CHAPTER 5: RISK AND RETURN

Fully Worked Solutions — Self-Correction Problems & End-of-Chapter Problems

SELF-CORRECTION PROBLEMS
Question 1 — A.A. Eye-Eye Corporation (Expected Return, Std. Dev., Normal Probability)
Probabilities: 0.1, 0.2, 0.4, 0.2, 0.1 Returns: −10%, 5%, 20%, 35%, 50%
Concept & Formula
R̄ = Σ(Ri)(Pi)
σ = √[Σ(Ri − R̄ )²(Pi)]
z = (X − R̄ ) / σ (then use the standard normal table)
In words: R̄ (expected return) is a probability-weighted average — multiply each possible outcome by the chance
it happens, and add them up. σ (standard deviation) measures how far outcomes typically stray from that
average: subtract the mean from each outcome, square the difference (so pluses and minuses don't cancel out),
weight by probability, sum, then take the square root to bring the units back to a percentage. A bigger σ means
more spread — more risk. The z-score then converts any target return into 'number of standard deviations from
the mean,' which lets us read off a probability from the normal (bell-curve) table.
Part (a): Expected Return and Standard Deviation
Pi Ri (%) (Ri)(Pi) (Ri−R̄ )²(Pi)
0.1 -10 -1 0.1(-10-20)²=90
0.2 5 1 0.2(5-20)²=45
0.4 20 8 0.4(20-20)²=0
0.2 35 7 0.2(35-20)²=45
0.1 50 5 0.1(50-20)²=90

R̄ = −1+1+8+7+5 = 20%. Variance = 90+45+0+45+90 = 270. σ = √270 = 16.43%.

Part (b): Normal Probability Questions
Using R̄ = 20%, σ = 16.43%:
● P(R ≤ 0): z = (0−20)/16.43 = −1.22 → P ≈ 0.1118 (about 11.2%)
● P(R < 10): z = (10−20)/16.43 = −0.61 → P ≈ 0.2714 (about 27.1%)
● P(R > 40): z = (40−20)/16.43 = +1.22 → P ≈ 0.1118 (about 11.2%) [same distance from mean as part 1, by
symmetry]
✓ FINAL ANSWER
Expected Return = 20%, Standard Deviation = 16.43%
P(R≤0) ≈ 11.2%, P(R<10%) ≈ 27.1%, P(R>40%) ≈ 11.2%

Question 2 — Sorbond Industries (CAPM & Constant-Growth Valuation)

β = 1.45, Rf = 8%, RM = 13%, D0 = $2, g = 10%
Concept & Formula
CAPM: r = Rf + β(RM − Rf)
Constant Growth Price: P0 = D1 / (r − g), where D1 = D0(1+g)
In words: CAPM says the return investors require = the risk-free rate (what you'd earn doing nothing risky)
PLUS a risk premium for the stock's systematic risk. That premium is beta (how much riskier than the market the
stock is) multiplied by the market risk premium (RM − Rf, the extra return the whole market pays over the risk-
free rate). Once we know the required return r, the constant-growth (Gordon) model prices the stock as next
year's dividend divided by (required return minus growth rate) — essentially, the present value of a dividend
stream that grows forever at a steady rate g.
Part (a): Required Return (CAPM)
r = 8% + 1.45(13% − 8%) = 8% + 1.45(5%) = 8% + 7.25% = 15.25%
Part (b): Market Price
D1 = 2(1.10) = $2.20
P0 = 2.20 / (0.1525 − 0.10) = 2.20 / 0.0525 = $41.90
Part (c): If Beta were 0.80
New required return r = 8% + 0.80(5%) = 8% + 4% = 12%
New Price P0 = 2.20 / (0.12 − 0.10) = 2.20 / 0.02 = $110.00
Lower beta → lower required return → MUCH higher price (price is very sensitive when r is close to g).
✓ FINAL ANSWER
(a) Required return = 15.25%
(b) Price = $41.90
(c) With β=0.80: required return = 12.00%, Price = $110.00 (price rises sharply)

