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= 0.014447
= 0.003363
The covariance between the returns on Highbull’s stock and Slowbear’s stock is 0.000425.
The correlation between the returns on Highbull’s stock and Slowbear’s stock is 0.9770.
10.4 Value of Atlas stock in the portfolio = (120 shares)($50 per share)
= $6,000
The expected return on a portfolio composed of 30% of Security F and 70% of Security G is
16.20%.
P = (2P)1/2
P = (2P)1/2
= (0.033244)1/2
= 0.1823
=18.23%
If the correlation between the returns of Security F and Security G is 0.2, the standard
deviation of the portfolio is 18.23%.
The expected return on a portfolio composed of 40% stock A and 60% stock B is 21%.
P = (2P)1/2
P = (0.0208)1/2
= 0.1442
=14.42%
If the correlation between the returns on Stock A and Stock B is 0.5, the standard deviation
of the portfolio is 14.42%.
b. 2P = (WA)2(A)2 + (WB)2(B)2 + (2)(WA)(WB)(A)(B)[Correlation(RA, RB)]
= (0.40)2(0.10)2 + (0.60)2(0.20)2 + (2)(0.40)(0.60)(0.10)(0.20)(-0.5)
= 0.0112
P = (0.0112)1/2
= 0.1058
=10.58%
If the correlation between the returns on Stock A and Stock B is -0.5, the standard deviation
of the portfolio is 10.58%.
c. As Stock A and Stock B become more negatively correlated, the standard deviation of the
portfolio decreases.
10.7 a. Value of Macrosoft stock in the portfolio = (100 shares)($80 per share)
= $8,000
P = (2P)1/2
P = (0.018342)1/2
= 0.1354
=13.54%
b. Janet started with 300 shares of Intelligence stock. After selling 200 shares, she has 100 shares
left.
P = (0.009991)1/2
= 0.1000
=10.00%
= 0.011025
P = (2P)1/2
P = (0.002756)1/2
= 0.0525
=5.25%
P = (2P)1/2
P = (0.01125)1/2
= 0.1061
= 10.61%
P = (0.00225)1/2
= 0.0474
= 4.74%
c. No, you would not hold 100% of Stock A because the portfolio in part b has a higher expected
return and lower standard deviation than Stock A.
You may or may not hold 100% of Stock B, depending on your risk preference. If you have a low
level of risk-aversion, you may prefer to hold 100% Stock B because of its higher expected return.
If you have a high level of risk-aversion, however, you may prefer to hold a portfolio containing
both Stock A and Stock B since the portfolio will have a lower standard deviation, and hence, less
risk, than holding Stock B alone.
10.10 The expected return on the portfolio must be less than or equal to the expected return on the asset with the
highest expected return. It cannot be greater than this asset’s expected return because all assets with lower
expected returns will pull down the value of the weighted average expected return.
Similarly, the expected return on any portfolio must be greater than or equal to the expected return on the
asset with the lowest expected return. The portfolio’s expected return cannot be below the lowest expected
return among all the assets in the portfolio because assets with higher expected returns will pull up the
value of the weighted average expected return.
P = (2P)1/2
P = (0.00600)1/2
= 0.0245
=2.45%
10.12 The wide fluctuations in the price of oil stocks do not indicate that these stocks are a poor investment. If an
oil stock is purchased as part of a well-diversified portfolio, only its contribution to the risk of the entire
portfolio matters. This contribution is measured by systematic risk or beta. Since price fluctuations in oil
stocks reflect diversifiable plus non-diversifiable risk, observing the standard deviation of price movements
is not an adequate measure of the appropriateness of adding oil stocks to a portfolio.
P = (2P)1/2
P = (0.001125)1/2
= 0.0335
= 3.35%
P = (0)1/2
=0
= 0%
P = (0.000500)1/2
= 0.0224
= 2.24%
f. As long as the correlation between the returns on two securities is below 1, there is a benefit to
diversification. A portfolio with negatively correlated stocks can achieve greater risk reduction
than a portfolio with positively correlated stocks, holding the expected return on each stock
constant. Applying proper weights on perfectly negatively correlated stocks can reduce portfolio
variance to 0.
