Tutorial

3_10 Questions

CQ7.3 Suppose that the standard deviation of the returns on the shares at two different
companies is exactly the same. Does this mean that the required rate of return will be the
same for these two shares? How might the required rate of return on the share of a third
company be greater than the required rates of return on the shares of the first two
companies even if the standard deviation of the returns of the third companys share is
lower?

No. Because some risk (i.e. unsystematic risk = diversifiable risk =unique risk) can be
diversified away, it is possible that two shares with the same standard deviation of returns can
have different required rates of return.
o Please note that a required rate of return is the rate of return required for a given level
of systematic risk (beta).

One of these shares can have a higher systematic risk (beta) than the other share and,
therefore, a higher required rate of return.

The third share can have a higher required rate of return if its systematic risk is greater than
the systematic risk of the shares in the other two companies.


QP7.1 Returns: Describe the difference between a total holding period return and an expected
return.

A holding period return is the total return over some investment or holding period. It consists of
a capital appreciation component and an income component. The holding period return reflects
past performance.

An expected return measures a return you expect to realize from an investment (may or may not
occur). You can use two types of data to compute the expected return.

Using information on possible future outcomes with the probability given to each outcome, the
expected return is a weighted average of the possible returns from an investment.

Using historical data, the expected return is the average of all available returns over the sample
period (may have to be annualized depending on the frequency of data). Here, the historical
performance is used as a proxy for the return to be received in the future.

Be able to distinguish the expected return and required return. The required rate of return is the
rate of return that investors require to compensate them for the systematic risk (beta) associated
with an investment.

The required rate of return measures what an investor should be able to receive for a given level
of systematic risk that the investor is prepared to tolerate. The expected return may or may not
match the required return.





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QP7.2 Expected returns: John is watching an old game show on rerun television called Lets
Make a Deal in which you have to choose a prize behind one of two curtains. One of the curtains
will yield a gag prize worth $150, and the other will give a car worth $7,200. The game show
has placed a subliminal message on the curtain containing the gag prize, which makes the
probability of choosing the gag prize equal to 75 per cent. What is the expected value of the
selection, and what is the standard deviation of that selection?

E(prize) =0.75($150) + (0.25) ($7,200) = $1,912.50
2prize = 0.75($150 $1,912.50)2 + (0.25) ($7,200 $1,912.50)2

= $9,319,218.75
prize = ($9,319,218.75)1/2 = $3,052.74

7.5 Singleasset portfolios: Shares A, B, and C have expected returns of 15 per cent, 15 per
cent, and 12 per cent, respectively, while their standard deviations are 45 per cent, 30
per cent, and 30 per cent, respectively. If you were considering the purchase of each of
these shares as the only holding in your portfolio, then which share should you choose?

Since each share will be held as a standalone investment and three shares have different levels of
expected returns and standard deviations, we have to calculate the risk per unit of return for each
share, the coefficient of variation, and choose the share with the lowest value.

CV(RA) = 0.45/0.15 = 3.0
CV(RB) = 0.30/0.15 = 2.0 ===> Choose B
CV(RC) = 0.30/0.12 = 2.5

Alternatively, we could have noted that the expected return for A and B was the same, with A
having a greater degree of risk. Therefore B is preferred to A.

B and C have the same degree of risk, but B has a greater expected return. This would lead you to
the conclusion, just as our coefficient of variation calculations did, that Share B is superior.

7.6 Diversification: Describe how investing in more than one asset can reduce risk through
diversification.

Diversification An investor can reduce the risk of his or her investments by investing in two
or more assets whose values do not always move in the same direction at the same time.

This is because negative returns in one asset may be offset by positive returns in another.

Such an example can exist between the oil sector (e.g. Santos) and airline sector (e.g. Qantas).
Both are dependent on the price of oil with oil price rises possibly meaning increased profits
for an oil company and lower profits for an airline.

