Chapter 8

Risk and Return

◼ Instructor’s Resources
Overview
This chapter focuses on the fundamentals of the risk and return relationship of assets and their valuation. For the
single asset held in isolation, risk is measured with the probability distribution and its associated statistics: the
mean, the standard deviation, and the coefficient of variation. The concept of diversification is examined by
measuring the risk of a portfolio of assets that are perfectly positively correlated, perfectly negatively correlated,
and those that are uncorrelated. Next, the chapter looks at international diversification and its effect on risk. The
Capital Asset Pricing Model (CAPM) is then presented as a valuation tool for securities and as a general
explanation of the risk-return tradeoff involved in all types of financial transactions. Chapter 8 highlights the
importance of understanding the relationship of risk and return when making professional and personal decisions.

◼ Suggested Answer to Opener-in-Review Question

In the chapter opener you learned that Bill Miller’s investment performance was alternating between the
very top and the very bottom of his profession. What aspect of his investment strategy would lead you to
expect that his performance might exhibit greater volatility than that of other mutual funds? In the table
below, we show the annual performance from 2009 to 2012 of Miller’s Opportunity fund and the S&P 500
index.

Opportunity S&P 500

Year Fund Return Return
2009 76.0% 26.5%
2010 16.6% 15.1%
2011 –34.9% 2.11%
2012 39.6% 16.0%

Calculate the average annual return of the Opportunity fund and the S&P 500. Which performed better
over this period? If you had invested $1,000 in each investment at the beginning of 2009, how much money
would you have in each investment at the end of 2012? Calculate the standard deviation of the Opportunity
fund’s return and those of the S&P 500. Which is more volatile?

Average annual return of the Opportunity fund = (76.0% + 16.6% − 34.9% + 39.6%) / 4 = 97.30% / 4 = 24.33%

Average annual return of the S & P 500 = (26.5% + 15.1% + 2.11% + 16.0%) / 4 =59.71% / 4 = 14.93%

Opportunity fund performed better over this period.

Money in each investment at the end of 2012:

Opportunity fund = $1,000 × (1 +2 4.33%) = $1,243.25

© Pearson Education Limited, 2015.

S & P Return = $1,000 × (1 + 14.93%) = $1,149.28

Year Return (Return – average return)2

2009 76.0% 26.70%

2010 16.60% 0.60%

2011 −34.90% 35.08%

2012 39.60% 2.33%

Total 64.71%

Standard deviation = √64.71% = 80.44

Answers to Review Questions

1. Risk is defined as the chance of financial loss, as measured by the variability of expected returns associated
with a given asset. A decision maker should evaluate an investment by measuring the chance of loss, or risk,
and comparing the expected risk to the expected return. Some assets are considered risk free; the most
common examples are U.S. Treasury issues.

2. The return on an investment (total gain or loss) is the change in value plus any cash distributions over a
defined time period. It is expressed as a percent of the beginning-of-the-period investment. The formula is:
[(ending value − initial value) + cash distribution]
Return =
initial value

Realized return requires the asset to be purchased and sold during the time periods the return is measured.
Unrealized return is the return that could have been realized if the asset had been purchased and sold during
the time period the return was measured.

3. a. The risk-averse financial manager requires an increase in return for a given increase in risk.
b. The risk-neutral manager requires no change in return for an increase in risk.
c. The risk-seeking manager accepts a decrease in return for a given increase in risk.
Most financial managers are risk averse.

4. Scenario analysis evaluates asset risk by using more than one possible set of returns to obtain a sense of the
variability of outcomes. The range is found by subtracting the pessimistic outcome from the optimistic
outcome. The larger the range, the greater the risk associated with the asset.

5. The decision maker can get an estimate of project risk by viewing a plot of the probability distribution, which
relates probabilities to expected returns and shows the degree of dispersion of returns. The more spread out
the distribution, the greater the variability or risk associated with the return stream.

6. The standard deviation of a distribution of asset returns is an absolute measure of dispersion of risk around
the mean or expected value. A higher standard deviation indicates a greater project risk. With a larger
standard deviation, the distribution is more dispersed, and the outcomes have a higher variability, resulting in
higher risk.

7. The coefficient of variation is another indicator of asset risk; however, this measures relative dispersion. It is
calculated by dividing the standard deviation by the expected value. The coefficient of variation indicates
how volatile an asset’s returns are relative to its average or expected return. Therefore, the coefficient of
variation is a better basis than the standard deviation for comparing risk of assets with differing expected
returns.
 8. An efficient portfolio is one that maximizes return for a given risk level or minimizes risk for a given level of
return. Return of a portfolio is the weighted average of returns on the individual component assets:
n
rˆp =  w j  rˆj
j =1

where:
n = number of assets
wj = weight of individual assets
r j = expected returns

The standard deviation of a portfolio is not the weighted average of component standard deviations; the risk
of the portfolio as measured by the standard deviation will be smaller. It is calculated by applying the
standard deviation formula to the portfolio assets:
n
(ri − r )2
 rp = 
i = 1 ( n − 1)

9. The correlation between asset returns is important when evaluating the effect of a new asset on the portfolio’s
overall risk. Returns on different assets moving in the same direction are positively correlated, while those
moving in opposite directions are negatively correlated. Assets with high positive correlation increase the
variability of portfolio returns; assets with high negative correlation reduce the variability of portfolio returns.
When negatively correlated assets are brought together through diversification, the variability of the expected
return from the resulting combination can be less than the variability or risk of the individual assets. When
one asset has high returns, the other’s returns are low and vice versa. Therefore, the result of diversification is
to reduce risk by providing a pattern of stable returns.
Diversification of risk in the asset selection process allows the investor to reduce overall risk by combining
negatively correlated assets so that the risk of the portfolio is less than the risk of the individual assets in it.
Even if assets are not negatively correlated, the lower the positive correlation between them, the lower their
resulting portfolio return variability.

