Chapter 07 - Introduction to Risk and Return

CHAPTER 7
Introduction to Risk and Return

Answers to Problem Sets

1. Expected payoff can be calculated by taking the sum of the probabilities times
their payoffs: (.1 x $500) + (.5 x $100) + (.4 x 0) = $100. The expected return can
be found by taking the sum of the probabilities times their net profits: (.1 x $400) +
(.5 x $0) + (.4 x -$100) = $0. The below table shows how the variance and
standard deviation are calculated:

Deviation from
Net Expected Probability ×
Probability Payof Profit Return Squared Deviation Squared Deviation

0.1 500 400 400 160,000 16,000

0.5 100 0 0 0 0

0.4 0 -100 -100 10,000 4,000

Variance = sum of
the probability x
squared
deviation: 20,000
Standard
deviation =
square root of the
variance: 141

 
Est. Time: 01 – 05

2. a. First, we must calculate the expected market return. This can be done by
multiplying each year’s return by its probability. Each return has an equal
probability of occurring, so the probability for each year is .2. The expected market
return is: (12.5 x .2) + (6.4 x .2) + (15.8 x .2) + (5.6 x .2) + (-37.2 x .2) = .62.

Once the expected return is found, the following table can be constructed to find
the variance and then the standard deviation:

Nominal Return Inflation Deviation from Squared Probability ×

Year (%) (%) Expected Return Deviation Squared Deviation
2004 12.5 3.3 11.88 141.13 28.23
2005 6.4 3.4 5.78 33.41 6.68
2006 15.8 2.5 15.18 230.43 46.09
2007 5.6 4.1 4.98 24.80 4.96

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Chapter 07 - Introduction to Risk and Return

2008 -37.2 0.1 -37.82 1430.35 286.07

Variance = sum of
the probability x
squared
deviation: 372.03
Standard
deviation =
square root of
the variance: 19.29
Standard deviation = 19.3%

b. The average real return can be calculated as shown below. First, the real
return must be derived from the nominal returns and inflation rates.

Real Return (%):

Year (1 + Nominal)/(1+Inflation) − 1
2004 8.91%
2005 2.90%
2006 12.98%
2007 1.44%
2008 −37.26%
Total −11.03%
Average −2.21%

 
Est. Time: 01 – 05

3. Ms. Sauros had a slightly higher average return (14.6% vs. 14.4% for the
market). However, the fund also had a higher standard deviation (13.6% vs.
9.4% for the market).
 
Est. Time: 01 – 05

4. a. False. Investors prefer diversified portfolios because diversification

reduces variability and therefore reduces risk. However, the diversification of an
individual company does not necessarily make it less risky.

b. True

c. False. The risk eliminated by diversification is called specific risk, or the

risk surrounding an individual company or industry. There will always remain some
risk, however, called market risk, that is present when investing.

d. False. It is true that the greatest benefit to diversification occurs when

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Chapter 07 - Introduction to Risk and Return

stocks are uncorrelated. However, most stocks tend to move in the same direction.
There are still benefits to diversification when stocks are slightly correlated.

e. False. The contribution to portfolio risk depends on the relationship of the

stock to the market as a whole.

f. True

g. True

h. False. An undiversified portfolio with a beta of 2.0 is still twice as risky as

the market portfolio.

  Est. Time: 01 – 05

5. This strategy does the most to reduce risks because the stocks move in opposite
directions. When one goes up, the other goes down, and vice versa. This does the
most to reduce risk in a portfolio.

Est. Time: 01 – 05
 
6.

