FIN223

Tutorial-Week 6
Chapter 5:
Problems: P 5.16, P5.17, P5.18. P5.19, P5.20 & P5.21
 P 5.16:
• You are evaluating two possible stock investments, Leverage Co. and
Value Corp. Leverage Co. has an expected return of 10% and a beta of 1.4.
Value Corp. has an expected return of 10% and a beta of 0.9. Based only
on this data, which stock should you buy and why?
Answer to P5.16
• You should buy the stock of Value Corp. because it provides the same
expected return at lower risk (beta) (as Leverage Co. has a lower risk
(a lower beta).
 P5.17
• P5.17 Referring to Problem 5.16, if you expect a significant market
slump, would your decision be altered? Explain.
Answer to P 5.17

• Your decision will not be altered because the stock of Leverage Co. is
likely to fall more sharply than that of Value Corp. when the market
slumps.
 P5.18:
• A security has a beta of 1.2. Is this security more or less risky than the market?
Explain. Assess the impact on the required return of this security in each of the
following cases.
• a. The market return increases by 15%.
• b. The market return decreases by 8%.
• c. The market return remains unchanged.
Answer to P5.18:
• A beta of 1.2 suggests that this security is 20% riskier than the market,
meaning that the stock has 20% more systematic risk than the overall
market does.
• When the market moves, this stock will, on average, move even more.
• If the market’s return increases 15%, the security’s expected return
should increase by 1.2(15%) = 18%.
• If the market’s return decreases 8%, the security’s expected return
should decrease by 1.2(8%) = 9.6%.
• If the market’s return remains constant, the security’s expected return
should be unchanged.
 P5.19:
Assume the betas for securities A, B, and C are as shown here

Security Beta

A 1.4

B 0.8

C -0.9
P5.19:
• a. Calculate the change in return for each security if the market
experiences an increase in its rate of return of 13.2% over the next
period.
• b. Calculate the change in return for each security if the market
experiences a decrease in its rate of return of 10.8% over the next
period.
• c. Rank and discuss the relative risk of each security based on your
findings. Which security might perform best during an economic
downturn? Explain
Answer to P5.19:

Security Beta Change in Change in

rm ri
A 1.4 13.2% 18.5%
B 0.8 13.2% 10.6%
C –0.9 13.2% –11.9%

b.
Security Beta Change in Change in
rm ri
A 1.4 –10.8% –15.1%
B 0.8 –10.8% –8.6%
C –0.9 –10.8% 9.7%
Answer to P5.19:
Security A is the most risky security in the sense that it has the highest
beta.
Security C’s negative beta means that its returns are negatively
correlated with the market, making it the least risky security.
Because Security C performs best when most other securities are
performing poorly (i.e., C does well when the market does poorly), it
acts like a kind of insurance policy for a stock portfolio.
Adding C to a portfolio with a positive beta would therefore reduce the
portfolio’s overall risk.
A portfolio comprised of 50% A and 50% C, for example, would have a
beta of only 0.5(1.4) + 0.5(–0.9) = 0.25.
P5.20:
Referring to Problem 5.19, assume you have a portfolio with $20,000
invested in each of investments A, B, and C. What is your portfolio
beta?
Answer to P5.20:
Because each investment has an equal weight, the portfolio beta is
simply 1/3(1.4) + 1/3(0.8) + 1/3(–.9) = 0.43.
P5.21:
Referring to Problem 5.20, using the portfolio beta, what would you
expect the value of your portfolio to be if the market rallied 20%?
Declined 20%?
 Answer to P5.21:
• If the market rallied 20%, the portfolio would be expected to rise by
0.43(20%) = 8.6%.
• The $60,000 portfolio would then have a value of $60,000(1.086) =
$65,160.
• If the market declined 20%, the portfolio would be expected to fall
by 0.43(20%) = 8.6%.
• The $60,000 portfolio would then have a value of $60,000(1 – 0.086)
= $54,840.