10. The inclusion of foreign assets in a domestic company’s portfolio reduces risk for two reasons. When returns
from foreign-currency-denominated assets are translated into dollars, the correlation of returns of the
portfolio’s assets is reduced. Also, if the foreign assets are in countries that are less sensitive to the U.S.
business cycle, the portfolio’s response to market movements is reduced.
When the dollar appreciates relative to other currencies, the dollar value of a foreign-currency-denominated
portfolio declines and results in lower returns in dollar terms. If this appreciation is due to better performance
of the U.S. economy, foreign-currency-denominated portfolios generally have lower returns in local currency
as well, further contributing to reduced returns.
Political risks result from possible actions by the host government that are harmful to foreign investors or
possible political instability that could endanger foreign assets. This form of risk is particularly high in
developing countries. Companies diversifying internationally may have assets seized or the return of profits
blocked.

11. The total risk of a security is the combination of nondiversifiable risk and diversifiable risk. Diversifiable risk
refers to the portion of an asset’s risk attributable to firm-specific, random events (strikes, litigation, loss of
key contracts, etc.) that can be eliminated by diversification. Nondiversifiable risk is attributable to market
factors affecting all firms (war, inflation, political events, etc.). Some argue that nondiversifiable risk is the
only relevant risk because diversifiable risk can be eliminated by creating a portfolio of assets that are not
perfectly positively correlated.

12. Beta measures nondiversifiable risk. It is an index of the degree of movement of an asset’s return in response
to a change in the market return. The beta coefficient for an asset can be found by plotting the asset’s
historical returns relative to the returns for the market. By using statistical techniques, the “characteristic
 line” is fit to the data points. The slope of this line is beta. Beta coefficients for actively traded stocks are
published in the Value Line Investment Survey, in brokerage reports, and several online sites. The beta of a
portfolio is calculated by finding the weighted average of the betas of the individual component assets.

13. The equation for the capital asset pricing model is:
rj = RF + [bj  (rm − RF)],
where:
rj = the required (or expected) return on asset j
RF = the rate of return required on a risk-free security (a U.S. Treasury bill)
bj = the beta coefficient or index of nondiversifiable (relevant) risk for asset j
rm = the required return on the market portfolio of assets (the market return)

The security market line (SML) is a graphical presentation of the relationship between the amount of
systematic risk associated with an asset and the required return. Systematic risk is measured by beta and is on
the horizontal axis, while the required return is on the vertical axis.

14. a. If there is an increase in inflationary expectations, the security market line will show a parallel shift
upward in an amount equal to the expected increase in inflation. The required return for a given level of
risk will also rise.
b. The slope of the SML (the beta coefficient) will be less steep if investors become less risk averse, and a
lower level of return will be required for each level of risk.

◼ Suggested Answer to Focus on Ethics Box:

If It Sounds Too Good to Be True, It Probably Is
What are some hazards of allowing investors to pursue claims based on their most recent accounts
statements?

Allowing claims based on fraudulent statements reduces investors’ incentive to perform due diligence. If investors
are allowed to profit from fraud engineered by their investment manager, becoming a “victim” of fraud could
become a desired outcome, as investors’ primary incentive would be to secure the largest possible return,
legitimate or not.

◼ Suggested Answer to Global Focus Box:

An International Flavor to Risk Reduction
International mutual funds do not include any domestic assets, whereas global mutual funds include both
foreign and domestic assets. How might this difference affect their correlation with U.S. equity mutual
funds?

The difference between global funds and international funds is that global funds can invest in stocks and bonds
around the world, including U.S. securities, whereas international funds invest in stocks and bonds around the
world but not U.S securities. Therefore, global funds are more likely to be correlated with U.S. equity mutual funds
because a significant portion of their portfolios are likely to be U.S. equities. An investor seeking increased
international diversification in a portfolio should consider international funds over global funds or increase the
portion of the portfolio devoted to global funds if seeking diversification through global funds.

◼ Answers to Warm-Up Exercises

E8-1. Total annual return
Answer: ($0 + $12,000,000 − $10,000,000)  $10,000,000 = $2,000,000  $10,000,000 = 20%
 Logistics, Inc., doubled the annual rate of return predicted by the analyst. The negative net income is
irrelevant to the problem.