 
Est. Time: 01 – 05

7. a. 26%

b. Zero

c. .75

d. Less than 1.0 (the portfolio’s risk is the same as the market, but some of
this risk is unique risk)
  Est. Time: 01 – 05

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Chapter 07 - Introduction to Risk and Return

8. a. 1.3 (Diversification does not affect market risk.) This can be found by finding the
average of all of the betas: (5 x 1.4) + (5 x 1.2) / 10 = 1.3.
Est. Time: 01 – 05
 

9. The beta of each stock is given by the slope of the line (rise over run). The
following table shows the calculation for each:

Stock -10% 10% Rise Run Slope

A 0% 20% 20% 20% 1
B -0.2 0.2 40% 20% 2
C -0.3 0 30% 20% 1.5
D 0.15 0.15 0% 20% 0
E 0.1 -0.1 -20% 20% -1

Est. Time: 01 – 05

10. Recall from Chapter 4 that:

(1 + rnominal) = (1 + rreal)  (1 + inflation rate)
Therefore:
rreal = [(1 + rnominal)/(1 + inflation rate)] – 1
a. The real return on the stock market in each year was:
1929: -14.7%
1930: -23.7%
1931: -38.0%
1932: 0.4%
1933: 56.5%

b. From the results for Part (a), the average real return was: -3.89%.

c. The risk premium for each year was:

1929: -19.3%
1930: -30.7%
1931: -45.0%
1932: -10.9%
1933: 57.0%

d. From the results for Part (c), the average risk premium was: –9.78%.

e. The standard deviation () of the risk premium is calculated as follows:

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Chapter 07 - Introduction to Risk and Return

 1 
σ 2  
5  1

  ( 0.193  (  0.0978)) 2  (  0.307  ( 0.0978)) 2  (  0.450  ( 0.0978)) 2
 
 ( 0.109  ( 0.0978)) 2  (0.570  ( 0.0978)) 2 ]  0.155739

σ 0.155739  0.394637  39.46%

Est. Time: 06 – 10

11. a. A long-term United States government bond is always absolutely safe in

terms of the dollars received. However, the price of the bond fluctuates as
interest rates change, and the rate at which coupon payments received
can be invested also changes as interest rates change. And, of course,
the payments are all in nominal dollars, so inflation risk must also be
considered.

b. It is true that stocks offer higher long-run rates of return than do bonds, but
it is also true that stocks have a higher standard deviation of return. So,
which investment is preferable depends on the amount of risk one is
willing to tolerate. This is a complicated issue and depends on numerous
factors, one of which is the investment time horizon. If the investor has a
short time horizon, then stocks are generally not preferred.

c. Unfortunately, 10 years is not generally considered a sufficient amount of

time for estimating average rates of return. Thus, using a 10-year average
is likely to be misleading.

Est. Time: 06 – 10

12. The risk to Hippique shareholders depends on the market risk, or beta, of the
investment in the black stallion. The information given in the problem suggests
that the horse has very high unique risk, but we have no information regarding
the horse’s market risk. So, the best estimate is that this horse has a market risk
about equal to that of other racehorses, and thus this investment is not a
particularly risky one for Hippique shareholders.

Est. Time: 01 – 05

13. In the context of a well-diversified portfolio, the only risk characteristic of a single
security that matters is the security’s contribution to the overall portfolio risk. This
contribution is measured by beta. Lonesome Gulch is the safer investment for a
diversified investor because its beta (+0.10) is lower than the beta of
Amalgamated Copper (+0.66). For a diversified investor, the standard deviations
are irrelevant.

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Chapter 07 - Introduction to Risk and Return

Est. Time: 01 – 05

14. xI = 0.60 I = 0.10

xJ = 0.40 J = 0.20
a. ρIJ  1
2 2 2 2 2
σ p  [ xI σI  x J σ J  2(x I x JρIJσ Iσ J )]
 [ (0.60) (0.10)  ( 0.40)2 (0.20)2  2(0.60)(0.40)(1)(0.10)(0.20) ]  0.0196
2 2

b. ρIJ  0.50
2 2 2 2 2
σp  [ xI σI  xJ σJ  2(x I x JρIJσ Iσ J )]

