FINANCIAL MANAGEMENT 2

1. What is the expected return for the following stock? (State your answer 8. Your have decided to invest all your wealth in two mutual funds: A and B.
in percent with one decimal place.) Their returns are characterized as follows:
Outcomes Possible returns Probability • The mean returns are ¯rA = 20% and ¯rB = 15%
better 32% 0.50 • The variance of asset A is rA = .36 and of asset B rB= .1225 and the
same 17% 0.20 covariance between asset A and B is 0.0840. You want your total
worse -10% 0.30 portfolio to yield a return of 18%. What proportion of your wealth
should you invest in fund A and B?
2. What is the expected return for the following portfolio? What is the standard deviation of the return on your portfolio?
Stock Expected returns Investment
AAA 31.2% $190,000 9. Assume that the risk-free rate of interest is 6% and the expected rate of
BBB 24.0% $350,000 return on the market is 16%. A share of stock sells for $50 today. It
CCC 18.6% $200,000 will pay a dividend of $6 per share at the end of the year. Its beta is
DDD 11.9% $500,000 1.2. What do investors expect the stock to sell for at the end of the
year?
3. The covariance on the returns of the two securities, A and B, is -.0005.
The standard deviation of A’s return is 4% and the standard deviation of 10. In 2010 the rate of return on short-term government securities
B’s return is 6%. (perceived to be risk-free) was about 5%. Suppose the expected rate of
a. What is the correlation between the returns of A and B? return required by the market for a portfolio with a beta measure of 1 is
b. What is the standard deviation of a portfolio consisting of 40% 12%. According to the capital asset pricing model (security market line):
invested in A and 60% invested in B? (a) What is the expected rate of return on the market portfolio?
(b) What would be the expected rate of return on a stock with β = 0?
4. Company X has a beta of 1.45. The expected risk free rate is 2.5% and the (c) Suppose you consider buying a share of stock at $40. The stock is
expected return on the market as a whole is 10%. Using CAPM, expected to pay $3 dividends next year and you expect it to sell then
a. What is Company X’s risk premium? for $41. The stock risk has been evaluated by β = −.5. Is the stock
b. What is Company X’s expected return? overpriced or underpriced?

5. An investor currently has all of his wealth in Treasury bills. He is 11. Consider the multifactor APT. There are two independent economic
considering investing one-third of his funds in Delta Airlines, whose factors, F1 and F2. The risk-free rate of return is 6%. The following
beta is 1.30, with the remainder left in Treasury bills. The expected information is available about two well-diversified portfolios:
risk-free rate (Treasury bills) is 6 percent and the market risk premium
is 8.8 percent. Determine the beta and the expected return on the
proposed portfolio.

6. You have the following information on two securities in which you have
invested:   
Expected Return Standard Deviation Security Beta % Invested (w) a. Assuming no arbitrage opportunities exist, the risk premium on the
Xerox 15% 4.5% 1.20 35% factor F1 portfolio should be ___________.
Kodak 12% 3.8% 0.98 65% b. Assuming no arbitrage opportunities exist, the risk premium on the
What is the expected return on the portfolio? What is the beta of the factor F2 portfolio should be ___________. 
portfolio?

7. You need to invest $10M in two assets: a risk-free asset with an expected
return of 5% and a risky asset with an expected return of 12% and a
standard deviation of 40%. You face a cap of 30% on the portfolio’s
standard deviation (the “risk budget”). What is the maximum expected
return you can achieve on your portfolio?
1 expected return = (32%)(0.50) + (17%)(0.20) + (-10%)(0.30) = 16.4%
2 First, covert the dollar investments into proportions of total investment by adding the investments in all stocks and then
dividing each stock investment by the total. Stock Expected returns Investment AAA 31.2% $190,000/1,240,000 = 0.1532
BBB 24.0% $350,000/1,240,000 = 0.2823 CCC 18.6% $200,000/1,240,000 = 0.1613 DDD 11.9% $500,000/1,240,000 =
0.4032 TOTAL $1,240,000 Now multiply the expected return for each asset times the proportion of investment allocated
to that asset and sum the resulting amounts. Exp ret = (31.2%)(0.1532) + (24%)(0.2823) + (18.6%)(0.1613) + (11.9%)
(0.4032) Exp ret = 19.35%
3 A. -.2083
b.
4
5 0.43; 9.81%
6 13.05%; 1.06
7 30% portfolio standard deviation ⇒ 30% 40% = 0.75 in risky and 0.25 in riskfree ⇒ portfolio expected return is (0.25)(5%)
+ (0.75)(12%) = 10.25%.
8 If you want an expected rate of return of 18%, the required weight on fund A (wA) is given by wA(.20) + (1 − wA)(.15) = .
18 (6) wA = .6 (7) 1 − wA = wB = .4 (8) Given these portfolio weights, the portfolio standard deviation is given by σ 2 p = w 2
Aσ 2 A + w 2 Bσ 2 B + 2wAwBσAB (9) = (.6 2 )(.36) + (.4 2 )(.1225) + 2(.6)(.4)(.0840) = .1895 (10) σp = .4353
9 Since the stock’s beta is equal to 1.2, its expected rate of return should be equal to 6 + 1.2(16 − 6) or 18%. E(r) = D + P1 −
P0 P0 .18 = 6 + P1 − 50 50 P1 = $53
10 a. Since the market portfolio by definition has a beta of 1, its expected rate of return is 12%. b. β = 0 means no
systematic risk. Hence, the portfolio’s fair return is the risk-free rate, 5%. c. Using the SML, the fair rate of return of a stock
with β = −0.5 is: E(r) = 5 + (−.5)(12 − 5) = 1.5%. The expected rate of return, using the expected price and dividend of next
year: E(r) = 44/40 − 1 = .10, or 10%. Because the expected return exceeds the fair return, the stock must be underpriced.
11 A. 3%
b. 5%