Tutorial Risk & Return

Fundamentals of Financial Management 2017
TUTORIAL 5 – RISK AND RETURN

1. Textbook chapters:
Chapter 6 (p. 280): 6-5, 6-6, 6-7, 6-9, 6-10, 6-11, 6-12, 6-13, 6-14.
2. You intend to make an investment in one stock and have the following stocks to choose from:
Stock Expected Standard

Return Deviation
A 20% p.a. 10% p.a.
B 30% p.a. 50% p.a.
C 15% p.a. 12% p.a.
D 20% p.a. 15% p.a.
E 35% p.a. 40% p.a.
F 25% p.a. 15% p.a.
Since every person’s preferred investment will differ, depending on their level of risk aversion, we
cannot say for certain which stock you will choose. The risk-return characteristics of some stocks,
however, clearly dominates others.
Begin by plotting each stock on a graph with risk (standard deviation) on the horizontal axis and
expected return on vertical axis. Just plot a single point for each stock.
a. If you had to choose just between stocks A and D, which dominates? Explain.
b. If you had to choose just between stocks D and E, which dominates? Explain.
c. If you had to choose just between stocks B and E, which dominates? Explain.
d. If you had to choose just between stocks A and C, which dominates? Explain.
e. If you had to choose just between stocks A and F, which dominates? How about E and F? how
about C and D? Explain.
3. Three stocks have the following risk-return characteristics:
Stock Expected Standard

Return Deviation
A 20% 38%
B 12% 15%
C 15% 28%
a. If there is no risk-free asset, does any of these three stocks clearly dominate any other in terms
of risk and return?
Now assume there is a risk-free asset with a guaranteed return of 5% p.a. You can now form a
portfolio consisting of one risky asset plus the risk-free asset. You are willing to bear a standard
deviation of 25% p.a. for your portfolio.
b. For a portfolio comprising Stock A and the risk-free asset, what weights will you assign to each
on order to get the desired level of risk?
4. Assume the following data:

The market risk premium is 7% p.a.
The variance of the return on the market is 0.14, and
12
The risk-free rate is 6% p.a.
Your task is to determine a discount rate appropriate for a single company, BHP. If the variance of
BHP’s return is 0.30 and its beta is 1.20, what is the expected return of BHP?
5. In a small economy, the market portfolio comprises shares in only three companies: D, E and F.
Details are set out in the table below.
Company name Shares issued Price per share Expected

Return
D 1,000,000 $2.00 8%
E 500,000 $8.00 10%
F 1,600,000 $2.50 21%
There is also a risk-free asset that offers a return of 4%.

a. Calculate the expected return on the market portfolio.
b. Assume that the capital asset pricing model (CAPM) applies in this market; calculate the beta of
company E.
6. Sorbond Industries has a beta of 1.45. The risk-free rate is 8 percent and the expected return on the
market portfolio is 13 percent. The company currently pays a dividend of $2 a share, and investors
expect it to experience a growth in dividends of 10 percent per annum for many years to come.
a. What is the stock’s required rate of return according to the CAPM?
b. What is the stock’s present market price per share, assuming this required return?
c. What would happen to the required return and to market price per share if the beta were 0.80?
(Assume that all else stays the same.)
7. You want to create a portfolio that is equally risky to the market, and you have $1,000,000 to
invest. Given this information, find the values of (a), (b) and (c) in the following table. Present your
detailed calculations.
Asset Investment Beta

Stock A $210,000 0.85
Stock B $320,000 1.20
Stock C (a) 1.35
Risk-free asset (b) (c)
8. Consider the following information about Stocks I and II:
State of Probability of State Rate of Return if State occurs

Economy of Economy Stock I Stock II
Recession 0.25 0.11 -0.40
Normal 0.50 0.29 0.10
Boom 0.25 0.13 0.56
The market risk premium is 8 percent, and the risk-free rate is 4 percent. Which stock has the most
systematic risk? Which one has the most unsystematic risk? Which stock is “riskier”? Explain.
13
9. Suppose Intel stock has a beta of 1.6, whereas Boeing stock has a beta of 1. If the risk-free rate is
4% and the expected return of the market portfolio is 10%, according to the CAPM:
a. What is the expected return of Intel stock?
b. What is the expected return of Boeing stock?
c. What is the beta of a portfolio that consists of 60% Intel stock and 40% Boeing stock?
d. What is the expected return of a portfolio that consists of 60% Intel stock and 40% Boeing stock?
10. Suppose you observe the following situation:
Security Beta Expected Return

Pete Corp. 1.35 0.132
Repete Co. 0.80 0.101
Assume these securities are correctly priced. Based on the CAPM, what is the expected return on
the market? What is the risk-free rate?
11. You have recently become very interested in real estate. To gain some experience as a real estate
investor, you have decided to get together with nine of your friends to buy three small cottages
near campus. If you and your friends pool your money, you will have just enough to buy the three
properties. Since each investment requires the same amount of money and you will have a 10
percent interest in each, you will effectively haveone-third of your portfolio invested in each
cottage. While the cottages cost the same, they are different distances from campus and in
different neighborhoods. You believe that this causes them to have different levels of systematic
risk, and you estimate that the betas for the individual cottages are 1.2, 1.3, and 1.5. If the risk-free
rate is 4 percent and the market risk premium is 6 percent, what will be the expected return on
your real estate portfolio after you make all three investments?
12. You have become concerned that you have too much of your money invested in your pizza
restaurant and have decided to diversify your personal portfolio. Right now the pizza restaurant is
your only investment. To diversify, you plan to sell 45 percent of your restaurant and invest the
proceeds from the sale, in equal proportions, into a stock and a bond. Over the next year, you
expect to earn a return of 15 percent on your remaining investment in the pizza restaurant,12
percent on your investment in the stock, and 8 percent on your investment in the bond. What
return will you expect from your diversified portfolio over the next year?
13. You have $100,000 to invest in a portfolio containing Stock X, Stock Y, and a risk-free asset. You
must invest all of your money. Your goal is to create a portfolio that has an expected return of
16.8% and that has only 80% of the risk of the overall market. If X has an expected return of 31%
and a beta of 1.8, Y has an expected return of 20% and a beta of 1.3, and the risk-free rate is 7%,
how much money will you invest in Stock X?
14

Tutorial Risk & Return

Uploaded by

Copyright:

Available Formats

Tutorial Risk & Return

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Tutorial Risk & Return

Uploaded by

Copyright:

Available Formats

Fundamentals of Financial Management 2017

TUTORIAL 5 – RISK AND RETURN

Stock Expected Standard

3. Three stocks have the following risk-return characteristics:

Stock Expected Standard

4. Assume the following data:

Company name Shares issued Price per share Expected

There is also a risk-free asset that offers a return of 4%.

Asset Investment Beta

8. Consider the following information about Stocks I and II:

State of Probability of State Rate of Return if State occurs

10. Suppose you observe the following situation:

Security Beta Expected Return

You might also like