E8-2. Expected return

Answer:

Analyst Probability Return Weighted Value

1 0.35 5% 1.75%
2 0.05 −5% −0.25%
3 0.20 10% 2.00%
4 0.40 3% 1.20%
Total 1.00 Expected return 4.70%

E8-3. Comparing the risk of two investments

Answer: CV1 = 0.10  0.15 = 0.6667 CV2 = 0.05  0.12 = 0.4167
Based solely on standard deviations, Investment 2 has lower risk than Investment 1. Based on
coefficients of variation, Investment 2 is still less risky than Investment 1. Because the two investments
have different expected returns, using the coefficient of variation to assess risk is better than simply
comparing standard deviations because the coefficient of variation considers the relative size of the
expected returns of each investment.

E8-4. Computing the expected return of a portfolio

Answer: rp= (0.25  0.048) + (0.5 0.152) + (0.25  0.234)
= 0.012+ 0.076 + 0.0585= 0.1465=14.65%
The portfolio is expected to have a return of approximately 14.7%.

E8-5. Calculating a portfolio beta

Answer:
Beta = (0.20  1.15) + (0.10  0.85) + (0.15  1.60) + (0.20  1.35) + (0.35  1.85)
= 0.2300 + 0.0850 + 0.2400 + 0.2700 + 0.6475 = 1.4725
E8-6. Calculating the required rate of return
Answer:
a. Required return = 0.05 + 1.8 (0.10 − 0.05) = 0.05 + 0.09 = 0.14
b. Required return = 0.05 + 1.8 (0.13 − 0.05) = 0.05 + 0.144 = 0.194
 c. Although the risk-free rate does not change, as the market return increases, the required return on
the asset rises by 180% of the change in the market’s return.

◼ Solutions to Problems
(Pt − Pt− 1 + Ct )
P8-1. Rate of return: rt =
Pt−1
LG 1; Basic
71,000 − 63,000 + 6,100
a. Investment A: Return = = 22.38%
63,000
32,000 − 35,000 + 2,800
Investment B: Return = −0.57%
35,000
b. Investment A should be selected because it has a higher rate of return for the same level
of risk.

(Pt − Pt−1 + Ct )
P8-2. Return calculations: rt =
Pt−1
LG 1; Basic

Investment Calculation rt(%)

A ($20,100 − $23,400 − $2,800)  $23,400 –26.07
B ($324,000 − $225,000 + $16,000)  $225,000 51.11
C ($8,000 − $6,500 + $700)  $6,500 33.85
D ($46,500− $36,600 + $3,580)  $36,600 3
E ($52,800 − $62,700 − $500)  $62,700 –16.59

P8-3. Risk preferences

LG 1; Intermediate
 a. The risk-neutral manager would accept Investments A and B because these have higher returns than
the 15% required return and the risk doesn’t matter.
b. The risk-averse manager would accept Investment A because it provides the highest return and has the
lowest amount of risk. Investment A offers an increase in return for taking on more risk than what the
firm currently earns.
c. The risk-seeking manager would accept Investments B and C because he or she is willing to take
greater risk without an increase in return.
d. Traditionally, financial managers are risk averse and would choose Investment A, since it provides the
required increase in return for an increase in risk.

P8-4. Risk analysis

LG 2; Intermediate
a.
Expansion Range
A 24% − 16% = 8%
B 30% − 10% = 20%

b. Project A is less risky because the range of outcomes for A is smaller than the range for Project B.
c. Because the most likely return for both projects is 20% and the initial investments are equal, the
answer depends on your risk preference.
d. The answer is no longer clear because it now involves a risk-return tradeoff. Project B has a slightly
higher return but more risk, while A has both lower return and lower risk.

P8-5. Risk and probability

LG 2; Intermediate
a.
Camera Range
R 30% − 20% = 10%
S 35% − 15% = 20%
b.
Possible Probability Expected Return Weighted
Outcomes Pri ri Value (%)(ri  Pri)
Camera R Pessimistic 0.25 20 5.00%
Most likely 0.50 25 12.50%
Optimistic 0.25 30 7.50%
1.00 Expected return 25.00%
Camera S Pessimistic 0.20 15 3.00%
Most likely 0.55 25 13.75%
Optimistic 0.25 35 8.75%
1.00 Expected return 25.50%
c. Camera S is considered more risky than Camera R because it has a much broader range of outcomes.
The risk-return tradeoff is present because Camera S is more risky and also provides a higher return
than Camera R.

P8-6. Bar charts and risk

LG 2; Intermediate
 a.

b.
Market Probability Expected Return Weighted Value
Acceptance Pri ri (ri  Pri)
Line J Very Poor 0.05 0.0075 0.000375
Poor 0.15 0.0125 0.001875
Average 0.60 0.0850 0.051000
Good 0.15 0.1475 0.022125
Excellent 0.05 0.1625 0.008125
1.00 Expected return 0.083500
Line K Very Poor 0.05 0.010 0.000500
Poor 0.15 0.025 0.003750
Average 0.60 0.080 0.048000
Good 0.15 0.135 0.020250
Excellent 0.05 0.150 0.007500
1.00 Expected return 0.080000

c. Line K appears less risky due to a slightly tighter distribution than line J, indicating a lower range of
outcomes.
r
P8-7. Coefficient of variation: CV =
r
LG 2; Basic
 7%
a. A CVA = = 0.3500
20%
9.5%
B CVB = = 0.4318
22%
6%
C CVC = = 0.3158
19%
5.5%
D CVD = = 0.3438
16%
b. Asset C has the lowest coefficient of variation and is the least risky relative to the other choices.