 [ (0.60)2 (0.10)2  ( 0.40)2 (0.20)2  2(0.60)(0. 40)(0.50)(0.10)(0.20 ) ]  0.0148

c. ρij  0
2 2 2 2 2
σp  [ xI σI  xJ σJ  2(x I x JρIJσ Iσ J )]

 [ (0.60)2 (0.10)2  ( 0.40)2 (0.20)2  2(0.60)(0.40)(0)(0.10)(0.20) ]  0.0100

Est. Time: 06 – 10

15. a. Refer to Figure 7.13 in the text. With 100 securities, the box is 100 by
100. The variance terms are the diagonal terms, and thus there are 100
variance terms. The rest are the covariance terms. Because the box has
(100 times 100) terms altogether, the number of covariance terms is:
1002 – 100 = 9,900
Half of these terms (i.e., 4,950) are different.

b. Once again, it is easiest to think of this in terms of Figure 7.13. With 50

stocks, all with the same standard deviation (0.30), the same weight in the
portfolio (0.02), and all pairs having the same correlation coefficient (0.40),
the portfolio variance is:
σ2 = 50(0.02)2(0.30)2 + [(50)2 – 50](0.02)2(0.40)(0.30)2 =0.03708
σ = 0.193 = 19.3%

c. For a fully diversified portfolio, portfolio variance equals the average

covariance:
σ2 = (0.30)(0.30)(0.40) = 0.036
σ = 0.190 = 19.0%

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Chapter 07 - Introduction to Risk and Return

Est. Time: 06 – 10

16. a. Refer to Figure 7.13 in the text. For each different portfolio, the relative
weight of each share is [one divided by the number of shares (n) in the
portfolio], the standard deviation of each share is 0.40, and the correlation
between pairs is 0.30. Thus, for each portfolio, the diagonal terms are the
same, and the off-diagonal terms are the same. There are n diagonal
terms and (n2 – n) off-diagonal terms. In general, we have:
Variance = n(1/n)2(0.4)2 + (n2 – n)(1/n)2(0.3)(0.4)(0.4)
For one share:
Variance = 1(1)2(0.4)2 + 0 = 0.160000
For two shares:
Variance = 2(0.5)2(0.4)2 + 2(0.5)2(0.3)(0.4)(0.4) = 0.104000
The results are summarized in the second and third columns of the
table below.

b. (Graphs are on the next page.) The underlying market risk that cannot be
diversified away is the second term in the formula for variance above:
Underlying market risk = (n2 - n)(1/n)2(0.3)(0.4)(0.4)
As n increases, [(n2 - n)(1/n)2] = [(n-1)/n] becomes close to 1, so that the
underlying market risk is: [(0.3)(0.4)(0.4)] = 0.048.

c. This is the same as Part (a), except that all of the off-diagonal terms are
now equal to zero. The results are summarized in the fourth and fifth
columns of the table below.
(Part a) (Part a) (Part c) (Part c)
No. of Standard Standard
Shares Variance Deviation Variance Deviation
1 .160000 .400 .160000 .400
2 .104000 .322 .080000 .283
3 .085333 .292 .053333 .231
4 .076000 .276 .040000 .200
5 .070400 .265 .032000 .179
6 .066667 .258 .026667 .163
7 .064000 .253 .022857 .151
8 .062000 .249 .020000 .141
9 .060444 .246 .017778 .133
10 .059200 .243 .016000 .126

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Chapter 07 - Introduction to Risk and Return

Graphs for Part (a):

0.2
P ortfo lio V aria
ortfolio nce
ariance 0.5 P oortfo
rtfolio
lio S ta ndaard
tand rd D eviation
evia tion
0.4
0.15

Standard Deviation
0.3
Variance

0.1
0.2
0.05
0.1

0 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12
Number of Securities Number of Securities

Graphs for Part (c):

0.2
P ortfo lio V aria
ortfolio nce
ariance 0.5 P oortfo
rtfolio
lio S ta ndaard
tand rd D eviation
evia tion
0.4
0.15
Standard Deviation

0.3
Variance

0.1
0.2
0.05
0.1

0 0
0 2 4 6 8 10 12 0 2 4 6 8 10 12
Number of Securities Number of Securities

Est. Time: 16 – 20

17. The table below uses the format of Figure 7.13 in the text in order to calculate the
portfolio variance. The portfolio variance is the sum of all the entries in the
matrix. Portfolio variance equals: 0.03326.