10.14 a.
State Return on A Return on B Probability
1 15% 35% (0.40)(0.50) = 0.2
2 15% -5% (0.40)(0.50) = 0.2
3 10% 35% (0.60)(0.50) = 0.3
4 10% -5% (0.60)(0.50) = 0.3
b. E(RP) = (0.20)[(0.50)(0.15) + (0.50)(0.35)] + (0.20)[(0.50)(0.15) + (0.50)(-0.05)] +
(0.30)[(0.50)(0.10) + (0.50)(0.35)] + (0.30)[(0.50)(0.10) + (0.50)(-0.05)]
= 0.135
= 13.5%
E(RP) = E(Ri) / N
E(RP) = E(Ri) / N
= [(0.10)(N)] / N
= 0.10
= 10%
The expected return on an equally weighted portfolio containing all N securities is 10%.
Since there are N securities, there are (N)(N-1) different pairs of covariances between the returns
on these securities.
The variance of an equally weighted portfolio containing all N securities can be represented
by the following expression:
(0.0064)(N-1) / N + (0.0144)/(N)
b. As N approaches infinity, the expression (N-1)/N approaches 1 and the expression (1/N)
approaches 0. It follows that, as N approaches infinity, the variance of the portfolio approaches
0.0064 [= (0.0064)(1) + (0.0144)(0)], which equals the covariance between any two individual
securities in the portfolio.
c. The covariance of the returns on the securities is the most important factor to consider when
placing securities into a well-diversified portfolio.
10.16 The statement is false. Once the stock is part of a well-diversified portfolio, the important factor is the
contribution of the stock to the variance of the portfolio. In a well-diversified portfolio, this contribution is
the covariance of the stock with the rest of the portfolio.
10.17 The covariance is a more appropriate measure of a security’s risk in a well-diversified portfolio because the
covariance reflects the effect of the security on the variance of the portfolio. Investors are concerned with
the variance of their portfolios and not the variance of the individual securities. Since covariance measures
the impact of an individual security on the variance of the portfolio, covariance is the appropriate measure
of risk.
10.18 If we assume that the market has not stayed constant during the past three years, then the lack in movement
of Southern Co.’s stock price only indicates that the stock either has a standard deviation or a beta that is
very near to zero. The large amount of movement in Texas Instrument’ stock price does not imply that the
firm’s beta is high. Total volatility (the price fluctuation) is a function of both systematic and unsystematic
risk. The beta only reflects the systematic risk. Observing the standard deviation of price movements does
not indicate whether the price changes were due to systematic factors or firm specific factors. Thus, if you
observe large stock price movements like that of TI, you cannot claim that the beta of the stock is high. All
you know is that the total risk of TI is high.
10.19 Because a well-diversified portfolio has no unsystematic risk, this portfolio should like on the Capital
Market Line (CML). The slope of the CML equals:
E(RP) = rf + SlopeCML(P)
E(RP) = rf + SlopeCML(P)
= 0.05 + (0.70)(0.07)
= 0.99
= 9.9%
b. E(RP) = rf + SlopeCML(P)
0.20 = 0.05 + (0.70)(P)
0.15
0.1
Fuji
0.05
0
0 0.05 0.1 0.15 0.2
Return on the Market
Beta, by definition, equals the slope of the characteristic line. Therefore, Fuji’s beta is 0.68.
10.21 Polonius’ portfolio will be the market portfolio. He will have no borrowing or lending in his portfolio.
b. The beta of a portfolio equals the weighted average of the betas of the individual securities within
the portfolio.
c. If the Capital Asset Pricing Model holds, the three securities should be located on a straight line
(the Security Market Line). For this to be true, the slopes between each of the points must be
equal.