P8-8. Standard deviation versus coefficient of variation as measures of risk

LG 2; Basic
a. Project A is least risky based on range with a value of 0.04.
b. Project A has the lowest standard deviation. The standard deviation measure fails to take into account
both the volatility and the return of the investment. Investors would prefer higher return but less
volatility, and the coefficient of variation provices a measure that takes into account both aspects of
investors’ preferences. Project D has the lowest CV, so it is the least risky investment relative to the
return provided.
0.029
c. A CVA = = 0.2417
0.12
0.032
B CVB = = 0.2560
0.125
0.035
C CVC = = 0.2692
0.13
0.030
D CVD = = 0.2344
0.128
In this case Project D is the best alternative because it provides the least amount of risk for each
percent of return earned. Coefficient of variation is probably the best measure in this instance because
it provides a standardized method of measuring the risk-return tradeoff for investments with differing
returns.

P8-9. Personal finance: Rate of return, standard deviation, coefficient of variation

LG 2; Challenge
a. Stock Price Variance
Year Beginning End Returns (Return–Average Return)2
2012 14.36 21.55 50.07% 0.0495
2013 21.55 64.78 200.60% 1.6459
2014 64.78 72.38 11.73% 0.3670
2015 72.38 91.80 26.83% 0.2068
b. Average return 72.31%
c. Sum of variances 2.2692
3 Sample divisor (n − 1)
0.7564 Variance
86.97% Standard deviation
d. 1.20 Coefficient of variation
e. The stock price of Hi-Tech, Inc. has definitely gone through some major price changes
 over this time period. It would have to be classified as a volatile security having an
upward price trend over the past 4 years. Note how comparing securities on a CV basis
allows the investor to put the stock in proper perspective. The stock is riskier than what
Mike normally buys, but if he believes that Hi-Tech, Inc., will continue to rise, then he
should include it. The coefficient of variation, however, is greater than the 0.90 target.
P8-10. Assessing return and risk
LG 2; Challenge
a. Project 257
(1) Range: 1.00 − (−.10) = 1.10
n
(2) Expected return: r =  ri  Pri
i =1

Expected Return
n
Rate of Return Probability Weighted Value r =  ri  Pri
ri Pr i ri  Pr i i=1

−.10 0.01 −0.001

0.10 0.04 0.004
0.20 0.05 0.010
0.30 0.10 0.030
0.40 0.15 0.060
0.45 0.30 0.135
0.50 0.15 0.075
0.60 0.10 0.060
0.70 0.05 0.035
0.80 0.04 0.032
1.00 0.01 0.010
1.00 0.450

n
(3) Standard deviation:  =  (r − r )
i =1
i
2
 Pri

ri r ri − r ( ri − r ) 2 Pr i ( ri − r ) 2  Pr i

−0.10 0.450 −0.550 0.3025 0.01 0.003025

0.10 0.450 −0.350 0.1225 0.04 0.004900
0.20 0.450 −0.250 0.0625 0.05 0.003125
0.30 0.450 −0.150 0.0225 0.10 0.002250
0.40 0.450 −0.050 0.0025 0.15 0.000375
0.45 0.450 0.000 0.0000 0.30 0.000000
0.50 0.450 0.050 0.0025 0.15 0.000375
0.60 0.450 0.150 0.0225 0.10 0.002250
0.70 0.450 0.250 0.0625 0.05 0.003125
0.80 0.450 0.350 0.1225 0.04 0.004900
1.00 0.450 0.550 0.3025 0.01 0.003025
0.027350
  Project 257 = 0.027350 = 0.165378

0.165378
(4) CV = = 0.3675
0.450
Project 432
(1) Range: 0.50 − 0.10 = 0.40
n
(2) Expected return: r =  ri  Pri
i =1

Expected Return
n
Rate of Return Probability Weighted Value r =  ri  Pri
ri Pr i ri  Pri i =1

0.10 0.05 0.0050

0.15 0.10 0.0150
0.20 0.10 0.0200
0.25 0.15 0.0375
0.30 0.20 0.0600
0.35 0.15 0.0525
0.40 0.10 0.0400
0.45 0.10 0.0450
0.50 0.05 0.0250
1.00 0.300

n
(3) Standard deviation:  =  (r − r )
i =1
i
2
 Pri

ri r ri − r ( ri − r )2 Pri ( ri − r )2  Pri

0.10 0.300 −0.20 0.0400 0.05 0.002000

0.15 0.300 −0.15 0.0225 0.10 0.002250
0.20 0.300 −0.10 0.0100 0.10 0.001000
0.25 0.300 −0.05 0.0025 0.15 0.000375
0.30 0.300 0.00 0.0000 0.20 0.000000
0.35 0.300 0.05 0.0025 0.15 0.000375
0.40 0.300 0.10 0.0100 0.10 0.001000
0.45 0.300 0.15 0.0225 0.10 0.002250
0.50 0.300 0.20 0.0400 0.05 0.002000
0.011250

