ECON 4400

Chapter 10: Questions 1-6, 8, 9, 11, 13, 15, 17, and 18

10.1 The return of any asset is the increase in price, plus any dividends or cash flows, all divided
by the initial price. The return of this stock is:

R = [($104 – $92) + $1.45]/$92

R = 0.1462 or 14.62%

10.2 Using the equation for total return, we find:

R = [($67 – $92) + $1.45]/$92

R = –0.2560 or –25.60%

And the dividend yield and capital gains yield are:

Dividend yield = $1.45/$92

Dividend yield = 0.0158 or 1.58%

Capital loss yield = ($67 – $92)/$92

Capital loss yield = –0.2717 or –27.17%

Here’s a question for you: Can the dividend yield ever be negative?
No, that would mean you were paying the company for the privilege of owning the stock.

10.3 a. The total dollar return is the change in price plus the coupon payment, so:
Total dollar return = ($1,063 – 1,040) + 60
Total dollar return = $83

b. The total nominal percentage return of the bond is:

R = [($1,063 – 1,040) + 60]/$1,040
R = 0.0798 or 7.98%

Notice here that we could have simply used the total dollar return of $83 in the numerator
of this equation.

10.4 We use the Fisher equation:

(1 + R) = (1 + r)(1 + h)

R denotes the nominal return, r denotes the real return, and h denotes the inflation rate

The historical real return on Canada Treasury bills is:

rG = 1.0549/1.0365 – 1
rG = 0.0199 or 1.99%
 The historical real return on long–term bonds is:

rC = 1.0790/1.0365 – 1
rC = 0.0410 or 4.10%

10.5 The average return is the sum of the returns, divided by the number of returns. The average
return for each stock was:

éN ù
X = êå x i ú N =
[0.08 + 0.21 - 0.27 + .011 + 0.18] = 0.0620 or 6.20%
ë i =1 û 5

éN ù
Y = êå y i ú N =
[0.12 + 0.27 - 0.32 + 0.18 + 0.24] = 0.0980 or 9.80%
ë i =1 û 5

We calculate the variance of each stock as:

éN ù
s X 2 = êå (xi - x )2 ú (N - 1)
ë i =1 û
sX2 =
1
5 -1
{ (0.08 - 0.062)2 + (0.21 - 0.062)2 + (- 0.27 - 0.062)2 + (0.11 - 0.062)2 + (0.18 - .0.062)2 }
= 0.037170

sY 2 =
1
5 -1
{ (0.12 - 0.098)2 + (0.27 - 0.098)2 + (- 0.32 - 0.098)2 + (0.18 - 0.098)2 + (0.24 - 0.098)2 }
= 0.057920

The standard deviation is the square root of the variance, so the standard deviation of each
stock is:
sX = (0.037170)1/2
sX = 0.1928 or 19.28%

sY = (0.057920)1/2
sY = 0.2407 or 24.07%

10.6 We will calculate the sum of the returns for each asset and the observed risk premium first.
Doing so, we get:

Year Common Stocks(%) T–bills(%) Risk Premuim(%)

1973 0.27 4.78 –4.51
1974 –25.93 7.68 –33.61
1975 18.48 7.05 11.43
1976 11.02 9.10 1.92
1977 10.71 7.64 3.07
1978 29.72 7.90 21.82
Sum 44.27 44.15 0.12

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a. The average return for common stocks over this period was:

Common stock average return = 44.27%/6

Common stock average return = 7.38%

And the average return for T–bills over this period was:

T–bills average return = 44.15%/6

T–bills average return = 7.36%

b. Using the equation for variance, we find the variance for common stocks over this period
was:

Variance = 1/5[(0.0027 – 0.0738)2 + (–0.2593 – 0.0738)2 + (0.1848 – 0.0738)2

+ (0.1102 – 0.0738)2 + (0.1071 – 0.0738)2 + (0.2972 – 0.0738)2]
Variance = 0.0361346

And the standard deviation for common stocks over this period was:

Standard deviation = (0.00361346)1/2

Standard deviation = 0.1901 or 19.01%

Using the equation for variance, we find the variance for T–bills over this period was:

Variance = 1/5[(0.0478 – 0.0736)2 + (0.0768 – 0.0736)2 + (0.0705 – 0.0736)2

+ (0.091 – 0.0736)2 + (0.0764 – 0.0736)2 + (0.0790 – 0.0736)2]
Variance = 0.000205

And the standard deviation for T–bills over this period was:

Standard deviation = (0.000205)1/2

Standard deviation = 0.01432 or 1.432%

c. The average observed risk premium over this period was:

Average observed risk premium = 0.12%/6

Average observed risk premium = 0.02%

The variance of the observed risk premium was:

