Corporate Finance Module

Questions on Portfolio Theory and CAPM

10-7. 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?

10-14. Explain the difference between the average return and the realized return. Are both numbers
useful? If so, explain why.

10-25. Explain why the risk premium of a stock does not depend on its diversifiable risk.

10-26. 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.

11-23. Calculate (a) the expected return and (b) the volatility (standard deviation) of a portfolio that is
equally invested in Johnson & Johnson’s and Walgreens’ stock. The correlation between the two stocks is
0.21.

11-36. 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? (Hint: Sharpe
ratios)

11-48. Suppose the risk-free return is 3.5% and the market portfolio has an expected return of 11.2%
and a volatility of 17.9%. Merck & Co. (Ticker: MRK) stock has a 21.5% volatility and a
correlation with the market of 0.045.
a. What is Merck’s beta with respect to the market?
b. Under the CAPM assumptions, what is its expected return?
Solutions

10-7. 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?
Given the data presented, make the calculations requested in the question.
-4% + 28% + 12% + 4%
a. Average annual return = = 10%
4

b.

c. Standard deviation of returns = variance = 0.01867 = 13.66%

The average annual return is 10%. The variance of return is 0.01867. The standard deviation of returns
is 13.66%.

10-14. Explain the difference between the average return and the realized return. Are both numbers
useful? If so, explain why.
Both numbers are useful. The realized return tells you what you actually made if you hold the stock over
this period. The average return over the period can be used as an estimate of the monthly expected return.
If you use this estimate, then this is what you expect to make on the stock in the next month.

10-25. Explain why the risk premium of a stock does not depend on its diversifiable risk.
Investors can costlessly remove diversifiable risk from their portfolio by diversifying. They, therefore,
do not demand a risk premium for it.

10-26. 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.
a. diversifiable risk
b. systematic risk
c. diversifiable risk
d. diversifiable risk

11-23. Calculate (a) the expected return and (b) the volatility (standard deviation) of a portfolio that is
equally invested in Johnson & Johnson’s and Walgreens’ stock.
 In this case, the portfolio weights are xj = xw = 0.50. From Eq. 11.3,
E[ RP ]  0.50(6.9%)  0.50(9.6%)  8.25%.
We can use Eq. 11.9.
Volatility  0.1792  0.502  0.2162  0.502  2  0.179  0.216  0.50  0.50  0.21
 15.4%

11-36. 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?
Sharpe ratios of A, B, and C are 1, 1.5, and 1.25, so you would choose B; it is the best choice no matter
what your clients’ risk preferences are.

11-48. Suppose the risk-free return is 3.5% and the market portfolio has an expected return of 11.2%
and a volatility of 17.9%. Merck & Co. (Ticker: MRK) stock has a 21.5% volatility and a
correlation with the market of 0.045.
a. What is Merck’s beta with respect to the market?
b. Under the CAPM assumptions, what is its expected return?
a. beta = 0.045  0.215 / 0.179 = 0.054
b. E[R] = 0.035 + 0.054 (0.112 – 0.035) = 3.92%