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CHAPTER 10 CALCULATING EXPECTED RETURN AND MARKET RISK Questions LG1 1. Consider an asset that provides the same return no matter what economic state occurs. What would be the standard deviation (or risk) of this asset? Explain. Since this asset has no variation in its return, it will have no standard deviation. This could be shown mathematically be demonstrating that each economic states return is the same as it average. Therefore, all terms in the standard deviation summation equation are zero. This asset would be known as a risk-free asset. LG1 2. Why is expected return considered forward-looking? What are the challenges for practitioners to utilize expected return? Expected return is forward-looking in the sense that it represents the return investors expect to receive in the future as compensation for the market risk taken. The challenge is that practitioners cannot precisely know what the future holds and thus what the expected return should be. Thus, we create methods to estimate the expected return. LG2 3. In 2000, the S&P 500 Index earned 9.1 percent while the T-bill yield was 5.9 percent. Does this mean the market risk premium was negative? Explain. The market risk premium is a forward-looking tool and should always be positive. Because the market has risk, it will periodically have a negative return or a small positive return that is smaller than the T-bill rate. Thus, realized returns over a short period of time will sometimes show what appears to be a negative risk premium. However, historical risk premiums should be measured over long periods of time. LG2 4. How might the magnitude of the market risk premium impact peoples desire to buy stocks? Everybody has a different level of risk aversion. People who have a low level of risk aversion would be willing to buy stocks with high risk . However, people who have a high level of risk aversion would only be willing to buy stocks with low risk. Therefore, the magnitude of the risk premium does impact who wants to buy stocks. LG3 5. Describe how adding a risk-free security to modern portfolio theory allows investors to do better than the efficient frontier. The best portfolios investors can hold with only risky assets are the efficient portfolios on the efficient frontier. If investors can borrow and lend at a risk free rate, then they can do better. To improve over the efficient frontier, investors should allocate their portfolio to the risk free rate and to the market portfolio. With the right weights between the two, an

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investor can find a portfolio with the same level of risk as an efficient portfolio but has a higher expected return. LG3 6. Show on a graph like Figure 10.2 where a stock with a beta of 1.3 would be located on the Security Market Line. Then show where that stock would be located if it is undervalued. Figure shown:

Required Return (%)

Security Market Line Under valued stock with 1.3 Beta Depot

Rf

1.3

Beta

LG3

7. Consider that you have three stocks in your portfolio and wish to add a fourth. You want to know if the fourth stock will make the portfolio riskier or less risky. Compare and contrast how this would be assessed using standard deviation versus market risk (beta) as the measure of risk. Using standard deviation, you would need to determine how the fourth stock interacts with the three stocks already owned. To do this you would have to compute the correlation between the new stock and each of the three already held. Then, the portfolio standard deviation could be computed. If the new portfolio standard deviation is lower then the original portfolio standard deviation, then adding the new stock lowers the risk. Of course, the portions, or weights of all the stocks will matter. Determining whether adding a stock will increase or lower the risk of the portfolio is much easier using beta. If the beta of the fourth stock is higher than the beta of the portfolio, then it will increase the risk when added.

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LG3

8. Describe how different allocations between the risk-free security and the market portfolio can achieve any level of market risk desired. Give examples of a portfolio from a person who is very risk averse and a portfolio for someone who is not so averse to taking risk. An investor can allocate money between a risk-free security that has zero risk (=0), and the market portfolio that has market risk (=1). If 75% of the portfolio is invested in the market, then the portfolio will have a =0.75. If only 25% is invested in the market, then the portfolio will have a market risk of =0.25. The first example (=0.75) might be taken by a less risk averse investor while the second example (=0.25) illustrates the portfolio of a more risk averse investor. By allocating the investment money between 0 and 100% into the market portfolio, an investor can achieve any level of market risk desired.

LG4

9. Cisco Systems has a beta of 1.88. Does this mean that you should expect Cisco to earn a return 88 percent higher than the S&P 500 Index return? Explain. Not quite. A beta of 1.88 means that Ciscos risk premium is 88% higher then the market risk premium. In other words, we must account for the risk free rate. This relationship is shown in the CAPM equation.

LG4

10. Note from Table 10.2 that some technology-oriented firms (Intel, and IBM) in the Dow Jones Industrial Average have high market risk while others (AT&T, Microsoft, and Verizon) have low market risk. How do you explain this? Not all technology industries have the same level of risk. Notice from this example that the more manufacturing (hardware) tech companies have higher risk. The service and software tech companies have lower risk. This may be an indication of the type of assets needed by the firms and the amount of debt required.