The less positively correlated (or the more negatively correlated) the returns from two
securities, the greater the reduction in portfolio risks.

Q: What is the type of risk being reduced here?
A: Unsystematic risk

Combining stocks with high correlation is not recommended as this does not reduce risk but
simply results in risk averaging. For example, combining a number of gold mining stocks
together to form a portfolio may not achieve the desired level of diversification.
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7.7 Define systematic risk.

Risk that cannot be diversified away is called systematic risk.
It is the only type of risk that exists in a diversified portfolio, and it is the only type of risk that
is rewarded in asset markets.


7.14 Interpreting the variance and standard deviation: The distribution of grades in an
introductory finance class is normally distributed, with an expected grade of 75. If the
standard deviation of grades is 7, in what range would you expect 95 per cent of the
grades to fall?

The normal distribution is a symmetric distribution that is described by its mean and
standard deviation.

The mean is the value that defines the centre of the distribution.

The standard deviation describes the dispersion of the values centred around the mean.

The following table shows the fraction of all observations in a normal distribution that
are within the indicated number of standard deviations from the mean.

Fraction of total observations
Number of
from the mean
1
68.26%
1.645
90%
1.96
95%
2.575
99%

So, back to our question, in what range would you expect 95 per cent of the grades to
fall?

As shown above, 95% is 1.96 standard deviations from the mean.

Therefore, mean 1.96*

=75 1.96(7) = (61.28 ,88.72)

95% of total grades are expected to range from 61.28 to 88.72.

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QP7.16
Calculating the variance and standard deviation: Ling Ying is considering
investing in a share, and is aware that the return on that investment is particularly
sensitive to how the economy is performing. Her analysis suggests that four states of the
economy can affect the return on the investment. Using the table of returns and
probabilities below, find the expected return and the standard deviation of the return on
Ling Yings investment.

Probability
Return
Boom
0.1
25.00%
Good
0.4
15.00%
Level
0.3
10.00%
Slump
0.2
5.00%

E(Ri) = 0.1(0.25) + (0.4) (0.15) + (0.3) (0.1) + (0.2) (0.05) = 0.105
2return = 0.1(0.25 0.105)2 + (0.4) (0.15 0.105)2 + (0.3) (0.1 0.105)2 + (0.2) (0.05 0.105)2
= 0.00773
return = (0.00773)1/2 = 0.08789


Qp7.19
Portfolios with more than one asset: Jackie is analysing a twoshare portfolio that
consists of a Utility share and a Commodity share. She knows that the return on the
Utility has a standard deviation of 40 per cent, and the return on the Commodity has a
standard deviation of 30 per cent. However, she does not know the exact covariance in
the returns of the two shares. Jackie would like to plot the variance of the portfolio for
each of three casescovariance of 0.12, 0, and 0.12in order to understand how the
variance of such a portfolio would react. Do the calculation for each of the extreme cases
(0.12 and 0.12), assuming an equal proportion of each share in Jackies portfolio.

2p x12 12 x22 22 2x1x2 12

Part 1, 12 = 0.12:


(0.5)2 (0.4)2 + (0.5)2 (0.3)2 + 2(0.5)(0.5)(0.12) = 0.1225

Part 2, 12= 0.0:


(0.5)2 (0.4)2 + (0.5)2 (0.3)2 + 2(0.5)(0.5)(0.0) = 0.0625

Part 3, 12 = 0.12:


(0.5)2 (0.4)2 + (0.5)2 (0.3)2 + 2(0.5)(0.5)(0.12) = 0.0025

Can you observe that the less positively correlated the returns from two securities, the smaller the
standard deviation (i.e. a greater reduction in portfolio risk)



32 The expected return on the market portfolio is 15%, and the return on the riskfree
security is 5%. What is the expected return on a portfolio with a beta equal to 0.5? 10%


Using the CAPM, we find

E(Rp) = Rrf + p (E[RM] Rrf)

0.10 = 0.05 + 0.5(0.15 0.05)






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