Variance = 1/5[(–0.0451 – 0.0002)2 + (–0.3361 – 0.0002)2 + (0.1143 – 0.0002)2

+ (0.0192 – 0.0002)2 + (0.0307 – 0.0002)2 + (0.2182 – 0.0002)2]
Variance = 0.035397

And the standard deviation of the observed risk premium was:

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 Standard deviation = (0.035397)1/2
Standard deviation = 0.1881 or 18.81%

10.8 Apply the five–year holding–period return formula to calculate the total return of the stock
over the five–year period, we find:

5–year holding–period return = [(1 + R1)(1 + R2)(1 + R3)(1 + R4)(1 + R5)] – 1

5–year holding–period return = [(1 + 0.1612) × (1 + 0.1211) × (1 + 0.0583) × (1 + 0.2614)
× (1 – 0.1319)] – 1
5–year holding–period return = 0.5086 or 50.86%

10.9 To find the return on the zero coupon bond, we first need to find the price of the bond today.
Since one year has elapsed, the bond now has 29 years to maturity, so the price today is:

P1 = $1,000/1.0929
P1 = $82.15

There are no intermediate cash flows on a zero coupon bond, so the return is the capital
gains, or:

R = ($82.15 – 77.81)/$77.81
R = 0.0558 or 5.58%

10.11 Looking at the small stock return history in Table 10.2, we see that the mean return was
13.61 percent, with a standard deviation of 25.55 percent. The range of returns you would
expect to see 68 percent of the time is the mean plus or minus 1 standard deviation, or:

R = µ ± 1s = 13.08% ± 25.22% = –12.14% to 38.30%

The range of returns you would expect to see 95 percent of the time is the mean plus or minus
2 standard deviations, or:

R = µ ± 2s = 13.08% ± (2 × 25.22%) = –37.36% to 63.52%

10.13 Here we know the average stock return, and four of the five returns used to compute the
average return. We can work the average return equation backward to find the missing return.
The average return is calculated as:

0.11 = (0.19 – 0.27 + 0.06 + 0.34 + R)/5

R = 0.23 or 23%

The missing return has to be 23 percent. Now we can use the equation for the variance to
find:

Variance = [(0.19 – 0.11)2 + (–0.27 – 0.11)2 + (0.06 – 0.11)2 + (0.34 – 0.11)2 + (0.23 –
2
0.11) ]/4

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 Variance = 0.05515

And the standard deviation is:

Standard deviation = (0.05515)1/2

Standard deviation = 0.2348 or 23.48%

10.15 To calculate the arithmetic and geometric average returns, we must first calculate the
return for each year. The return for each year is:

R1 = ($64.83 – 61.18 + 0.72)/$61.18 = 0.0714 or 7.14%

R2 = ($72.18 – 64.83 + 0.78)/$64.83 = 0.1254 or 12.54%
R3 = ($63.12 – 72.18 + 0.86)/$72.18 = – 0.1136 or –11.36%
R4 = ($69.27 – 63.12 + 0.95)/$63.12 = 0.1125 or 11.25%
R5 = ($76.93 – 69.27 + 1.08)/$69.27 = 0.1262 or 12.62%

The arithmetic average return was:

RA = (0.0714 + 0.1254 – 0.1136 + 0.1125 + 0.1262)/5

RA = 0.0644 or 6.44%

And the geometric average return was:

RG = [(1 + 0.0714) × (1 + 0.1254) × (1 – 0.1136) × (1 + 0.1125) × (1 + 0.1262)]1/5 – 1

RG = 0.0601 or 6.01%

10.17 To find the return on the coupon bond, we first need to find the price of the bond today. The
bond now has six years to maturity, so the price today is:

P1 = $70 × 𝐴%!.!## + $1,000/1.0556

P1 = $1,074.93

You received the coupon payments on the bond, so the nominal return was:

R = ($1,074.93 – $1,080.50 + $70)/$1,080.50

R = 0.0596 or 5.96%

And using the Fisher equation to find the real return, we get:

r = (1.0596/1.032) – 1
r = 0.0267 or 2.67%

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10.18 Looking at the bond return history in Table 10.2, we see that the mean return was 7.90
percent, with a standard deviation of 9.48 percent.

You can use the z–statistic and the cumulative standard normal distribution table to find the
answer. Doing so, we find:

z = (X – µ)/s

z = (–3.3% – 7.90%)/9.48% = –1.1814

Using the NORMDIST function in Excel, we find a probability of 11.87%, or:

Pr (R < –3.3%) = Pr (Z < –1.1814) » 11.87%

The range of returns you would expect to see 95 percent of the time is the mean plus or minus
2 standard deviations, or:

95% level: R = µ ± 2s = 7.90% ± (2 × 9.48%) = –11.06% to 26.86%

The range of returns you would expect to see 99 percent of the time is the mean plus or minus
3 standard deviations, or:

99% level: R = µ ± 3s = 7.90% ± (3 × 9.48%) = –20.54% to 36.34%