Risk and return questions and practice problems

Risk and return part 1:

Questions
Suppose the standard deviation of the returns on the shares of stock at two different companies is exactly the same. Does this mean that the required rate of return will be the same for these two stocks? Why?
1.

2. The correlation between stocks A and B is 0.50, while the correlation between stocks A and C is -0.5. You already own stock A and are thinking of buying either stock B or stock C. If you want your portfolio to have the lowest possible risk, would you buy stock B or C? 3. toward risk? 4. 5. 6. What does the historical relation between volatility and return tell us about investors attitude What is the intuition behind using the average annual return as a measure of expected return? What does it mean to be risk averse? Describe how investing in more than one asset can reduce risk through diversification.

7. If you randomly select 10 stocks for a portfolio and 20 other stocks for a different portfolio, which portfolio is likely to have the lower standard deviation? Why? 8. What does correlation tell us?

9. Why isnt the total risk of a portfolio simply equal to the weighted average of the risks of the securities in the portfolio? 10. In which of the following situations would you get the largest reduction in risk by spreading your portfolio across two stocks? a. The stock returns vary with each other b. The stock returns are independent c. The stock returns vary against each other

Selected Answers
1. 2. 7. 10. No Stock C The 20 stock portfolio C.

Problems
1. Stocks A, B, and C have expected returns of 15%, 15% and 12%, respectively, while their standard deviations are 45%, 30%, and 30%, respectively. If you are considering the purchase of each of these stocks as the only holding in your portfolio, which stock should you choose? Jose is thinking about purchasing a soft drink machine and placing it in a business office. He knows that there is a 5% probability that someone who walks by the machine will make a purchase from it, and he knows that the profit on each drink sold is $0.10. If Jose expects one thousand people per day to pass by the machine and requires a complete return of his investment in one year (sounds like payback method doesnt it), then what is the maximum price that he should be willing to pay for the soft drink machine? Assume 250 working days in a year and ignore taxes and TVM.
2.

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% of the grades to fall?
3.

Kate recently invested in real estate with the intention of selling the property one year from today. She has modeled the returns on that investment based on three economic scenarios. She believes that if the economy stays healthy, then her investment will generate a 30% return. However, if the economy softens, as predicted, the return will be 10%, while the return will be -25% if the economy slips into a recession. If the probabilities of the healthy, soft and recessionary states are 0.4, 0.5, and 0.1, respectively, then what are the expected returns and standard deviation of the return on Kates investment?
4.

5.

The last four years of return for a stock are as follows: 1 -4% 2 +28% 3 +12% 4 +4%

a. What is the average annual return? b. What is the standard deviation of the stocks return? Barbara is considering investing in a stock 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 standard deviation of the return on Barbaras investment.
6.

Boom Good Level Slump

7.

Probability 0.1 0.4 0.3 0.2

Return 25% 15% 10% -5%

David is going to purchase two stocks to form the initial holding in his portfolio. Iron stock has an expected return of 15%, while Copper stock has an expected return of 20%. If David plans to invest 30% of his funds in Iron and the remainder in Copper, what will be the expected return from his portfolio?
8. Freemont has an expected return of 15% and Laurelhurst has an expected return of 20%. If you put 70% of your portfolio in Fremont and 30% in Laurelhurst, what is the expected return of your portfolio?

Suppose Johnson & Johnson and the Walgreen Company have the expected returns and volatilities shown below, with a correlation of 22%.
9.

Johnson & Johnson Walgreen

E[R] 7% 10%

SD[R] 16% 20%

For a portfolio that is equally invested in Johnson &Johnsons and Walgreens stock, calculate: a. The expected return. b. The standard deviation. 10. You have a portfolio with a standard deviation of 30% and an expected return of 18%. You are considering adding one of the two stocks in the below table. If after adding the stock you will have 20% of your money in the new stock and 80% of your money in your existing portfolio, which one should you add? Expected return 15% 15% Standard Deviation 25% 20% Correlation with your portfolios return 0.2 0.6

Stock A Stock B

Answers
1. 2. 3. 4. 5.

