)
c. 𝑅𝑒𝑎𝑙 𝑅𝑒𝑡𝑢𝑟𝑛 = − 1 = .1632 𝑜𝑟 16.32%
(1+ .08)
Est. Time: 01 – 05
(1+ .95)
2. 𝑅𝑒𝑡𝑢𝑟𝑛 𝐹𝑟𝑜𝑚 𝐶𝑜𝑠𝑡𝑎𝑔𝑢𝑎𝑛𝑎𝑛 𝑀𝑎𝑟𝑘𝑒𝑡 = (1+ .8)
− 1 = .0833 𝑜𝑟 8.33%
(1+ .12)
𝑅𝑒𝑡𝑢𝑟𝑛 𝐹𝑟𝑜𝑚 𝑅𝑢𝑟𝑖𝑡𝑎𝑛𝑖𝑎 𝑀𝑎𝑟𝑘𝑒𝑡 = (1+ .02)
− 1 = .0980 𝑜𝑟 9.8%
Est. Time: 01 – 05
1 1 1
3. a. 𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = (3 × −10%) + (3 × 20%) + (3 × 50%)
𝑃𝑟𝑜𝑏𝑎𝑏𝑖𝑙𝑖𝑡𝑦 𝑤𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 = 20%
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑦𝑒𝑎𝑟 𝑒𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 = $150 × (1.20) = $180
1⁄ )
d. 𝐺𝑒𝑜𝑚𝑒𝑡𝑟𝑖𝑐 𝑟𝑒𝑡𝑢𝑟𝑛 = [(1 − .10) × (1 + .20) × (1 + .50)]( 3 −1=
.1745 𝑜𝑟 17.45%
Est. Time: 01 – 05
4. a. r = [(1 + R) / (1 + h)] – 1
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Chapter 07 - Introduction to Risk and Return
Est. Time: 06 – 10
5. a. Stock prices rise by 15%. Investors require less expected return to offset
the lower risk, so they are willing to pay more for the same level of future
dividends.
b. The inclusion of the 2030 data point will pull the average down since the
risk premium decreased. Depending on how long your sample period
goes back in time, this may not make a big difference.
c. If the market risk premium remains at the 8% level, the historical rate of
10% may overstate the required return. However, many financial
managers and economists believe that the long-run historical average
return is the best measure available for future market risk premiums.
From this perspective, the historical average of 10% may be appropriate.
Est. Time: 06 – 10
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Chapter 07 - Introduction to Risk and Return
b. It is true that stocks offer higher long-run rates of return than do bonds, but
it is also true that stocks have a higher standard deviation of return. So,
which investment is preferable depends on the amount of risk one is
willing to tolerate. This is a complicated issue and depends on numerous
factors, one of which is the investment time horizon. If the investor has a
short time horizon, then stocks are generally not preferred.
Est. Time: 06 – 10
Rates of return:
Est. Time: 01 – 05
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Chapter 07 - Introduction to Risk and Return
Est. Time: 01 – 05
9. Ms. Sauros:
S&P 500:
Est. Time: 01 – 05
10. The risk to Hippique shareholders depends on the market risk, or beta, of the
investment in the black stallion. The information given in the problem suggests
that the horse has very high unique risk, but we have no information regarding
the horse’s market risk. So, the best estimate is that this horse has a market risk
about equal to that of other racehorses, and thus this investment is not a
particularly risky one for Hippique shareholders.
Est. Time: 01 – 05
11. In the context of a well-diversified portfolio, the only risk characteristic of a single
security that matters is the security’s contribution to the overall portfolio risk. This
contribution is measured by beta. Lonesome Gulch is the safer investment for a
diversified investor because its beta of .10 is lower than the beta of Amalgamated
Copper of .66. For a diversified investor, the standard deviations are irrelevant.
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Chapter 07 - Introduction to Risk and Return
Est. Time: 01 – 05
12. a.&b. The table below calculates the mean, variance, and standard deviation on
both stocks as well as a 50%-50%- portfolio made up of each. Digital
Chees is more risky of held on its own with a standard deviation of 6.9.
c. The variance of the portfolio is 30.1, which is less than the 50%-50%
weighting of the two individual stock variances of 35.4 [.5 x 47.5 + .5 x
23.2]. This occurs because the two stocks are less than perfectly
correlated, at a rho of +0.75.
Est. Time: 01 – 05
13. Perfect negative correlation does the most to reduce risks because the stocks
always move in opposite directions. When one goes up, the other goes down,
and vice versa.
