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CHAPTER 22
I. Questions
1. Risk is the variability of an assets future returns. When only one return is
possible, there is no risk. When more than one return is possible, the
asset is risky.
2. An objective probability distribution is generally based on past outcomes
of similar events while a subjective probability distribution is based on
opinions or educated guesses about the likelihood that an event will
have a particular future outcome.
3. A discrete probability distribution is an arrangement of the probabilities
associated with the values of a variable that can assume a limited or
finite number of values (outcomes) while a continuous probability
distribution is an arrangement of probabilities associated with the values
of a variable that can assume an infinite number of possible values
(outcomes).
4. The accuracy of forecasted returns generally decreases as the length of
the project being forecast increases. This increases the variability of an
assets returns and therefore risk.
5. The expected value of return of a single asset is the weighted average of
the returns, with the weights being the probabilities of each return.
6. The risk of a single asset is measured by its standard deviation or
coefficient of variation. The standard deviation measures the variability
of outcomes around the expected value and is an absolute measure of
risk. The coefficient of variation is the ratio of the standard deviation to
the expected value and is a relative measure of risk.
7. The characteristic of a normal curve is a bell-shaped distribution that is
dependent upon the mean and the standard deviation of the population
under investigation. Since the normal distribution is a continuous rather
than a discrete distribution, it is not possible to speak of the probability
of a point but only of the probability of falling within some specified
range of values. Thus, the area under the curve between any two points
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Chapter 22 Estimating Risk and Return on Assets
must then also depend upon the values of the mean and standard
deviation. However, it is possible to standardize any normal distribution
so that it has a mean of zero and a standard deviation of one.
8. Decision makers may be classified into three categories according to
their risk preferences: risk-averse, risk-neutral and risk-taker. Financial
theory assumes that decision makers are risk-averse.
9. Portfolio risk is measured by the portfolio standard deviation. Portfolio
risk is influenced by diversification. Risk reduction is achieved through
diversification whenever the returns of the assets combined in a portfolio
are not perfectly positively correlated. Correlation measures the tendency
of two variables to move together.
10. No to both questions. The portfolio expected return is a weighted average
of the asset returns, so it must be less than the largest asset return and
greater than the smallest asset return.
11. False. The variance of the individual assets is a measure of the total risk.
The variance on a well-diversified portfolio is a function of systematic
risk only.
12. Yes, the standard deviation can be less than that of every asset in the
portfolio. However, p cannot be less than the smallest beta because p is
a weighted average of the individual asset betas.
1. B 3. D 5. B 7. A
2. C 4. A 6. B
III. Problems
Problem 1
(a) The bar charts for Stock A and Stock B are shown in the next page.
(b) Stock As probability distribution is skewed to the left and Stock Bs
probability distribution is symmetrical.
(c) Stock As range of returns is 24 percentage points (25 1) and Stock Bs
range of returns is 20 points (30 10).
(d) Stock A is riskier than Stock B because Stock A has a wider range of
returns and a flatter probability distribution.
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Estimating Risk and Return on Assets Chapter 22
Stock A
0.60
0.50
0.40
bab
ility
Pro
0.30
0.20
0.10
-10 40 0 5 10 15 20 25 30 35 40
-5
Return (%)
Stock B
0.60
0.50
0.40
babi
Pro
lity
0.30
0.20
0.10
-10 -5 0 5 10 15 20 25 30 35 40
-5
Return (%)
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Chapter 22 Estimating Risk and Return on Assets
Problem 2
Problem 3
(a) The calculation of the expected value can be set up in tabular form.
i pi ri (%) pi ri (%)
1 0.1 0 0
2 0.2 10 2.0
3 0.4 20 8.0
4 0.2 30 6.0
5 0.1 40 4.0
= 20.0%
(b) The calculation of the standard deviation can also be set up in tabular
form. The square root of the variance, 2, of 120 percent is 10.95 percent
(rounded).
120.0 = 10.95%
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Estimating Risk and Return on Assets Chapter 22
10.95
CV = 20.00 = 0.55
A coefficient of variation of 0.55 means that there is 0.55 percent risk for
every 1 percent of return.
Problem 4
Problem 5
Standard
Expected Deviation
Value (20,000) Range
P100,000 1 P80,000 P120,000
P100,000 2 P60,000 P140,000
Problem 6
(a) Calculating the probability that the return will exceed P130,000 requires
three steps:
First, compute the z value as follows:
P130,000 P100,000
z = P20,000 = 1.50
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Chapter 22 Estimating Risk and Return on Assets
Next, find Pr (0 < z < 1.5) which is 0.4332 or 43.32 percent. This
probability is the chance of getting a return between the expected return
of P100,000 and a return of P130,000.
Finally, the probability of getting a return greater than P130,000 must be
calculated. Remember that in a normal distribution, 50 percent of the
outcomes lies on each side of the expected value. The probability of
receiving a return of more than P130,000 is 0.0668 (0.5000 0.4332) or
6.68 percent.
(b) Determining the probability of a return falling between P50,000 and
P130,000 requires several additional steps.
First, determine the z value for a return between P50,000 and P100,000.
