CHAPTER5:RISKANDRETURN:PASTANDPROLOGUE

1. iandii.Thestandarddeviationisnonnegative.

2. c. Determinesmostoftheportfoliosreturnandvolatilityovertime.

3. Investment4. Foreachportfolio:Utility=E(r)(0.532)
Investment E(r) U
1 0.15 0.30 0.0150
2 0.20 0.50 -0.1750
3 0.15 0.16 0.1116
4 0.18 0.21 0.1139
Wechoosetheportfoliowiththehighestutilityvalue.

4. Investment2.Whenaninvestorisriskneutral,A=0sothattheportfoliowiththe
highestutilityistheportfoliowiththehighestexpectedreturn.

5. b.

6. V(12/31/2004)=V(1/1/1998)(1+g)7=100,000(1.06)7=150,363.03

7. E(r)=[0.3540%]+[0.415%]+[0.25(20%)]=15%
2=[0.35(4015)2]+[0.4(1515)2]+[0.25(2015)2]=525.00
=22.91%
Themeanhasincreasedandthestandarddeviationhasincreased.

8. E(rX)=[0.25(25%)]+[0.4518%]+[0.360%)]=19.85%
E(rY)=[0.25(20%)]+[0.4520%]+[0.315%)]=8.5%

51
9. X2=[0.25(2519.85)2]+[0.45(1819.85)2]+[0.3(6019.85)2]=988.03
X=31.43%
Y2=[0.25(208.5)2]+[0.45(208.5)2]+[0.3(158.5)2]=275.25
Y=16.59%

10. E(r)=(0.919.85%)+(0.18.5%)=18.715%

11. a. Theholdingperiodreturnsforthethreescenariosare:
Boom: (3525+1)/25=0.44=44.00%
Normal: (2525+0.50)/25=0.02=2.00%
Recession: (1025+0.25)/25=0.59=59.00%
E(HPR)=[(1/3)44%]+[(1/3)2%]+[(1/3)(59.00%)]=4.33%
2(HPR)=[(1/3)(44(4.33))]2+[(1/3)(2(4.33))]2+(1/3)[(59(4.33))]2
=1788.22
= 1788.22 =42.29%

b. E(r)=(0.54.33%)+(0.54%)=0.165%
=0.542.29%=21.145%

12. a. E(rP)=(0.36%)+(0.715%)=12.30%peryear
P=0.725%=17.5%peryear

b.
Investment
Security Proportions
TBills 30.0%
StockA 0.727%= 18.9%
StockB 0.733%= 23.1%
StockC 0.740%= 28.0%

15 6
c. YourRewardtovariabilityratio=S= =0.360
25
12.30 6
Client'sRewardtovariabilityratio= =0.360
17.5

52
 d.

E(r)

% CALslope=0.360)
(
P
15

12.3
client

17.5 25 %

13. a. Meanofportfolio=(1y)rf+yrP=rf+(rPrf)y=6+9y
Iftheexpectedrateofreturnfortheportfoliois12%,then,solvingfory:
12 6
12=6+9yy= =0.667
9
Therefore,inordertoachieveanexpectedrateofreturnof12%,theclient
mustinvest66.7%oftotalfundsintheriskyportfolioand33.3%inTbills.

b.
Investment
Security Proportions
TBills 33.3%
StockA 0.66727%= 18.0%
StockB 0.66733%= 22.0%
StockC 0.66740%= 26.7%

c. P=0.66725%=16.7%peryear

53
14. a. Portfoliostandarddeviation=P=y25%
Iftheclientwantsastandarddeviationof20%,then:
y=(20%/25%)=0.80=80.0%intheriskyportfolio.

b. Expectedrateofreturn=6+9y=6+(0.809)=13.20%

14 6
15. a. SlopeoftheCML= =0.333
24

b. Myfundallowsaninvestortoachieveahigherexpectedrateofreturnforany
givenstandarddeviationthanwouldapassivestrategy,i.e.,ahigherexpected
returnforanygivenlevelofrisk.