Project 432 = 0.011250 = 0.106066

0.106066
(4) CV = = 0.3536
0.300
b. Bar Charts

c. Summary statistics

Project 257 Project 432

Range 1.100 0.400
Expected return (r ) 0.450 0.300
Standard deviation ( r ) 0.165 0.106
Coefficient of variation (CV) 0.3675 0.3536

Because Projects 257 and 432 have differing expected values, the coefficient of variation should be
the criterion by which the risk of the asset is judged. Because Project 432 has a smaller CV, it is the
opportunity with lower risk.
P8-11. Integrative—expected return, standard deviation, and coefficient of variation
LG 2; Challenge
n
a. Expected return: r =  ri  Pri
i =1

Expected Return
n
Rate of Return Probability Weighted Value r =  ri  Pri
ri Pr i ri  Pri i =1

Asset F 0.40 0.10 0.04

0.10 0.20 0.02
0.00 0.40 0.00
−0.05 0.20 −0.01
−0.10 0.10 −0.01
0.04
Asset G 0.35 0.40 0.14
0.10 0.30 0.03
−0.20 0.30 −0.06
0.11
Asset H 0.40 0.10 0.04
0.20 0.20 0.04
0.10 0.40 0.04
0.00 0.20 0.00
−0.20 0.10 −0.02
0.10

Asset G provides the largest expected return.

n
b. Standard deviation:  =  (r − r )
i =1
i
2
xPri

ri − r ( ri − r ) 2 Pr i 2 r
Asset F 0.40 − 0.04 = 0.36 0.1296 0.10 0.01296
0.10 − 0.04 = 0.06 0.0036 0.20 0.00072
0.00 − 0.04 = −0.04 0.0016 0.40 0.00064
−0.05 − 0.04 = −0.09 0.0081 0.20 0.00162
−0.10 − 0.04 = −0.14 0.0196 0.10 0.00196
0.01790 0.1338
Asset G 0.35 − 0.11 = .24 0.0576 0.40 0.02304
0.10 − 0.11 = −0.01 0.0001 0.30 0.00003
−0.20 − 0.11 = −0.31 0.0961 0.30 0.02883
0.05190 0.2278
Asset H 0.40 − 0.10 = .30 0.0900 0.10 0.009
 0.20 − 0.10 = .10 0.0100 0.20 0.002
0.10 − 0.10 = 0.00 0.0000 0.40 0.000
0.00 − 0.10 = −0.10 0.0100 0.20 0.002
−0.20 − 0.10 = −0.30 0.0900 0.10 0.009
0.022 0.1483

Based on standard deviation, Asset G appears to have the greatest risk, but it must be measured
against its expected return with the statistical measure coefficient of variation because the three assets
have differing expected values. An incorrect conclusion about the risk of the assets could be drawn
using only the standard deviation.

standard deviation ( )
c. Coefficient of variation =
expected value
0.1338
Asset F: CV = = 3.345
0.04
0.2278
Asset G: CV = = 2.071
0.11
0.1483
Asset H: CV = = 1.483
0.10
As measured by the coefficient of variation, Asset F has the largest relative risk.

P8-12. Normal probability distribution

LG 2; Challenge
a. Coefficient of variation: CV =  r  r
Solving for standard deviation: 0.75 = r  0.189
r = 0.75  0.189 = 0.14175
b. (1) 68% of the outcomes will lie between 1 standard deviation from the expected value:
+1 = 0.189 + 0.14175 = 0.33075
−1 = 0.189 − 0.14175 = 0.04725
(2) 95% of the outcomes will lie between  2 standard deviations from the expected value:
+2 = 0.189 + (2  0.14175) = 0.4725
−2 = 0.189 − (2  0.14175) = −0.0945

(3) 99% of the outcomes will lie between 3 standard deviations from the expected value:
+3 = 0.189 + (3  0.14175) = 0.61425
−3 = 0.189 − (3  0.14175) = −0.23625
c.
Return
P8-13. Personal finance: Portfolio return and standard deviation
LG 3; Challenge
a. Expected portfolio return for each year: rp = (wL  rL) + (wM  rM)

Expected
Asset L Asset M Portfolio Return
Year (wL  rL) + (wM  rM) rp
2015 (14%  0.40 = 5.6%) + (20%  0.60 = 12.0%) = 17.6%
2016 (14%  0.40 = 5.6%) + (18%  0.60 = 10.8%) = 16.4%
2017 (16%  0.40 = 6.4%) + (16%  0.60 = 9.6%) = 16.0%
2018 (17%  0.40 = 6.8%) + (14%  0.60 = 8.4%) = 15.2%
2019 (17%  0.40 = 6.8%) + (12%  0.60 = 7.2%) = 14.0%
2020 (19%  0.40 = 7.6%) + (10%  0.60 = 6.0%) = 13.6%

w
j =1
j  rj
b. Portfolio return: rp =
n
17.6 + 16.4 + 16.0 + 15.2 + 14.0 + 13.6
rp = = 15.467 = 15.5%
6
n
(ri − r )2
c. Standard deviation:  rp = 
i =1 ( n − 1)