LG4

11. Find a beta estimate from three different sources for General Electric (GE). Compare these three values. Why might they be different? Yahoo! Finance beta was 0.59. MSN Money shows a beta of 0.76. Hoovers lists a beta of 0.8. The beta sources may use (i) different market portfolios, (ii) different time periods, or (iii) different time increments (annual returns versus months, weeks, etc.).

LG4

12. If you were to compute beta yourself, what choices would you make regarding the market portfolio, the holding period for the returns (daily, weekly, etc.), and the number of returns? Justify your choices. It is common to use the S&P500, monthly returns, and either three to five years of data.

LG5

13. Explain how the concept of a positive risk-return relationship breaks down if you can systematically find stocks that are over-valued and under-valued.

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Consider two stocks: one stock has a beta of 0.9 and is undervalued, the other has a beta of 1 and is overvalued. If beta perfectly explained expected returns, then the higher beta stock would offer a higher expected return. However, if you believe the lower beta stock is undervalued, then you are saying it will achieve a return higher than expected by its beta. You also believe the overvalued stock will earn a return lower than expected by its beta. Thus, you might expect the undervalued stock to outperform the overvalued stock even though the risks of the two stocks suggest otherwise. LG5 14. Determine what level of market efficiency each event is consistent with: A. Immediately after an earnings announcement the stock price jumps and then stays at the new level. B. The CEO buys 50,000 shares of his company and the stock price does not change. C. The stock price immediately jumps when a stock split is announced, but then retraces half of the gain over the next day. D. An investor analyzes company quarterly and annual balance sheets and income statements looking for under-valued stocks. The investor earns about the same return as the S&P 500 Index. A. semi-strong form B. strong form C. not efficient D. semi-strong form LG5 15. Why do most investment scams conducted over the Internet and e-mail involve penny stocks instead of S&P 500 Index stocks? There is tremendous liquidity in the large stocks. As such, these scams would not impact their stocks price and thus not be effective. Penny stocks have very little liquidity. So if a few investors buy the stocks in the scam, they will push up the price and allow the scam promoters to sell at a profit. LG5 16. Describe a stock market bubble. Can a bubble occur in a single stock? Bubbles are initially started with an increase in price that is typically justified by the economics and fundamentals. Then many people get irrationally exuberant about the asset(s) and push prices beyond those that are justified. Eventually, there are no more buyers for the overvalued asset and prices drop. As people begin to believe that the price is a bubble, the price free falls. No one buys the stock while it is plummeting. Yes, a bubble can occur in a single stock. LG6 17. If stock prices are not strong-form efficient, then what might be the price reaction to a firm announcing a stock buyback? Explain.

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Two different arguments could be made. First, the price could increase with the realization that this demand for stock will push up the stock price. Alternatively, the price could decline if investors believe that the company does not have any good product related investments and thus must buy back its stock. LG7 18. Compare and contrast the assumptions that need to be made to compute a required return using CAPM and the constant growth rate model. When using the CAPM to compute required return, you need to make assumptions about what the expected market return will be, what the risk free rate will be, and what the future beta of the firm will be. The future beta is commonly similar to the recent past beta. The risk free rate is well estimated by T-bill rates and the yield curve. These two are reasonably estimated. However, the stock market is very volatile and the future market return is difficult to estimate. The constant growth rate model assumes that the growth of the firm will remain constant. The growth rate and the dividend must be assumed. Firms do not change their dividends very much, so that estimation is not difficult. However, the required rate is very sensitive to the estimated growth rate. Both models require difficult assumptions. LG7 19. How should you handle a case where required return computations from CAPM and the constant growth rate model are very different? First, examine the assumptions of each model. If no mistakes have been made, then compute the required return for similar firms in the same industry. Use the CAPM or constant growth rate estimate that most resembles that of its competitors. Problems Basic Problems LG1 10-1 Expected Return Compute the expected return given these three economic states, their likelihoods, and the potential returns: Economic Probability Return State Fast Growth 0.3 40% Slow Growth 0.5 10% Recession 0.2 25% Expected return = 0.340% + 0.510% + 0.2-25% = 12% LG2 10-3 Required Return If the risk-free rate is 6 percent and the risk premium is 5 percent, what is the required return? Required return = 6% + 5% = 11%