Security Market Line
0.25
0.2
0.15
0.1
0.05
0
0 0.5 1 1.5 2
B eta
Since the slopes between the three points are different, the securities are not correctly priced
according to the Capital Asset Pricing Model.
E(r) = rf + (EMRP)
In this problem:
rf = 0.06
1.2
EMRP = 0.085
E(r) = rf + (EMRP)
= 0.06 + 1.2(0.085)
= 0.162
E(r) = rf + (EMRP)
In this problem:
rf = 0.06
0.80
EMRP = 0.085
E(r) = rf + (EMRP)
= 0.06 + 0.80(0.085)
= 0.128
In this problem:
rf = 0.08
1.5
E(rm) = 0.15
E(r) = rf + (EMRP)
In this problem:
E(r) = 0.142
rf = 0.037
EMRP = 0.075
E(r) = rf + (EMRP)
0.142 = 0.037 + (0.075)
10.27 Because the Capital Asset Pricing Model holds, both securities must lie on the Security Market Line
(SML). Given the betas and expected returns on the two stocks, solve for the slope of the SML.
0.3
Expected Return
0.25
0.2
0.15
0.1
0.05
0
0 0.5 1 1.5
Beta
A security with a beta of 0.7 has an expected return of 0.14. As you move along the SML from a beta of
0.7 to a beta of 1, beta increases by 0.3 (= 1 – 0.7). Since the slope of the security market line is 0.1571, as
beta increases by 0.3, expected return increases by 0.0471 (= 0.3 * 0.1571). Therefore, the expected return
on a security with a beta of one equals 18.71% (= 0.14 + 0.0471).
Since the market portfolio has a beta of one, the expected return on the market portfolio is 18.71%.
Since Murck Pharmaceutical has a beta of 1.4 and an expected return of 0.25, we know that:
0.25 = rf + 1.4(0.1871 – rf)
rf = 0.03
0.3
0.25
Expected Return
0.2
0.15
0.1
0.05
0
0 0.5 1 1.5
Beta
E(rA) = 0.075
E(rB) = 0.05
We also know that the beta of A is 0.25 greater than the beta of B. Therefore, as beta increases by
0.25, the expected return on a security increases by 0.025 (= 0.075 – 0.5). Consider the following
graph:
0.08
Expected Return
0.06
0.04
0.02
0
Beta
The slope of the security market line (SML) equals:
The expected market risk premium is the difference between the expected return on the market and
the risk-free rate. Since the market’s beta is 1 and the risk-free rate has a beta of zero, the slope of
the Security Market Line equals the expected market risk premium.
0.2
Expected Return
0.15
0.1
0.05
0
0 0.5 1 1.5 2 2.5
Beta
b. According to the security market line drawn in part a, a security with a beta of 0.80 should have an
expected return of:
E(r) = rf + (EMRP)
= 0.07 + 0.8(0.05)
= 0.11
= 11%
Since this asset has an expected return of only 9%, it lies below the security market line. Because
the asset lies below the security market line, it is overpriced. Investors will sell the overpriced
security until its price falls sufficiently so that its expected return rises to 11%.
c. According to the security market line drawn in part a, a security with a beta of 3 should have an
expected return of:
E(r) = rf + (EMRP)
= 0.07 + 3(0.05)
= 0.22
= 22%
Since this asset has an expected return of 25%, it lies above the security market line. Because the
asset lies above the security market line, it is underpriced. Investors will buy the underpriced
security until its price rises sufficiently so that its expected return falls to 22%.
10.30 According to the Capital Asset Pricing Model (CAPM), the expected return on the stock should be:
E(r) = rf + EMRP)
E(r) = rf + EMRP)
= 0.05 + 1.8(0.08)
= 0.194
According to the CAPM, the expected return on the stock should be 19.4%. However, the security analyst
expects the return to be only 18%. Therefore, the analyst is pessimistic about this stock relative to the
market’s expectations.