(17.6% − 15.5%)2 + (16.4% − 15.5%)2 + (16.0% − 15.5%)2 

 2
 + (15.2% − 15.5%) + (14.0% − 15.5%) + (13.6% − 15.5%) 
2 2
 rp =
6 −1
(2.1%)2 + (0.9%)2 + (0.5%)2 
 2
 + (−0.3%) + (−1.5%) + (−1.9%) 
2 2
 rp =
5
(.000441 + 0.000081 + 0.000025 + 0.000009 + 0.000225 + 0.000361)
 rp =
5
0.001142
 rp = = 0.000228% = 0.0151 = 1.51%
5
d. The assets are negatively correlated.
e. Combining these two negatively correlated assets reduces overall portfolio risk.
P8-14. Portfolio analysis
LG 3; Challenge
a. Expected portfolio return:
Alternative 1: 100% Asset F
16% + 17% + 18% + 19%
rp = = 17.5%
4
Alternative 2: 50% Asset F + 50% Asset G
Asset F Asset G Portfolio Return
Year (wF  rF) + (wG  rG) rp

2016 (16%  0.50 = 8.0%) + (17%  0.50 = 8.5%) = 16.5%

2017 (17%  0.50 = 8.5%) + (16%  0.50 = 8.0%) = 16.5%
2018 (18%  0.50 = 9.0%) + (15%  0.50 = 7.5%) = 16.5%
2019 (19%  0.50 = 9.5%) + (14%  0.50 = 7.0%) = 16.5%

16.5% + 16.5% + 16.5% + 16.5%

rp = = 16.5%
4
Alternative 3: 50% Asset F + 50% Asset H
Asset F Asset H Portfolio Return
Year (wF  rF) + (wH  rH) rp

2016 (16%  0.50 = 8.0%) + (14%  0.50 = 7.0%) 15.0%

2017 (17%  0.50 = 8.5%) + (15%  0.50 = 7.5%) 16.0%
2018 (18%  0.50 = 9.0%) + (16%  0.50 = 8.0%) 17.0%
2019 (19%  0.50 = 9.5%) + (17%  0.50 = 8.5%) 18.0%

15.0% + 16.0% + 17.0% + 18.0%

rp = = 16.5%
4
n
(ri − r )2
b. Standard deviation:  rp = 
i =1 ( n − 1)

(1)
[(16.0% − 17.5%)2 + (17.0% − 17.5%)2 + (18.0% − 17.5%)2 + (19.0% − 17.5%)2 ]
F =
4 −1
[(−1.5%)2 + (−0.5%)2 + (0.5%)2 + (1.5%)2 ]
F =
3
(0.000225 + 0.000025 + 0.000025 + 0.000225)
F =
3
0.0005
F = = .000167 = 0.01291 = 1.291%
3
 (2)
[(16.5% − 16.5%)2 + (16.5% − 16.5%)2 + (16.5% − 16.5%)2 + (16.5% − 16.5%)2 ]
 FG =
4 −1
[(0)2 + (0)2 + (0)2 + (0)2 ]
 FG =
3
 FG = 0
(3)
[(15.0% − 16.5%)2 + (16.0% − 16.5%)2 + (17.0% − 16.5%)2 + (18.0% − 16.5%)2 ]
 FH =
4 −1
[(−1.5%)2 + (−0.5%)2 + (0.5%)2 + (1.5%)2 ]
 FH =
3
[(0.000225 + 0.000025 + 0.000025 + 0.000225)]
 FH =
3
0.0005
 FH = = 0.000167 = 0.012910 = 1.291%
3
c. Coefficient of variation: CV =  r  r
1.291%
CVF = = 0.0738
17.5%
0
CVFG = =0
16.5%
1.291%
CVFH = = 0.0782
16.5%
d. Summary:

rp: Expected Value

of Portfolio rp CVp
Alternative 1 (F) 17.5% 1.291% 0.0738
Alternative 2 (FG) 16.5% 0 0.0
Alternative 3 (FH) 16.5% 1.291% 0.0782

Because the assets have different expected returns, the coefficient of variation should be used to
determine the best portfolio. Alternative 3, with positively correlated assets, has the highest
coefficient of variation and therefore is the riskiest. Alternative 2 is the best choice; it is perfectly
negatively correlated and therefore has the lowest coefficient of variation.

P8-15. Correlation, risk, and return

LG 4; Intermediate
a. (1) Range of expected return: between 8% and 13%
(2) Range of the risk: between 5% and 10%
b. (1) Range of expected return: between 8% and 13%
(2) Range of the risk: 0  risk  10%
c. (1) Range of expected return: between 8% and 13%
(2) Range of the risk: 0  risk  10%
P8-16. Personal finance: International investment returns
LG 1, 4; Intermediate
24,750 − 20,500 4,250
a. Returnpesos = = = 0.20732 = 20.73%
20,500 20,500
Price in pesos 20.50
b. Purchase price= = = $2.22584  1,000 shares = $2,225.84
Pesos per dollar 9.21
Price in pesos 24.75
Sales price= = = $2.51269 1,000 shares = $2,512.69
Pesos per dollar 9.85
2,512.69 − 2,225.84 286.85
c. Returnus$ = = = 0.12887 = 12.89%
2,225.84 2,225.84
d. The two returns differ due to the change in the exchange rate between the peso and the dollar. The
peso had depreciation (and thus the dollar appreciated) between the purchase date and the sale date,
causing a decrease in total return. The answer in part c is the more important of the two returns for
Joe. An investor in foreign securities will carry exchange-rate risk.