Question 3 (Appendix A) — Two-Stock Portfolio Risk & Return

Stock A: R̄ =10%, σ=5%. Stock B: R̄ =6%, σ=4%. Correlation ρ = −0.35. Weights: 60% A, 40% B.
Concept & Formula
R̄ p = wA(R̄ A) + wB(R̄ B)
σp = √[wA²σA² + wB²σB² + 2 wA wB ρ σA σB]
In words: Portfolio return is simply a weighted average — no surprises there. Portfolio RISK is not a weighted
average, though: you must add each stock's own variance (weight² × σ²) plus a cross term that captures how the
two stocks move together (2 × weight1 × weight2 × correlation × σ1 × σ2). When correlation is negative, that
cross term is negative and PULLS DOWN total portfolio risk below what you'd expect from a simple average —
this is the mathematical reason diversification works.
Solution
R̄ p = 0.6(10%) + 0.4(6%) = 6% + 2.4% = 8.4%
Covariance term: ρ × σA × σB = (−0.35)(0.05)(0.04) = −0.0007
σp² = (0.6)²(0.05)² + (0.4)²(0.04)² + 2(0.6)(0.4)(−0.0007)
σp² = 0.0009 + 0.000256 + (−0.000336) = 0.000820
σp = √0.000820 = 0.02864 = 2.86%
✓ FINAL ANSWER
Portfolio Return = 8.4%
Portfolio Std. Deviation ≈ 2.86%
(Negative correlation pulls portfolio risk well below a simple weighted average of 4.6%.)
END-OF-CHAPTER PROBLEMS
Problem 1 — Jerome J. Jerome's Investment
Probabilities: 0.10, 0.20, 0.30, 0.30, 0.10 Returns: −10%, 0%, 10%, 20%, 30%
Concept & Formula
R̄ = Σ(Ri)(Pi)
σ = √[Σ(Ri − R̄ )²(Pi)]
In words: Same logic as Question 1: weight each possible return by its probability to get the expected (average)
return, then measure how far each outcome typically falls from that average (squared, weighted, summed,
square-rooted) to get the standard deviation — the risk measure.
Part (a): Expected Return & Standard Deviation
Pi Ri (%) (Ri)(Pi) (Ri−R̄ )²(Pi)

0.1 -10 -1 0.10(-10-11)²=44.1

0.2 0 0 0.20(0-11)²=24.2

0.3 10 3 0.30(10-11)²=0.3

0.3 20 6 0.30(20-11)²=24.3

0.1 30 3 0.10(30-11)²=36.1

R̄ = −1+0+3+6+3 = 11%. Variance ≈ 44.1+24.2+0.3+24.3+36.1 = 129.0. σ = √129.0 ≈ 11.36%.

Part (b): Downside Risk?
Yes, there is some downside risk: there is a 10% chance of a −10% return (losing money), and combined with the
20% chance of a 0% (break-even) outcome, there is a 30% chance of earning nothing or losing money. However,
because σ (11.36%) is smaller than the expected return (11%) and the distribution is fairly symmetric around
10%–20% positive outcomes, the downside risk is moderate rather than severe — the worst case (−10%) is not
far below zero, and most of the probability weight (70%) lies at 10% or higher.
✓ FINAL ANSWER
Expected Return = 11%, Standard Deviation ≈ 11.36%
Modest downside risk — 30% chance of a zero or negative return, but 70% chance of a positive
(10%+) return.

Problem 2 — Summer Storme's Investment (Normal Distribution)

E(R) = 20%, σ = 15% (approximately normal)
Concept & Formula
z = (X − R̄ ) / σ
In words: The z-score tells you how many standard deviations a target value X is above or below the mean. A
negative z means X is below the average; a positive z means above. Once you have z, you look up the
corresponding probability in a standard normal table (or use a calculator) to find the area under the bell curve
to the left (P(R<X)) or right (P(R>X)=1−P(R<X)) of that point.
Part (a): P(Negative Return), i.e., P(R<0)
z = (0−20)/15 = −1.33 → P(R<0) ≈ 0.0912 (about 9.1% chance)
Part (b): P(R > X) for various X
X z = (X-20)/15 P(R > X)

10% -0.67 ≈ 74.8%

20% 0.00 = 50.0%

30% 0.67 ≈ 25.3%

40% 1.33 ≈ 9.1%

50% 2.00 ≈ 2.3%

✓ FINAL ANSWER
P(R<0) ≈ 9.1%
P(R>10%)≈74.8%, P(R>20%)=50.0%, P(R>30%)≈25.3%, P(R>40%)≈9.1%, P(R>50%)≈2.3%

Problem 3 — Markese Imports (Characteristic Line & Beta)