Stock B $1,250 61-89 E[R] = 0.145; SD = 0.1619 a. 0.10; b. 0.13663

6. E[R] = 0.105; SD = 0.08789 7. E[R] = 0.185 8. E[R] = 0.165 9. E[R] = 0.085; SD = 0.1411 10. SD [A] = 0.2548; SD [B] = 0.2659 (choose A)

Risk and return questions and practice problems

Risk and return part 2:
Questions
1. 2. Define systematic risk. Describe the CAPM and explain what it does.

3. Susan is expecting the returns on the market portfolio to be negative in the near term. Since she is managing a stock mutual fund, she must remain invested in a portfolio of stocks. However, she is allowed to adjust the beta of her portfolio. What kind of beta would you recommend for Susans portfolio? 4. Evaluate the following statement: By fully diversifying a portfolio, such as by buying every asset in the market, we can completely eliminate all types of risk, thereby creating a synthetic Treasury Bill. 5. The beta of an asset is equal to 0. Discuss what the asset must be.

6. Which of the following risks of a stock are likely to be unsystematic, diversifiable risks and which are likely to be systematic risks? a. The risk that the founder and CEO retires. b. The risk that oil prices rise, increasing production costs. c. The risk that a product design is faulty and the product must be recalled. d. The risk that the economy slows, reducing demand for a firms product. e. The risk that your best employee will be hired away. f. The risk that the new product you expect your R&D division to product will not materialize. 7. 8. What is the difference between systematic and unsystematic risk? True or false? a. The expected rate of return on an investment with a beta of 2.0 is twice as high as the expected rate of return of the market portfolio. b. The contribution of a stock to the risk of a diversified portfolio depends on the market risk of the stock. c. If a stocks expected rate of return plots below the security market line, it is underpriced. d. A diversified portfolio with a beta of 2.0 is twice as volatile as the market portfolio. e. An undiversified portfolio with a beta of 2.0 is twice as volatile as the market portfolio. Why doesnt the risk premium of a stock depend on its diversifiable risk? What does beta measure and how is it different than standard deviation? What relation is described the security market line (SML)?

9. 10. 11.

12.

Which firms of each pair below would you expect to have greater market risk? a. General Steel or General Food Supplies b. Club Med or General Cinemas True or false, explain too a. Investors demand higher expected rates of return on stocks with more variable rates of return. b. The CAPM predicts that a security with a beta of zero will provide an expected return of zero. c. An investor who puts $10,000 in Treasury bills and $20,000 in the market portfolio will have a portfolio beta of 2.0. d. Investors demand higher rates of return from stocks with returns that are highly exposed to macroeconomic changes.

13.

14. In light of what youve learned about market versus diversifiable (unique) risk, explain why an insurance company has no problem in selling life insurance to individuals but is reluctant to issue policies insuring against flood damage to resident of coastal areas.

Selected Answers
6a. 6b. 6c. 6d. 6e. 6f. unsystematic systematic unique market firm specific systematic 8a. 8b. 8c. 8d. 8e. false true false true false 12a. 12b. 13a. 13b. 13c. 13d. General steel General Cinemas false false false true

Problems
1. Damien knows that the beta of his portfolio is equal to 1, but he does not know the risk-free rate of return or the market risk premium. He also knows that the expected return on the market is 8%. What is the expected return on Damiens portfolio? 2. Suppose the risk-free return is 4% and the market portfolio has an expected return of 10% and a standard deviation of 16%. Johnson and Johnson stock has a beta of 0.32. What is its required rate of return? 3. A project under consideration has an internal rate of return of 14% and a beta of 0.6. The risk-free rate is 4%, and the expected rate of return on the market is 14%. a. Should the project be accepted? b. Should the project be accepted if its beta is 1.6? c. Why does your answer change? 4. You are analyzing a stock that has a beta of 1.2. The risk-free rate is 5% and you estimate the market risk premium to be 6%. If you expect the stock to have a return of 11% over the next year, should you buy it? Why or why not? Graph it! 5. At the beginning of 2007, Apples beta was 1.4 and the risk-free rate was about 4.5%. Apples price was $84.84. Apples price at the end of 2007 was 198.08. If you estimate the market risk premium to have been 6%, did Apples managers exceed their investors required return as given by the CAPM?