Est. Time: 21 – 25

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 Chapter 07 - Introduction to Risk and Return

18. “Safest” means lowest risk; in a portfolio context, this means lowest variance of
return. Half of the portfolio is invested in British Petroleum stock (BP), and half of
the portfolio must be invested in one of the other securities listed. Thus, we
calculate the portfolio variance for seven different portfolios to see which is the
lowest (see table below). The safest attainable portfolio is comprised of British
Petroleum stock (BP) and Nestle.

Company with BP Variance Variance

BHP =(1/2)2 x (22.0%)2 + (1/2)2 x (33.8%)2+ 2 x 1/2 x 1/2 x (0.30) x (22.0%) x (33.8%) = 0.05182

Fiat =(1/2)2 x (44.6%)2 + (1/2)2 x (33.8%)2+ 2 x 1/2 x 1/2 x (0.28) x (44.6%) x (33.8%) = 0.09939

Heineken =(1/2)2 x (20.3%)2 + (1/2)2 x (33.8%)2+ 2 x 1/2 x 1/2 x (0.25) x (20.3%) x (33.8%) = 0.04744

Nestle =(1/2)2 x (14.0%)2 + (1/2)2 x (33.8%)2+ 2 x 1/2 x 1/2 x (0.15) x (14.0%) x (33.8%) = 0.03701

Sony =(1/2)2 x (34.5%)2 + (1/2)2 x (33.8%)2+ 2 x 1/2 x 1/2 x (0.29) x (34.5%) x (33.8%) = 0.07523

TAM =(1/2)2 x (42.4%)2 + (1/2)2 x (33.8%)2+ 2 x 1/2 x 1/2 x (-0.12) x (42.4%) x (33.8%) = 0.06491

Tata Motors =(1/2)2 x (44.5%)2 + (1/2)2 x (33.8%)2+ 2 x 1/2 x 1/2 x (0.17) x (44.5%) x (33.8%) = 0.09085

Est. Time: 11 – 15

19.
a. In general, we expect a stock’s price to change by an amount equal to
(beta  change in the market). Beta equal to –0.25 implies that, if the
market rises by an extra 5%, the expected change in the stock’s rate of
return is –1.25%. If the market declines an extra 5%, then the expected
change is +1.25%.

b. “Safest” implies lowest risk. Assuming the well-diversified portfolio is

invested in typical securities, the portfolio beta is approximately one. The
largest reduction in beta is achieved by investing the $20,000 in a stock
with a negative beta. Answer (iii) is correct.

Est. Time: 06 – 10

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Chapter 07 - Introduction to Risk and Return

20. Expected portfolio return = xA E[RA ] + xB E[RB ] = 12% = 0.12

Let xB = (1 – xA )
xA(0.10) + (1 – xA) (0.15) = 0.12  xA = 0.60 and xB = 1 – xA = 0.40

Portfolio variance = xA2 σA2 + xB2 σB2 +2(xA xB ρAB σA σB )

= (0.60 2 ) (20 2 ) + (0.40 2 ) (40 2 ) + 2(0.60)(0.40)(0.50)(20)(40) = 592
Standard deviation = σ 592  24.33%