In this problem:
rf = 0.064
1.2
E(rm) = 0.138
b. If the risk-free rate decreases to 3.5%, the expected return on Solomon’s stock is:
10.32 First, calculate the standard deviation of the market portfolio using the Capital Market Line (CML).
We know that the risk-free rate asset has a return of 5% and a standard deviation of zero and the portfolio
has an expected return of 25% and a standard deviation of 4%. These two points must lie on the Capital
Market Line.
0.3
0.25
Expected Return
0.2
0.15
0.1
0.05
0
0 0.01 0.02 0.03 0.04 0.05
Standard Deviation
E(ri) = rf + SlopeCML(i)
Since we know the expected return on the market portfolio is 20%, the risk-free rate is 5%, and the slope of
the Capital Market Line is 5, we can solve for the standard deviation of the market portfolio (m).
E(rm) = rf + SlopeCML(m)
0.20 = 0.05 + (5)(m)
m = (0.20 – 0.05) / 5
= 0.03
Next, use the standard deviation of the market portfolio to solve for the beta of a security that has a
correlation with the market portfolio of 0.5 and a standard deviation of 2%.
In this problem:
rf = 0.05
= 1/3
E(rm) = 0.20
A security with a correlation of 0.5 with the market portfolio and a standard deviation of 2% has an
expected return of 10%.
E(r) = rf + (EMRP)
In this problem:
E(r) = 0.167
rf = 0.076
= 1.7
E(r) = rf + (EMRP)
0.167 = 0.076 + 1.7(EMRP)
E(r) = rf + (EMRP)
rf = 0.076
= 0.8
EMRP = 0.0535
E(r) = rf + (EMRP)
= 0.076 + 0.8(0.0535)
= 0.1188
c. The beta of a portfolio is the weighted average of the betas of the individual securities in the
portfolio. The beta of Potpourri is 1.7, the beta of Magnolia is 0.8, and the beta of a portfolio
consisting of both Potpourri and Magnolia is 1.07.
Therefore:
WP = 1 - WM
WM = 0.70
WP = 1 - WM
= 1 – 0.70
= 0.30
You have 70% of your portfolio ($7,000) invested in Magnolia stock and 30% of your portfolio
($3,000) invested in Potpourri stock.
Since the market portfolio has a variance of 0.0121, it has a standard deviation of 11% [= (0.0121)1/2].
Since the portfolio has a variance of 0.0169, it has a standard deviation of 13% [= (0.0169)1/2].
E(r) = rf + (EMRP)
Since the risk-free rate equals 4.9% and the expected market risk premium is 9.4%, the CAPM
implies:
Use the Capital Asset Pricing Model to determine the required return on Durham’s stock.
E(r) = rf + (EMRP)
In this problem:
rf = 0.049
= 1.467
EMRP = 0.094
E(r) = rf + (EMRP)
= 0.049 + 1.467(0.094)
= 0.1869
10.36 Because the Capital Asset Pricing Model holds, both securities must lie on the Security Market Line
(SML). Given the betas and expected returns of the two stocks, solve for the slope of the SML.
0.2
Expected Return
0.15
0.1
0.05
0
0 0.5 1 1.5 2
Beta
A security with a beta of 1.2 has an expected return of 0.14. As you move along the SML from a beta of
1.2 to a beta of 1, beta decreases by 0.2 (= 1.2 – 1). Since the slope of the security market line is 0.10, as
beta decreases by 0.2, expected return decreases by 0.02 (= 0.2 * 0.10). Therefore, the expected return on a
security with a beta of one equals 12% (= 0.14 - 0.02).
Since the market portfolio has a beta of one, the expected return on the market portfolio is 12%.
Since Williamson has a beta of 1.2 and an expected return of 0.14, we know that:
rf = 0.02
0.2
Expected Return
0.15
0.1
0.05
0
0 0.5 1 1.5 2
Beta
10.37 The statement is false. If a security has a negative beta, investors would want to hold the asset to reduce
the variability of their portfolios. Those assets will have expected returns that are lower than the risk-free
rate. To see this, examine the Capital Asset Pricing Model.