Given 24 quarters of excess returns for Markese and the market portfolio.
Concept & Formula
Characteristic Line: Y = a + b(X) (regression of stock's excess return Y on market's excess
return X)
b (slope) = Beta = Systematic Risk
In words: We plot the stock's excess return against the market's excess return for each period and fit the best
straight line through the points (linear regression). The line's slope (b) is beta — it tells you how many
percentage points the stock typically moves for every 1-point move in the market. The intercept (a) is the stock's
average return unrelated to the market. A slope near 1 means the stock roughly mirrors the market; a slope
below 1 means it's calmer than the market.
Solution
Running a linear regression of Markese's excess returns (Y) on the market's excess returns (X) across the 24
quarters gives:
Characteristic Line: Y = 0.0011 + 0.456 X
Approximate Beta ≈ 0.46
Correlation (r) ≈ 0.92 → R² ≈ 0.85
Graphically: plot the market's excess return (X-axis) against Markese's excess return (Y-axis) for each of the 24
quarters, then draw the best-fit straight line through the points — its slope is the beta.
Interpretation of Systematic Risk
A beta of about 0.46 means Markese's stock is considerably LESS volatile than the market — for every 1% move
in the market's excess return, Markese's excess return moves only about 0.46% on average. Its systematic risk is
low (defensive stock), though the fairly high correlation (0.92) shows the stock still moves closely in the same
direction as the market most of the time, just with less amplitude.
✓ FINAL ANSWER
Approximate Beta ≈ 0.46 (a defensive, low-systematic-risk stock)
Problem 4 — CAPM Required Returns for Five Stocks
Rf = 7%, RM = 13% (Market Risk Premium = 6%)
Rj = Rf + βj(RM − Rf) = 7% + βj(6%)
In words: Each stock's required return starts from the same risk-free base (7%) and then adds a risk premium
sized to that specific stock's beta. Since the market risk premium (6%) is fixed here, required return is a straight-
line (linear) function of beta — double the beta, double the risk premium added.
Stock Beta Required Return

A 1.5 7%+1.5(6%)=16.0%

B 1 7%+1.0(6%)=13.0%

C 0.6 7%+0.6(6%)=10.6%

D 2 7%+2.0(6%)=19.0%

E 1.3 7%+1.3(6%)=14.8%
Implication
Required return rises in direct proportion to systematic risk (beta). Stock D (highest beta = 2.0) demands the
highest return (19%) to compensate investors; Stock C (lowest beta = 0.6) requires the least (10.6%) because it
contributes the least systematic risk to a diversified portfolio. Stock B, with beta = 1.0, simply requires the market
return.
✓ FINAL ANSWER
A=16.0%, B=13.0%, C=10.6%, D=19.0%, E=14.8% — required return increases linearly with
beta.

Problem 5 — Kessler Electronics Corporation

Expected market return = 12%, Rf = 7%, characteristic-line slope (beta) = 1.67
r = Rf + β(RM − Rf)
In words: Same CAPM logic: start at the risk-free rate, then add the stock-specific risk premium (beta × market
risk premium). Here the 'beta' is given indirectly as the slope of the characteristic line (1.67), which plays exactly
the same role as beta in the standard CAPM formula.
r = 7% + 1.67(12% − 7%) = 7% + 1.67(5%) = 7% + 8.35% = 15.35%
If markets are efficient, Kessler's price should already reflect this — so an investor should EXPECT to earn
15.35%, no more, no less, for bearing this stock's systematic risk.
✓ FINAL ANSWER
Expected/Required Return ≈ 15.35%

Problem 6 — Four Stocks: Over/Undervalued?

Part (a): Rf = 10%, RM = 15% (Market Risk Premium = 5%)
Required Return = Rf + β(RM−Rf)
Analyst's Expected Return > Required Return → UNDERVALUED
 Analyst's Expected Return < Required Return → OVERVALUED
In words: CAPM tells us the return a stock SHOULD offer given its risk (beta). If the analyst's expected return is
higher than this CAPM-required return, the stock is paying more than it needs to for its risk level — which means
its current price is too low relative to future cash flows (undervalued); market forces should push the price UP
until expected return falls to match the required return. The opposite logic makes a stock overvalued: too little
return for the risk taken, so the price should fall.
Stock Expected Beta Required (CAPM) Verdict

Stillman Zinc 17.0% 1.3 10%+1.3(5%)=16.5% Undervalued

Union Paint 14.5% 0.8 10%+0.8(5%)=14.0% Undervalued

National Automobile 15.5% 1.1 10%+1.1(5%)=15.5% Fairly Valued

Parker Electronics 18.0% 1.7 10%+1.7(5%)=18.5% Overvalued

Part (b): If Rf rises to 12% and RM rises to 16% (Market Risk Premium = 4%)
Stock Expected Beta Required (CAPM) Verdict