P8-17. Total, nondiversifiable, and diversifiable risk

LG 5; Intermediate
a. and b.

c. Only nondiversifiable risk is relevant because, as shown by the graph, diversifiable risk can be
virtually eliminated through holding a portfolio of at least 20 securities that are not positively correlated.
David Talbot’s portfolio, assuming diversifiable risk could no longer be reduced by additions to the
portfolio, has 6.47% relevant risk.
P8-18. Graphic derivation of beta
LG 5; Intermediate
a.

Rise Y
b. To estimate beta, the “rise over run” method can be used: Beta = =
Run X
Taking the points shown on the graph:
Y 0 − (−3) −3
Beta A = = = = 0.75
X −8 − (−4) −4
Y 26 − 22 4
Beta B = = = = 1.33
X 13 − 10 3
A financial calculator with statistical functions can be used to perform linear regression analysis. The
beta (slope) of line A is 0.79; of line B, 1.379.
c. With a higher beta of 1.33, Asset B is more risky. Its return will move 1.33 times for each one point
the market moves. Asset A’s return will move at a lower rate, as indicated by its beta coefficient of
0.75.
P8-19. Graphical derivation and interpretation of beta
LG 5; Intermediate
a. With a return range from −0% to + 30%, Biotech Cures, exhibited in Panel B, is the more risky stock.
Returns are widely dispersed in this return range regardless of market conditions. By comparison, the
returns of Panel A’s Cyclical Industries Incorporated only range from about −20% to + 40%. There is
less dispersion of returns within this return range.
b. The returns on Cyclical Industries Incorporated’s stock are more closely correlated with the market’s
performance. Hence, most of Cyclical Industries’ returns fit around the upward-sloping least-squares
regression line. By comparison, Biotech Cures has earned returns approaching 60% during a period
when the overall market experienced a loss. Even if the market is up, Biotech Cures has lost almost
half of its value in some years. So, Cyclical Industries Inc. has a lower beta than Biotech Cures.
c. On a standalone basis, Biotech Cures Corporation is riskier. However, if an investor was seeking to
diversify the risk of their current portfolio, the unique, nonsystematic performance of Biotech Cures
Corporation makes it a good addition. Other considerations would be the mean return for both (here
Cyclical Industries has a higher return when the overall market return is zero), expectations regarding
the overall market performance, and level to which one can use historic returns to accurately forecast
stock price behavior.

P8-20. Interpreting beta

LG 5; Basic
 Effect of change in market return on asset with beta of 0.8:
a. 0.8 (42%) = 33.6% increase
b. 0.8 (−%) = 25.6% decrease
c. 0.8 (0%) = no change
d. The asset is less risky than the market portfolio, which has a beta of 1. The higher beta makes the
return move more than the market.

P8-21. Betas
LG 5; Basic
a. and b.
Decrease in Expected Impact Increase in Impact on
Asset Beta Market Return on Asset Return Market Return Asset Return
W 0.90 −0.10 –0.09 0.10 0.09
X –0.60 −0.10 0.06 0.10 –0.06
Y 1.80 −0.10 −0.18 0.10 0.18
Z 2.30 −0.10 –0.23 0.10 0.23
c. Asset X would be the appropriate choice because it is a defensive asset, moving in opposition to the
market. In an economic downturn, Asset X’s return is increasing.
d. Asset Z should be chosen because it will have the highest increase in return.

P8-22. Personal finance: Betas and risk rankings

LG 5; Intermediate
a.
Stock Beta
Most risky B 1.40
A 0.80
Least risky C −0.30

b. and c.

Increase in Expected Impact Decrease in Impact on

Asset Beta Market Return on Asset Return Market Return Asset Return
A 0.80 0.12 0.096 −0.05 −0.040
B 1.40 0.12 0.168 −0.05 −0.070
C −0.30 0.12 −0.036 −0.05 0.015

d. In a declining market, an investor would choose the defensive stock, Stock C. While the market
declines, the return on C increases.
e. In a rising market, an investor would choose Stock B, the aggressive stock. As the market rises one
point, Stock B rises 1.40 points.
n
P8-23. Personal finance: Portfolio betas: bp = w
j =1
j  bj

LG 5; Intermediate
 a.
Portfolio X Portfolio Y
Asset Beta WX WX  bX WY W Y  bY
1 2.5 0.20 0.50 0.10 0.25
2 0.8 0.10 0.08 0.30 0.24
3 1.2 0.30 0.36 0.10 0.12
4 0.9 0.10 0.09 0.30 0.27
5 1.6 0.30 0.48 0.20 0.32
bX= 1.51 bY= 1.20

b. Portfolios X and Y are both more risky than the market (average risk). Comparatively speaking,
Portfolio Y is slightly less risky than Portfolio X. Portfolio X’s return will move more than Portfolio
Y’s for a given increase or decrease in market return. Thus, Portfolio X is the more risky.