Est. Time: 06 – 10

21. a.
2007 14.56%
2008 -42.53
2009 36.73
2010 0.58
2011 -14.06

b. Average real rate of return = -0.94%

c.
2007 11.4%
2008 -47.6
2009 36.5
2010 -1.0
2011 -16.2

d. Average risk premium = -3.4%

e. Standard deviation of the risk premium = 31.4%

Est. Time: 06 – 10

22. a. In general:
Portfolio variance = P2 = x1212 + x2222 + 2x1x21212
Thus:
P2 = (0.52)(32.42)+(0.52)(142)+2(0.5)(0.5)(0.48)(32.4)(14)
P2 = 420.304
Standard deviation = P = 20.50%

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Chapter 07 - Introduction to Risk and Return

b. We can think of this in terms of Figure 7.13 in the text, with three
securities. One of these securities, T-bills, has zero risk and, hence, zero
standard deviation. Thus:
P2 = (1/3)2(32.42)+(1/3)2(142)+2(1/3)(1/3)(0.48)(32.4)(14)
P2 = 186.8018
Standard deviation = P = 13.67%
Another way to think of this portfolio is that it is comprised of one-third
T-Bills and two-thirds a portfolio which is half Dell and half McDonalds.
Because the risk of T-bills is zero, the portfolio standard deviation is two-
thirds of the standard deviation computed in Part (a) above:
Standard deviation = (2/3)(20.50) = 13.67%

c. With 50% margin, the investor invests twice as much money in the
portfolio as he had to begin with. Thus, the risk is twice that found in Part
(a) when the investor is investing only his own money:
Standard deviation = 2  20.5% = 41%

d. With 100 stocks, the portfolio is well diversified, and hence the portfolio
standard deviation depends almost entirely on the average covariance of
the securities in the portfolio (measured by beta) and on the standard
deviation of the market portfolio. Thus, for a portfolio made up of 100
stocks, each with beta = 1.25, the portfolio standard deviation is
approximately: 1.25  19.5% = 24.38%.
For stocks like McDonalds, it is: 0.45  19.5% = 8.775%.
Est. Time: 11 – 15

23. For a two-security portfolio, the formula for portfolio risk is:
Portfolio variance = x1212 + x2222 + 2x1x21212
If security one is Treasury bills and security two is the market portfolio, then 1 is
zero, and 2 is 20%. Therefore:
Portfolio variance = x2222 = x22(0.20)2
Standard deviation = 0.20x2
Portfolio expected return = x1(0.06) + x2(0.06 + 0.85)
Portfolio expected return = 0.06x1 + 0.145x2
Expected Standard
Portfolio x1 x2
Return Deviation
1 1.0 0.0 0.060 0.000
2 0.8 0.2 0.077 0.040

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Chapter 07 - Introduction to Risk and Return

3 0.6 0.4 0.094 0.080

4 0.4 0.6 0.111 0.120
5 0.2 0.8 0.128 0.160
6 0.0 1.0 0.145 0.200

Est. Time: 11 – 15

24. The matrix below displays the variance for each of the eight stocks along the
diagonal and each of the covariances in the off-diagonal cells:

The covariance of BP with the market portfolio (σBP, Market) is the mean of the eight
respective covariances between BP and each of the eight stocks in the portfolio.

(The covariance of BP with itself is the variance of BP.) Therefore, σBP, Market is
equal to the average of the eight covariances in the first row or, equivalently, the

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Chapter 07 - Introduction to Risk and Return

average of the eight covariances in the first column. Beta for BP is equal to the
covariance divided by the market variance, which we calculated at 0.03326 in
problem 17. The covariances and betas are displayed in the table below:

Market
Covariance Variance Beta
BHP 0.0283187 0.03326 0.851370374
BP 0.0306503 0.03326 0.921467033
Fiat 0.0541974 0.03326 1.629385159
Heineken 0.0225858 0.03326 0.679017078
Nestle 0.0094008 0.03326 0.282625649
Sony 0.0381945 0.03326 1.148276948
TAM 0.0244595 0.03326 0.735348446

Est. Time: 21 – 25

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