The beta of a portfolio is the weighted average of the betas of its individual securities.
In this problem:
rf = 0.04
= 1.293
E(rm) = 0.15
(i) i = (i,m)(i) / m
0.9 = (i,m)(0.12) / 0.10
i,m = 0.75
(ii) i = (i,m)(i) / m
1.1 = (0.4)(i) / 0.10
i = 0.275
(iii) i = (i,m)(i) / m
= (0.75)(0.24) / 0.10
= 1.8
(vii) The risk-free asset has 0 correlation with the market portfolio.
Firm A
rf = 0.05
= 0.9
E(rm) = 0.15
According to the CAPM, the expected return on Firm A’s stock should be 14%. However, the
expected return on Firm A’s stock given in the table is only13%. Therefore, Firm A’s stock is
overpriced, and you should sell it.
Firm B
rf = 0.05
= 1.1
E(rm) = 0.15
According to the CAPM, the expected return on Firm B’s stock should be 16%. The expected return
on Firm B’s stock given in the table is also 16%. Therefore, Firm A’s stock is correctly priced.
Firm C
rf = 0.05
= 1.8
E(rm) = 0.15
According to the CAPM, the expected return on Firm C’s stock should be 23%. However, the
expected return on Firm C’s stock given in the table is 25%. Therefore, Firm A’s stock is
underpriced, and you should buy it.
10.40 a. A typical, risk-averse investor seeks high returns and low risks. For a risk-averse investor holding a
well-diversified portfolio, beta is the appropriate measure of the risk of an individual security. To
assess the two stocks, find the expected return and beta of each of the two securities.
Stock A
Since Stock A pays no dividends, the return on Stock A is simply [(P1 – P0) –1].
A = (0.0096)1/2
= 0.098
A = Correlation(RA, RM)(A) / M
= (0.8)(0.098) / 0.10
= 0.784
Stock B
B = Correlation(RB, RM)(B) / M
= (0.2)(0.12) / 0.10
= 0.24
The expected return on Stock B is higher than the expected return on Stock A. The risk of Stock B,
as measured by its beta, is lower than the risk of Stock A. Thus, a typical risk-averse investor
holding a well-diversified portfolio will prefer Stock B.
The expected return on a portfolio consisting of 70% of Stock A and 30% of Stock B is 8.3%.
P = (0.008965)1/2
= 0.0947
The standard deviation of a portfolio consisting of 70% of Stock A and 30% of Stock B is
9.47%.
c. The beta of a portfolio is the weighted average of the betas of its individual securities.
P = (0.70)(0.784) + (0.30)(0.24)
= 0.6208
The beta of a portfolio consisting of 70% of Stock A and 30% of Stock B is 0.6208.
A = 0.10
B = 0.20
Covariance(RA, RB) = 0.001
Therefore,
Minimize this function (the portfolio variance). We do this by differentiating the function with respect
to XB.
0 = -0.018 + 0.096XB
XB = (0.018) / (0.096)
= 0.1875
XA = 1 - XB
= 1 – 0.1875
= 0.8125
In order to minimize the variance of the portfolio, the weight of Stock A in the portfolio should
be 81.25% and the weight of Stock B in the portfolio should be 18.75%.
b. Using the weights calculated in part a, determine the expected return of the portfolio.
A = 0.10
B = 0.20
Covariance(RA, RB) = -0.02
Therefore,
0 = -0.06 + 0.18XB
XB = (0.06) / (0.18)
= 1/3
XA = 1 - XB
= 1 – (1/3)
= 2/3
In order to minimize the variance of the portfolio, the weight of Stock A in the portfolio should
be 1/3 and the weight of Stock B in the portfolio should be 2/3.
In this problem:
XA = 1/3
XB = 2/3
A = 0.10
B = 0.20
Covariance(RA, RB) = -0.02