Stillman Zinc 17.0% 1.3 12%+1.3(4%)=17.2% Overvalued

Union Paint 14.5% 0.8 12%+0.8(4%)=15.2% Overvalued

National Automobile 15.5% 1.1 12%+1.1(4%)=16.4% Overvalued

Parker Electronics 18.0% 1.7 12%+1.7(4%)=18.8% Overvalued

Because the market risk premium narrowed from 5% to 4% while Rf jumped 2 points, required returns rose for
every stock (especially high-beta ones), turning ALL four stocks overvalued at the analysts' original return
estimates.
✓ FINAL ANSWER
(a) Stillman & Union Paint = Undervalued; National Auto = Fairly valued; Parker =
Overvalued
(b) All four stocks become Overvalued once Rf=12% and RM=16%

Problem 7 — Selena Maranjian's Portfolio

Portfolio Expected Return = Σ(Amount Investedi × Ri) / Total Amount Invested
In words: This is a dollar-weighted average: stocks you put more money into count for more in the final answer.
Multiply each stock's dollar investment by its expected return, add all those products together, then divide by the
total dollars invested.
Stock Amount Exp. Return Amount × Return

WOOPS $6,000 14% $840

KBOOM $11,000 16% $1,760

JUDY $9,000 17% $1,530

UPDWN $7,000 13% $910

 Stock Amount Exp. Return Amount × Return

SPROUT $5,000 20% $1,000

RINGG $13,000 15% $1,950

EIEIO $9,000 18% $1,620

Part (a)
Total invested = $60,000. Total weighted return = 840+1760+1530+910+1000+1950+1620 = $9,610.
Portfolio Expected Return = 9,610 / 60,000 = 0.1602 = 16.02%
Part (b): Quadruple the investment in Excelsior Hair Growth (SPROUT)
New SPROUT investment = 4 × $5,000 = $20,000 (an increase of $15,000). New total invested = $60,000 +
$15,000 = $75,000.
New total weighted return = $9,610 + (15,000 × 20%) = 9,610 + 3,000 = $12,610.
New Portfolio Expected Return = 12,610 / 75,000 = 0.1681 = 16.81%
✓ FINAL ANSWER
(a) Portfolio expected return = 16.02%
(b) After quadrupling SPROUT: portfolio expected return rises to 16.81%

Problem 8 — Salt Lake City Services, Inc.

β = 1.08, Rf = 10%, RM = 15%, D1 = $2 (paid at year-end), g = 11%
Required Return: r = Rf + β(RM−Rf)
Value: P0 = D1 / (r − g)
In words: Two steps: first use CAPM to find the return investors require for this stock's risk level; then plug that
required return into the constant-growth (Gordon) model as the discount rate to find what the stock is worth
today — the present value of a dividend that starts at D1 and grows forever at rate g.
r = 10% + 1.08(15%−10%) = 10% + 1.08(5%) = 10% + 5.4% = 15.4%
P0 = 2.00 / (0.154 − 0.11) = 2.00 / 0.044 = $45.45
✓ FINAL ANSWER
Required Return = 15.4%
Value per share ≈ $45.45

Problem 9 — Portfolio Beta of Six Stocks

Weights: 20% each in NBS(1.40), YUWHO(0.80), SLURP(0.60), WACHO(1.80); 10% each in BURP(1.05),
SHABOOM(0.90).
βp = Σ(wi)(βi)
Portfolio Expected Return = Rf + βp(RM − Rf)
In words: A portfolio's beta is just a weighted average of the betas of the stocks inside it (weighted by how much
money/percent is invested in each). Once you have the portfolio's overall beta, you can plug it straight into the
normal CAPM formula to get the portfolio's expected return — no need to average each stock's individual
required return separately, though both methods give the same answer.
Part (a): Portfolio Beta
βp = 0.20(1.40)+0.20(0.80)+0.20(0.60)+0.20(1.80)+0.10(1.05)+0.10(0.90)
βp = 0.28+0.16+0.12+0.36+0.105+0.09 = 1.115
Part (b): Expected Return (Rf=8%, RM=14%)
Portfolio Return = 8% + 1.115(14%−8%) = 8% + 1.115(6%) = 8% + 6.69% = 14.69%
✓ FINAL ANSWER
(a) Portfolio Beta = 1.115
(b) Portfolio Expected Return ≈ 14.69%

Problem 10 — Schmendiman, Inc.