16. a. With70%ofhismoneyinmyfund'sportfolio,theclienthasanexpectedrate
ofreturnof12.3%peryearandastandarddeviationof17.5%peryear.Ifhe
shiftsthatmoneytothepassiveportfolio(whichhasanexpectedrateofreturn
of14%andstandarddeviationof24%),hisoverallexpectedreturnand
standarddeviationwouldbecome:
E(rC)=rf+0.7(rMrf)
Inthiscase,rf=6%andrM=14%.Therefore:
E(rC)=6+(0.78)=11.6%
Thestandarddeviationofthecompleteportfoliousingthepassiveportfolio
wouldbe:
C=0.7M=0.724%=16.8%
Therefore,theshiftentailsadeclineinthemeanfrom12.3%to11.6%anda
declineinthestandarddeviationfrom17.5%to16.8%.Sincebothmeanreturn
andstandarddeviationfall,itisnotyetclearwhetherthemoveisbeneficial.
Thedisadvantageoftheshiftisapparentfromthefactthat,ifmyclientis
willingtoacceptanexpectedreturnonhistotalportfolioof11.6%,hecan
achievethatreturnwithalowerstandarddeviationusingmyfundportfolio
ratherthanthepassiveportfolio.Toachieveatargetmeanof11.6%,wefirst
writethemeanofthecompleteportfolioasafunctionoftheproportions
investedinmyfundportfolio,y:
E(rC)=6+y(156)=6+9y

54
 Becauseourtargetis:E(rC)=11.6%,theproportionthatmustbeinvestedin
myfundisdeterminedasfollows:
11 .6 6
11.6=6+9yy= =0.62
9
Thestandarddeviationoftheportfoliowouldbe:
C=y25%=0.6225%=15.50%
Thus,byusingmyportfolio,thesame11.6%expectedrateofreturncanbe
achievedwithastandarddeviationofonly15.50%asopposedtothestandard
deviationof16.8%usingthepassiveportfolio.

b. Thefeewouldreducetherewardtovariabilityratio,i.e.,theslopeofthe
CAL.Clientswillbeindifferentbetweenmyfundandthepassiveportfolioif
theslopeoftheafterfeeCALandtheCMLareequal.Letfdenotethefee:
15 6 f 9f
SlopeofCALwithfee= =
25 25
14 6
SlopeofCML(whichrequiresnofee)= =0.3333
24
Settingtheseslopesequalandsolvingforf:
9f
=0.3333
25
9f=250.3333=8.33
f=98.33=0.67%peryear

17. Theprobabilityis0.45thatthestateoftheeconomyisneutral.Givenaneutral
economy,theprobabilitythattheperformanceofthestockwillbepooris0.15,
andtheprobabilityofbothaneutraleconomyandpoorstockperformanceis:
0.450.15=0.0675

18. E(r)=[0.120%]+[0.610%]+[0.35%)]=9.5%

19. a. E(rP)rf=AP2=4(0.25)=0.125=12.5%

b. 0.09=AP2=A(0.25)A=0.09/(0.0625)=2.88

c. Increasedrisktolerancemeansdecreasedriskaversion(A),whichresultsina
declineinriskpremiums.

55
20. a. Timeweightedaveragereturnsarebasedonyearbyyearratesofreturn.
Year Return=[(capitalgains+dividend)/price]
20022003 (20110+4)/110=12.73%
20032004 (80120+4.5)/120=29.58%
20042005 (9080+4.5)/80=18.13%
Arithmeticmean:0.43%
Geometricmean:2.12%

b.
Time Cashflow
0 330.00
1 228.00
2 102.50
3 378.00
Explanation
Purchaseofthreesharesat110pershare
Purchaseoftwosharesat120,
plusdividendincomeonthreesharesheld
Dividendsonfiveshares,
plussaleofoneshareat80
Dividendsonfourshares,
plussaleoffoursharesat90pershare

378
|
|
|
|
102.50 |
| |

|
|
Date: 1/1/02 1/1/03 1/1/04 1/1/05
| |
| |
| |
| |
| 228
330

Dollarweightedreturn=Internalrateofreturn=6.100%

21. Fortheperiod19262003,themeanannualriskpremiumforlargestocksover
Tbillsis:12.25%3.79%=8.46%
E(r)=Riskfreerate+Riskpremium=4%+8.46%=12.46%

56
22. a. Theexpectedcashflowis:(0.560,000)+(0.5160,000)=110,000
Withariskpremiumof10%,therequiredrateofreturnis15%.Therefore,if
thevalueoftheportfolioisX,then,inordertoearna15%expectedreturn:
X(1.15)=110,000X=95,652

b. Iftheportfolioispurchasedat95,652,andtheexpectedpayoffis110,000,
thentheexpectedrateofreturn,E(r),is:
110,000 95,652
=0.15=15.0%
95,652

Theportfoliopriceissettoequatetheexpectedreturnwiththerequiredrate
ofreturn.

c.IftheriskpremiumoverTbillsisnow16%,thentherequiredreturnis:
5%+16%=21%
Thevalueoftheportfolio(X)mustsatisfy:
X(1.21)=110,000X=90,909

d. Foragivenexpectedcashflow,portfoliosthatcommandgreaterriskpremiamust
sellatlowerprices.Theextradiscountfromexpectedvalueisapenaltyforrisk.