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Chapter 07 - Introduction to Risk and Return
Est. Time: 01 – 05
e. False. Diversification
reduces specific risk, not market risk. Beta is a
measure of market risk.
g. False. Stocks subject to high specific risk might contain low market risk
and would therefore contribute less to portfolio risk.
h. True.
i. True.
Est. Time: 01 – 05
15.
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Chapter 07 - Introduction to Risk and Return
Est. Time: 01 – 05
16. a. Refer to Figure 7.13 in the text. With 100 securities, the box is 100 by 100.
The variance terms are the diagonal terms, and thus there are 100
variance terms. The rest are the covariance terms. Because the box has
(100 × 100) terms altogether, the number of covariance terms is:
Number of covariance terms = 1002 – 100 = 9,900
Half of these terms (i.e., 4,950) are different.
σ2 = (.30)(.30)(.40) = .036
σ = .190, or 19.0%
Est. Time: 06 – 10
17. a. Refer to Figure 7.13 in the text. For each different portfolio, the relative
weight of each share is (1 / number of shares (n) in the portfolio), the
standard deviation of each share is .40, and the correlation between pairs
is .30. Thus, for each portfolio, the diagonal terms are the same, and the
off-diagonal terms are the same. There are n diagonal terms and (n2 – n)
off-diagonal terms. In general, we have:
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Chapter 07 - Introduction to Risk and Return
The results are summarized in the second and third columns of the
table in part (c) below.
b. The underlying market risk that cannot be diversified away is the second
term in the formula for variance above:
c. This is the same as Part (a), except that all of the off-diagonal terms are
now equal to zero. The results are summarized in the fourth and fifth
columns of the table below.
(Part a) (Part a) (Part c) (Part c)
No. of Standard Standard
Shares Variance Deviation Variance Deviation
1 .160000 .400 .160000 .400
2 .104000 .322 .080000 .283
3 .085333 .292 .053333 .231
4 .076000 .276 .040000 .200
5 .070400 .265 .032000 .179
6 .066667 .258 .026667 .163
7 .064000 .253 .022857 .151
8 .062000 .249 .020000 .141
9 .060444 .246 .017778 .133
10 .059200 .243 .016000 .126
0 .4
0 .1 5
Variance
0 .3
0 .1
0 .2
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0 .0 5 © 2019 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
0 .1
McGraw-Hill Education.
0 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12
N u m b e r o f S e c u ritie s N u m b e r o f S e c u ritie s
Chapter 07 - Introduction to Risk and Return
Standard Deviation
0 .4
0 .1 5
Variance
0 .3
0 .1
0 .2
0 .0 5
0 .1
0 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12
N u m b e r o f S e c u ritie s N u m b e r o f S e c u ritie s
Est. Time: 16 – 20
18. The table below calculates the portfolio variance. The portfolio variance is the
sum of all the entries in the matrix or 0.0148.
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McGraw-Hill Education.
Chapter 07 - Introduction to Risk and Return
Standard deviation (%) 26.10% 18.90% 12.80% 21.40% 15.70% 26.50% 21.60%
Portfolio Risk Contribution X1σ1 X1σ2 X1σ3 X1σ4 X1σ5 X1σ6 X1σ7
BHP 0.0013902 0.0001913 -0.0000750 0.0002508 0.0003345 0.0004517 0.0003337
Siemens 0.0001913 0.0007290 0.0001580 0.0004292 0.0002543 0.0002555 0.0001666
Nestlé -0.0000750 0.0001580 0.0003344 0.0001342 0.0000410 0.0001454 0.0001411
LVMH 0.0002508 0.0004292 0.0001342 0.0009346 0.0000480 0.0002430 0.0001226
TDB 0.0003345 0.0002543 0.0000410 0.0000480 0.0005030 0.0001613 0.0001038
Samsung 0.0004517 0.0002555 0.0001454 0.0002430 0.0001613 0.0014332 0.0003621
BP 0.0003337 0.0001666 0.0001411 0.0001226 0.0001038 0.0003621 0.0009522
Sum of Columns 0.002877 0.002184 0.000879 0.002162 0.001446 0.003052 0.002182
Est. Time: 21 – 25
19. “Safest” means lowest risk; in a portfolio context, this means lowest variance of
return. Half of the portfolio is invested in British Petroleum stock (BP), and half of
the portfolio must be invested in one of the other securities listed. Thus, we
calculate the portfolio variance for seven different portfolios to see which is the
lowest (see table below). The safest attainable portfolio is comprised of British
Petroleum stock (BP) and Nestlé.