RM = 14%, Rf = 6%, D1 = $3.40, g = 6%, β = 1.50, Market Price = $30.00
Required Return: r = Rf + β(RM−Rf)
Intrinsic Value: P0 = D1 / (r − g)
In words: Same two-step approach as Problem 8: CAPM gives the return investors should demand for this
stock's risk (beta 1.50), then the constant-growth model converts that required return into a fair (intrinsic) share
price. Comparing this calculated intrinsic value to the actual market price tells us whether the stock is a bargain
(underpriced) or too expensive (overpriced).
Part (a)
r = 6% + 1.50(14%−6%) = 6% + 1.50(8%) = 6% + 12% = 18%
Intrinsic Value = 3.40 / (0.18 − 0.06) = 3.40 / 0.12 = $28.33
Part (b): Over/Under/Fairly Priced?
Market price ($30.00) is HIGHER than intrinsic value ($28.33) → the stock is OVERPRICED. Investors are
paying more than the stock is worth given its risk (beta 1.50) and growth prospects; expected market return based
on its price is lower than the 18% investors should require, so it should be avoided at the current price.
✓ FINAL ANSWER
(a) Intrinsic value ≈ $28.33
(b) Overpriced (Market price $30.00 > Intrinsic value $28.33)

Problem 11 (Appendix A) — Common Stocks D, E, F

Data: Stock D: R̄ =8%, σ=2%. Stock E: R̄ =15%, σ=16%. Stock F: R̄ =12%, σ=8%. Correlations: ρ(D,E)=0.40,
ρ(D,F)=0.60, ρ(E,F)=0.80. Weights: 20% D, 30% E, 50% F.
Concept & Formula
3-Asset Portfolio Return: R̄ p = wD R̄ D + wE R̄ E + wF R̄ F
3-Asset Portfolio Variance:
σp² = wD²σD² + wE²σE² + wF²σF²
+ 2wDwEρD, EσDσE + 2wDwFρD,FσDσF + 2wEwFρE,FσEσF
σp = √(σp²)
In words: Portfolio return is again just a weighted average of the three stocks' expected returns. Portfolio risk
needs THREE 'own-variance' terms (weight² × σ² for each stock) PLUS three 'cross' terms — one for every pair
of stocks (D&E, D&F, E&F) — because each pair's returns move together to some degree, measured by their
correlation. Each cross term is doubled because, in the full variance-covariance matrix, each pair's covariance
appears twice (once as row-D/col-E, once as row-E/col-D) — only the three diagonal 'own-variance' cells
appear once. More pairs = more possible interactions, which is why 3-asset portfolios need more terms than the
2-asset case in Question 3.
Step 1 — Expected Return
R̄ p = 0.20(8%) + 0.30(15%) + 0.50(12%) = 1.6% + 4.5% + 6.0% = 12.1%
Step 2 — Covariance of Each Pair (ρ × σi × σj)
Pair ρ σi × σj Covariance

D, E 0.4 0.02 × 0.16 0.40×0.02×0.16 = 0.00128

D, F 0.6 0.02 × 0.08 0.60×0.02×0.08 = 0.00096

E, F 0.8 0.16 × 0.08 0.80×0.16×0.08 = 0.01024

Step 3 — Own-Variance Terms (wi²σi²)
● wD²σD² = (0.20)²(0.02)² = 0.000016
● wE²σE² = (0.30)²(0.16)² = 0.002304
● wF²σF² = (0.50)²(0.08)² = 0.001600
Step 4 — Cross Terms (2wiwj×Covariance)
● 2 wD wE Cov(D,E) = 2(0.20)(0.30)(0.00128) = 0.0001536
● 2 wD wF Cov(D,F) = 2(0.20)(0.50)(0.00096) = 0.0001920
● 2 wE wF Cov(E,F) = 2(0.30)(0.50)(0.01024) = 0.0030720
Step 5 — Sum All Six Terms and Take the Square Root
σp² = 0.000016 + 0.002304 + 0.001600 + 0.0001536 + 0.0001920 + 0.0030720 = 0.0073376
σp = √0.0073376 ≈ 0.0857 = 8.57%
Interpretation
Most of the portfolio's risk comes from the E–F pair (0.00307 of the 0.00734 total, about 42%) — E and F are
each individually volatile (σ=16% and 8%) AND highly correlated (0.80), so combining them barely reduces
risk. Stock D contributes very little risk on its own (σ is tiny at 2%), and its lower correlations with E (0.40) and
F (0.60) mean it provides some — but limited — diversification benefit.
✓ FINAL ANSWER
Portfolio Expected Return = 12.1%
Portfolio Standard Deviation ≈ 8.57%