23. Inthetablebelow,weusedatafromTable5.3andtheapproximation:rRi:
LargeStocks: r12.25%3.12%= 9.13%
SmallStocks: r18.43%3.12%= 15.31%
LongTermTBonds: r5.64%3.12%= 2.52%
TBills: r3.79%3.12%= 0.67%
Next,wecomputerealratesusingtheexactrelationship:
1 R R i
r 1
1 i 1 i
LargeStocks: r=0.0913/1.0312= 8.85%
SmallStocks: r=0.1531/1.0312= 14.85%
LongTermTBonds: r=0.0252/1.0312= 2.44%
TBills r=0.0067/1.0312= 0.65%

24. Assumingnochangeintastes,thatis,anunchangedriskaversion,investorsperceiving
higherriskwilldemandahigherriskpremiumtoholdthesameportfoliotheyheld
before.Ifweassumethattheriskfreerateisunaffected,theincreaseintherisk
premiumwouldrequireahigherexpectedrateofreturnintheequitymarket.
57
25. b.

26. Expectedreturnforyourfund=Tbillrate+riskpremium=5%+8%=13%
Expectedreturnofclientsoverallportfolio=(0.613%)+(0.45%)=9.8%
Standarddeviationofclientsoverallportfolio=0.614%=8.4%

Risk premium 8
27. Rewardtovariabilityratio 0.57
Standard deviation 14

28.
Average Rate of Return, Standard Deviation
and Reward-to-Variability Ratio of the Risk Premiums
for Small Common Stocks over One Month Bills
for 1926-2003 and Various Sub-Periods
Risk Premium(%) Reward-to-
Mean SD Variability Ratio
1926-1943 18.40 60.00 0.3066
1944-1963 17.84 29.86 0.5975
1964-1983 13.61 35.30 0.3855
1984-2003 9.08 25.69 0.3535
1926-2003 14.64 38.72 0.3780

Table 5.5 (for comparison)

Risk Premium(%) Reward-to-
Mean SD Variability Ratio
1926-1943 7.15 29.07 0.2460
1944-1963 14.74 18.38 0.8018
1964-1983 2.76 17.29 0.1596
1983-2003 9.08 16.79 0.5408
1926-2003 8.46 20.80 0.4071

a. Fortheentireperiod(19262003),smallstockshadalowerrewardto
variabilityratio(0.3780)thanlargestocks(0.4071).However,intwoofthe
foursubperiods,smallstocksperformedbetterthanlargestocks.

b. Ingeneral,yes.

58
29.
Average Real Return, Standard Deviation
and Reward-to-Variability Ratio for Real Returns
for Large Stocks for 1926-2003 and Various Sub-Periods
Real Return(%) Reward-to-
Mean SD Variability Ratio
1926-1943 8.16 28.20 0.2895
1944-1963 13.39 19.44 0.6887
1964-1983 3.51 16.80 0.2091
1984-2003 10.96 16.86 0.6496
1926-2003 9.03 20.56 0.4391

Exceptfortheperiod19441963,rewardtovariabilityratiosforrealratesare
higherthanthoseforexcessreturns.

30.
Average Real Return, Standard Deviation
and Reward-to-Variability Ratio for Real Returns
for Small Stocks for 1926-2003 and Various Sub-Periods
Real Return(%) Reward-to-
Mean SD Variability Ratio
1926-1943 18.99 57.93 0.3278
1944-1963 16.48 30.15 0.5467
1964-1983 13.84 33.77 0.4099
1984-2003 11.04 24.59 0.4491
1926-2003 14.99 37.48 0.4000

Asisthecasewithlargestocks,rewardtovariabilityratiosofrealratesforsmall
stocksaregenerallyhigherthanthoseforexcessreturns.Thissuggeststhatboth
portfolioshavesimilarcorrelationswithinflation.

59