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Chapter 07 - Introduction to Risk and Return
Standard deviation (%) 26.10% 18.90% 12.80% 21.40% 15.70% 26.50% 21.60%
(Note that the formulas give the Variances and the Std. Dev. values are the square root
of the variances.)
Est. Time: 11 – 15
20. a. σP2 = .602 × .102 + .402 × .202 + 2(.60 × .40 × 1 × .10 × .20)
σP2 = .0196
b. σP2 = .602 × .102 + .402 × .202 + 2(.60 × .40 × .50 × .10 × .20)
σP2 = .0148
Est. Time: 06 – 10
21. The beta of each stock is given by the slope of the line, or the rise divided by the
run. The run is the range of the market returns while the rise is the range of the
stock returns.
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Chapter 07 - Introduction to Risk and Return
Est. Time: 01 – 05
22. a-1. Change in stock’s rate of return = .05 × –.25 = –.0125, or –1.25%
Est. Time: 06 – 10
Est. Time: 01 – 05
b. σp = 0 × 20% = 0%
d. βp = Less than 1
Est. Time: 01 – 05
25. a. In general:
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Chapter 07 - Introduction to Risk and Return
Thus:
b. We can think of this in terms of Figure 7.13 in the text, with three
securities. One of these securities, T-bills, has zero risk and, hence, zero
standard deviation. Thus:
c. With 50% margin, the investor invests twice as much money in the
portfolio as he had to begin with. Thus, the risk is twice that found in Part
(a) when the investor is investing only his own money:
d. With 100 stocks, the portfolio is well diversified, and hence the portfolio
standard deviation depends almost entirely on the average covariance of
the securities in the portfolio (measured by beta) and on the standard
deviation of the market portfolio. Thus, for a portfolio made up of 100
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Chapter 07 - Introduction to Risk and Return
stocks each with Ford’s beta of 1.26, the portfolio standard deviation is
approximately:
For stocks like Harley Davidson, the approximate standard deviation is:
Est. Time: 11 – 15
26. For a two-security portfolio, the formula for portfolio risk is:
If security one is Treasury bills and security two is the market portfolio, then 1 is
zero, and 2 is 20%. Therefore:
Expected Standard
Portfolio x1 x2
Return Deviation
1 1.0 .0 .060 .000
2 .8 .2 .077 .040
3 .6 .4 .094 .080
4 .4 .6 .111 .120
5 .2 .8 .128 .160
6 .0 1.0 .145 .200
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Solution Manual for Principles of Corporate Finance 13th by Brealey
.15
.10
.05
.00
.00 .05 .10 .15 .20 .25
Standard Deviation
Est. Time: 11 – 15
27. The matrix below displays the variance for each of the eight stocks along the
diagonal and each of the covariances in the off-diagonal cells:
Variances/Covariances BHP Siemens Nestlé LVMH TDB Samsung BP σs,mkt
BHP 0.068121 0.009373 -0.003675 0.012288 0.016391 0.022133 0.016349 0.020140
Siemens 0.009373 0.035721 0.007741 0.021032 0.012463 0.012521 0.008165 0.015288
Nestlé -0.003675 0.007741 0.016384 0.006574 0.002010 0.007123 0.006912 0.006153
LVMH 0.012288 0.021032 0.006574 0.045796 0.002352 0.011909 0.006009 0.015137
TDB 0.016391 0.012463 0.002010 0.002352 0.024649 0.007905 0.005087 0.010122
Samsung 0.022133 0.012521 0.007123 0.011909 0.007905 0.070225 0.017744 0.021366
BP 0.016349 0.008165 0.006912 0.006009 0.005087 0.017744 0.046656 0.015275
The covariance of BP with the market portfolio (σBP, Market) is the mean of the
seven respective covariances between BP and each of the seven stocks in the
portfolio. (The covariance of BP with itself is the variance of BP.) Therefore, σBP,
Market is equal to the average of the seven covariances in the second row or,
equivalently, the average of the seven covariances in the second column. Beta
for BP is equal to the covariance divided by the market variance, which we
calculated at 0.014783 in problem 18. The covariances and betas are displayed
in the table below:
Market
Covariance Variance Beta
BHP 0.020140 0.014783 1.362376
Siemens 0.015288 0.014783 1.034163
Nestlé 0.006153 0.014783 0.416209
LVMH 0.015137 0.014783 1.023962
TDB 0.010122 0.014783 0.684726
Samsung 0.021366 0.014783 1.445305
BP 0.015275 0.014783 1.033260
Est. Time: 21 – 25
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