P50,000 P100,000
z = P20,000 = 2.50
Problem 7
= 0.01005
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Estimating Risk and Return on Assets Chapter 22
= 0.10025 or 10.025%
Plan B
p = (0.2) 2 (0.16) 2 + (0.8) 2 (0.02) 2 + (2) (0.2) (0.8) (0.5) (0.16) (0.02)
= 0.00102 + 0.00026 + 0.00051
= 0.00179
= 0.04231 or 4.231%
(b) As shown in Plan B, both the expected portfolio return and portfolio
standard deviation decrease as a greater proportion of the portfolio is
invested in Mega Value Food Stores. Thus, the influence of Gigabyte
Computers higher expected risk and return are replaced in the portfolio
by Mega Value Food Stores lower expected risk and return.
Problem 8
The expected returns are just the possible returns multiplied by the associated
probabilities:
E (RA) = (.20 x -.15) + (.50 x .20) + (.30 x .60) = 25%
E (RB) = (.20 x.20) + (.50 x .30) + (.30 x .40) = 31%
The variances are given by the sums of the squared deviations from the expected
returns multiplied by their probabilities:
2A = .20 x (-.15 .25) 2 + .50 x (.20 .25) 2 + .30 x (.60 .25) 2
= (.20 x -.402) + (.50 x -.052) + (.30 x .352)
= (.20 x .16) + (.50 x .0025) + (.30 x .1225)
= .0700
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Chapter 22 Estimating Risk and Return on Assets
Problem 9
The portfolio weights are P15,000/20,000 = .75 and P5,000/20,000 = .25. The
expected return is thus:
E (RP) = .75 x E (RA) + .25 x E (RB)
= (.75 x 25%) + (.25 x 31%)
= 26.5%
Probability Weighted
State of of State of Portfolio Return if Returns
Economy Economy State Occurs (%)
Recession .20 (.75 x .15) + (.25 x .20) = .0625 1.25%
Normal .50 (.75 x .20) + (.25 x .30) = .2250 11.25%
Boom .30 (.75 x .60) + (.25 x .40) = .5500 16.5%
26.5%
Problem 10
The portfolio weight of an asset is total investment in that asset divided by the
total portfolio value. First, we will find the portfolio value, which is:
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Estimating Risk and Return on Assets Chapter 22
= .3182
Problem 11
The expected return of a portfolio is the sum of the weight of each asset times the
expected return of each asset. The total value of the portfolio is:
Problem 12
The expected return of a portfolio is the sum of the weight of each asset times the
expected return of each asset. So, the expected return of the portfolio is:
Problem 13
Here, we are given the expected return of the portfolio and the expected return of
each asset in the portfolio, and are asked to find the weight of each asset. We can
use the equation for the expected return of a portfolio to solve this problem.
Since the total weight of a portfolio must equal 1 (100%), the weight of Stock Y
must be one minus the weight of Stock X. Mathematically speaking, this means:
We can now solve this equation for the weight of Stock X as:
So, the amount invested in Stock X is the weight of Stock X times the total
portfolio value, or:
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Chapter 22 Estimating Risk and Return on Assets
The expected return of an asset is the sum of the probability of each return
occurring times the probability of that return occurring. So, the expected return of
the asset is:
Problem 15
The expected return of an asset is the sum of the probability of each return
occurring times the probability of that return occurring. So, the expected return of
the asset is:
Problem 16
The expected return of an asset is the sum of the probability of each return
occurring times the probability of that return occurring. So, the expected return of
each stock asset is:
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Estimating Risk and Return on Assets Chapter 22
Problem 17
The expected return of a portfolio is the sum of the weight of each asset times the
expected return of each asset. So, the expected return of the portfolio is:
Problem 18
(a) To find the expected return of the portfolio, we need to find the return of the
portfolio in each state of the economy. This portfolio is a special case since
all three assets have the same weight. To find the expected return in an
equally weighted portfolio, we can sum the returns of each asset and divide
by the number of assets, so the expected return of the portfolio in each state
of the economy is:
To find the expected return of the portfolio, we multiply the return in each
state of the economy by the probability of that state occurring, and then sum.
Doing this, we find:
(b) This portfolio does not have an equal weight in each asset. We still need to
find the return of the portfolio in each state of the economy. To do this, we
will multiply the return of each asset by its portfolio weight and then sum the
products to get the portfolio return in each state of the economy. Doing so,
we get:
Boom: E (Rp) = .20(.07) +.20(.15) + .60(.33) =.2420 or 24.20%
Recession: E (Rp) = .20(.13) +.20(.03) + .60(.06) = .0040 or 0.40%
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Chapter 22 Estimating Risk and Return on Assets
= .0821 or 8.21%
To find the variance, we find the squared deviations from the expected return.
We then multiply each possible squared deviation by its probability, than add
all of these up. The result is the variance. So, the variance and standard
deviation of the portfolio is:
p2 = .35(.2420 .0821)2 + .65(.0040 .0821)2
= .013767
= 11.73%
Problem 19
(a) This portfolio does not have an equal weight in each asset. We first need to
find the return of the portfolio in each state of the economy. To do this, we
will multiply the return of each asset by its portfolio weight and then sum the
products to get the portfolio return in each state of the economy. Doing so,
we get:
(b) To calculate the standard deviation, we first need to calculate the variance. To
find the variance, we find the squared deviations from the expected return.
We then multiply each possible squared deviation by its probability, than add
all of these up. The result is the variance. So, the variance and standard
deviation of the portfolio is:
p = .02436
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Estimating Risk and Return on Assets Chapter 22
= .1561 or 15.61%
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