FINANCIAL MANAGEMENT
TUTORIAL 8: RISK AND RETURN
Questions:
1.
Stock A has an expected return of 7%, a standard deviation of expected returns of 35%, a correlation
coefficient with the market of −0.3, and a beta coefficient of −0.5. Stock B has an expected return of
12%, a standard deviation of returns of 10%, a 0.7 correlation with the market, and a beta coefficient
of 1.0. Which security is riskier, and why?
2.
If investors’ aversion to risk increased, would the risk premium on a high-beta stock increase by more
or less than that on a low-beta stock? Explain.
Problems:
1.
Stock A and B have the following historical returns:
Year Stock A’s Returns, rA Stock B’s Returns, rB
2016 (24.25%) 5.50%
2017 18.50 26.73
2018 38.67 48.25
2019 14.33 (4.50)
2020 39.13 43.86
a. Calculate the average rate of return for each stock during the period 2016 through 2020.
Assume that someone held a portfolio consisting of 50% of Stock A and 50% of Stock B. What
would the realized rate of return on the portfolio have been in each year from 2016 through
2020? What would the average return on the portfolio have been during that period?
b. Calculate the standard deviation of returns for each stock and for the portfolio.
c. Assume the risk-free rate during this time was 3.5%. What are the Sharpe ratios for Stocks A
and B and for the portfolio over this time period, using their average returns?
d. Looking at the annual returns on the two stocks, would you guess that the correlation
coefficient between the two stocks is closer to +0.8 or to −0.8?
2.
ECRI Corporation is a holding company with four main subsidiaries. The percentage of its capital
invested in each of the subsidiaries (and their respective betas) is as follows:
Subsidiary Percentage of Capital Beta
Electric utility 60% 0.70
Cable company 25% 0.90
Real estate development 10% 1.30
International/special projects 5% 1.50
a. What is the holding company’s beta?
b. If the risk-free rate is 4% and the market risk premium is 5%, what is the holding company’s
required rate of return?
c. ECRI is considering a change in its strategic focus. It will reduce its reliance on the electric
utility subsidiary, so the percentage of its capital in this subsidiary will be reduced to 50%. At
the same time, it will increase the firm’s reliance on the international/special projects division,
so the percentage of its capital in that subsidiary will rise to 15%. What will the company’s
required rate of return be after these changes?
3.
An individual has $20,000 invested in a stock with a beta of 0.6 and another $75,000 invested in a
stock with a beta of 2.5. If these are the only two investments in her portfolio, what is her portfolio’s
beta?
4.
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Assume that the risk-free rate is 3.5% and the market risk premium is 4%. What is the required return
for the overall stock market? What is the required rate of return on a stock with a beta of 0.8?
5.
A stock has a required return of 9%, the risk-free rate is 4.5%, and the market risk premium is 3%.
a. What is the stock’s beta?
b. If the market risk premium increased to 5%, what would happen to the stock’s required rate?
6.
Suppose you are the money manager of a $4.82 million investment fund. The fund consists of four
stocks with the following investments and betas:
Stock Investment Beta (βᵢ)
A $460,000 1.50
B $500,000 −0.50
C $1,260,000 1.25
D $2,600,000 0.75
If the market’s required rate of return is 8% and the risk-free rate is 4%, what is the fund’s required
rate of return?
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