6. Suppose Intel stock has a beta of 1.6, whereas Boeing stock has a beta of 1. If the risk-free interest rate is 4% and the expected return of the market portfolio is 10%, according to CAPM what is the Beta and required return of a portfolio containing Intel stock and Boeing stock?

7. You are thinking of buying a stock priced at $100 per share. Assume that the risk-free rate is about 4.5% and the market risk premium is 6%. If you think the stock will rise to $117 per share by the end of the year, at which time it will pay a $1 dividend, what beta would it need to have for this expectation to be consistent with the CAPM? 8. You are considering acquiring a firm that you believe can generate expected cash flow of $10,000 a year forever. However, you recognize that those cash flows are uncertain. Suppose you believe that the beta of the firm is 0.4. How much is the firm worth if the risk-free rate is 4% and the expected rate of return on the market portfolio is 11%? 9. If the risk-free rate is 6% and the expected rate of return on the market portfolio is 13%, is a security with a beta of 1.25 and an expected rate of return of 16% overpriced or underpriced? 10. You have the following information: Beta Standard deviation Ford 1.34 42.7% GE 0.97 24.3% Microsoft 1.53 41.7% a. Which stock is safest for a diversified investor? b. Which stock is safest for an undiversified investor who puts all of her fund in one of these stocks? c. Consider a portfolio with equal investment in each stock. What would this portfolios beta have been?

11. Draw the security market line when the Treasury bill rate is 4% and the market risk premium is 7%. Which of the following capital investments have positive NPVs? Project Beta IRR P 1.0 14% Q 0 6% R 2.0 18% S 0.4 7% T 1.6 20%

12. You are a consultant to a firm evaluating an expansion of its current business. The cash-flow forecast (in millions) for the project at: Years Cash flow 0 -100 1-10 +15 On the basis of the behavior of the firms stock, you believe that the beta of the firm is 1.4. Assuming that the rate of return available on risk-free investments is 4% and that the expected rate of return on the market portfolio is 12%, what is the NPV of the project? 13. You are considering the purchase of real estate that will provide perpetual income that should average $50,000 per year. How much will you pay for the property if you believe its market risk is the same as the market portfolios? The T-bill rate is 5%, and the expected market return is 12.5 %.

14. A share of stock with a beta of 0.5 now sells for $50. Investors expect the stock to pay a year-end dividend of $2. The T-bill rate is 4%, and the market risk premium is 7%. If the stock is perceived to be fairly priced today, what must be investors expectation of the price of the stock at the end of the year? 15. Reconsider the stock in the preceding problem. Suppose investors actually believe the stock will sell for $52 at year-end. Is the stock a good or bad buy? What will investors do? At what point will the stock reach an equilibrium at which it again is perceived as fairly priced? 16. A mutual fund manager expects her portfolio to earn a rate of return of 11% this year. The beta of her portfolio is 0.8. If the rate of return available on risk-free assets is 4% and you expect the rate of return on the market portfolio to be 14%, should you invest in this mutual fund?

Answers

1. 8% 2. 0.06 3. A) Yes IRR = 0.14, r=0.10; B) No IRR=0.14, r=0.20; Inc risk => Inc required rtn 4. Required return = 0.122; expected return = 0.11; Overpriced 5. Required return = 0.13; expected return = 1.33 6. E[B]=1.3; r=0.12 7. Expected return = 0.18; => required return = 0.18, => Beta = 2.25 8. r = 0.068; V = $147,059 9. Required return = 0.1475; expected return = 0.16; underpriced 10.A) GE Beta = 0.97; B) GE (SD) = 0.243; C) Beta = 1.28 11.

Project P Q R S T

Beta 1.0 0 2.0 0.4 1.6

IRR 14% 6% 18% 7% 20%

Required 11% 4% 18% 6.8% 15.2%

Value Under Under Correct Under Under

12.r = 0.152; NPV = -25.28 13.r = 0.125; V = 400,000 14.r = 0.075; P(1) = 51.75 15.P(0) = 50.23 16.Expected = 0.11; Required = 0.12; No