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LG2

10-5 Risk Premium The average annual return on the S&P 500 Index from 1986 to 1995 was 15.8 percent. The average annual T-bill yield during the same period was 5.6 percent. What was the market risk premium during these ten years? Average market risk premium = 15.8% 5.6% = 10.2%

LG3

10-7 CAPM Required Return Hastings Entertainment has a beta of 0.24. If the market return is expected to be 11 percent and the risk-free rate is 4 percent, what is Hastings required return? Hastings required return = 4% + 0.24 (11% 4%) = 5.68%

LG3

10-9 Company Risk Premium Netflicks, Inc. has a beta of 3.61. If the market return is expected to be 13 percent and the risk-free rate is 6 percent, what is Netflicks risk premium? Netflicks risk premium = 3.61 (13% 6%) = 25.27%

LG3

10-11 Portfolio Beta You have a portfolio with a beta of 1.2. What will be the new portfolio beta if you keep 90 percent of your money in the old portfolio and 10 percent in a stock with a beta of 1.9? New portfolio beta = 0.901.2 + 0.101.9 = 1.27

LG5

10-13 Stock Market Bubble The Nasdaq stock market bubble peaked at 4,816 in 2000. Two and a half years later it had fallen to 1,000. What was the percentage decline? Market decline = (1,000 4,816) 4,816 = 0.7924 = 79.24%

LG7

10-15 Required Return Paccars current stock price is $73.10 and it is likely to pay a $2.69 dividend next year. Since analysts estimate Paccar will have a 11.2% growth rate, what is its required return? Use equation 10.6:

i D1 P0 g $ 2 . 69 $ 73 . 10 0 . 112 0 . 1488 14 . 88 %

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Intermediate Problems 10-17 Expected Return Risk For the same economic state probability distribution in Problem 10.1, determine the standard deviation of the expected return. LG1

Use equation 10.2 and expected return from Problem 10.1 of 12%:

Standard Deviation 0 .3 235 . 2 40% 2 12 % 273 . 8

2

0 .5 22 . 6 %

10%

12 %

0 .2

( 25 %

12 %)

LG3

10-19 Under/Over Valued Stock A manager believes his firm will earn a 14 percent return next year. His firm has a beta of 1.5, the expected return on the market is 12 percent, and the risk-free rate is 4 percent. Compute the return the firm should earn given its level of risk and determine whether the manager is saying the firm is under-valued or over-valued. Use CAPM to determine the firms required return = 4% + 1.5 (12% 4%) = 16% Since the return required for the level of risk is 16% and the manager believes a 14% return will be achieved, the manager is saying the firm is over-valued.

LG3

10-21 Portfolio Beta You own $5,000 of Olympic Steel stock that has a beta of 2.9. You also own $7,000 of Rent-a-Center (beta=1.5) and $8,000 of Lincoln Educational (beta=0.2). What is the beta of your portfolio? First determine the total value of the portfolio and the weights of each stock in the portfolio: Total value = $5,000 + $7,000 + $8,000 = $20,000 Olympic Steel weight = $5,000 / $20,000 = 25% Rent-a-Center weight = $7,000 / $20,000 = 35% Lincoln Educational weight = $8,000 / $20,000 = 40% Now compute the portfolio beta = 0.252.9 + 0.351.5 + 0.400.2 = 1.33

LG3

10-25 Risk Premiums You own $10,000 of Dennys Corp stock that has a beta of 2.9. You also own $15,000 of Qwest Communications (beta=1.5) and $15,000 of Southwest Airlines (beta=0.4). Assume that the market return will be 13 percent and the risk-free rate is 5.5 percent. What is the market risk premium? What is the risk premium of each stock? What is the risk premium of the portfolio?

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Market risk premium = 13% 5.5% = 7.5% Dennys risk premium = 2.9(13%5.5%) = 21.75% Qwests risk premium = 1.5(13%5.5%) = 11.25% Southwest Airlines risk premium = 0.4(13%5.5%) = 3.0% For the portfolio, determine the total value of the portfolio and the weights of each stock in the portfolio: Total value = $10,000 + $15,000 + $15,000 = $40,000 Dennys weight = $10,000 / $40,000 = 25% Qwests weight = $15,000 / $40,000 = 37.5% Southwest Airlines weight = $15,000 / $40,000 = 37.5% Now compute the portfolio beta = 0.252.9 + 0.3751.5 + 0.3750.4 = 1.44 So the portfolios risk premium = 1.44(13%5.5%) = 10.8%

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