P8-24. Capital asset pricing model (CAPM): rj = RF + [bj  (rm − RF)]

LG 6; Basic
States rj = RF+ [bj  (rm−RF)]
A 44.4% = 6% + [2.40  (22% −6%)]
B 0.5% = 3% + [–0.50  (8% −3%)]
C 14.5% = 10% + [0.90  (15% −10%)]
D 18.0% = 12% + [1.00  (18% − 12%)]
E 8.5% = 5% + [0.70  (10% −5%)]

P8-25. Personal finance: Beta coefficients and the capital asset pricing model
LG 5, 6; Intermediate
To solve this problem you must take the CAPM and solve for beta. The resulting model is:
r − RF
Beta =
rm − RF
13% − 3% 10%
a. Beta = = = 1.1111
12% − 3% 9%
25% − 3% 22%
b. Beta = = = 2.4444
12% − 3% 9%
16% − 3% 13%
c. Beta = = = 1.4444
12% − 3% 9%
18% − 3% 15%
d. Beta = = = 1.6666
12% − 3% 9%
e. If you are willing to take a maximum of average risk then you will be able to have an expected return
of only 12%. (r= 3% + 1.0(12% − 3%) = %.)

P8-26. Manipulating CAPM: rj = RF + [bj  (rm − RF)]

LG 6; Intermediate
a. rj = 5% + [2.2  (32% − 5%)]
rj = 64.4%
 b. 23.75% = RF + [1.25  (20% −RF)]
RF = 5%
c. 18% = 8% + [1.2  (rm− 8%)]
rm = 16.33%
d. 15% = 3% + [bj  (15% − 3%)
bj = 1

P8-27. Personal finance: Portfolio return and beta

LG 1, 3, 5, 6: Challenge
a. bp = (0.20)(0.80) + (0.35)(0.95) + (0.30)(1.50) + (0.15)(1.25)
= 0.16 + 0.3325 + 0.45 + 0.1875 = 1.13
($20,000 − $20,000) + $1,600 $1,600
b. rA = = = 8%
$20,000 $20,000
($36,000 − $35,000) + $1,400 $2,400
rB = = = 6.86%
$35,000 $35,000
($34,500 − $30,000) + 0 $4,500
rC = = = 15%
$30,000 $30,000
($16,500 − $15,000) + $375 $1,875
rD = = = 12.5%
$15,000 $15,000
($107,000 − $100,000) + $3,375 $10,375
c. rP = = = 10.375%
$100,000 $100,000
d. rA = 4% + [0.80  (10% − 4%)] = 8.8%
rB = 4% + [0.95  (10% − 4%)] = 9.7%
rC = 4% + [1.50  (10% − 4%)] = 13.0%
rD = 4% + [1.25  (10% − 4%)] = 11.5%
e. Of the four investments, only C (15% vs. 13%) and D (12.5% vs. 11.5%) had actual returns that
exceeded the CAPM expected return (15% vs. 13%). The underperformance could be due to any
unsystematic factor that would have caused the firm not to do as well as expected. Another possibility
is that the firm’s characteristics may have changed such that the beta at the time of the purchase
overstated the true value of beta that existed during that year. A third explanation is that beta, as a
single measure, may not capture all of the systematic factors that cause the expected return. In other
words, there is error in the beta estimate.
P8-28. Security market line, SML
LG 6; Intermediate
a, b, and d.

c. rj = RF + [bj  (rm − RF)]

Asset A
rj = 0.09 + [0.80  (0.13 − 0.09)]
rj = 0.122
Asset B
rj = 0.09 + [1.30  (0.13 − 0.09)]
rj = 0.142
d. Asset A has a smaller required return than Asset B because it is less risky, based on the beta of 0.80
for Asset A versus 1.30 for Asset B. The market risk premium for Asset A is 3.2% (12.2% − 9%),
which is lower than Asset B’s market risk premium (14.2% − 9% = 5.2%).

P8-29. Shifts in the security market line

LG 6; Challenge
a, b, c, d.

b. rj = RF + [bj  (rm − RF)]

rA = 8% + [1.1  (12% − 8%)]
rA = 8% + 4.4%
 rA = 12.4%
c. rA = 6% + [1.1  (10% − 6%)]
rA = 6% + 4.4%
rA = 10.4%
d. rA = 8% + [1.1  (13% − 8%)]
rA = 8% + 5.5%
rA = 13.5%
e. (1) A decrease in inflationary expectations reduces the required return as shown in the parallel
downward shift of the SML.
(2) Increased risk aversion results in a steeper slope because a higher return would be required for
each level of risk as measured by beta.

P8-30. Integrative—risk, return, and CAPM

LG 6; Challenge
a.
Project rj = RF + [bj  (rm − RF)]
A rj = 9% + [1.5  (14% − 9%)] = 16.50%
B rj = 9% + [0.75  (14% − 9%)] = 12.75%
C rj = 9% + [2.0  (14% − 9%)] = 19.00%
D rj = 9% + [0  (14% − 9%)] = 9.00%
E rj = 9% + [(−0.5)  (14% − 9%)] = 6.50%

b. and d.

c. Project A is 150% as responsive as the market.

Project B is 75% as responsive as the market.
Project C is twice as responsive as the market.
Project D is unaffected by market movement.
Project E is only half as responsive as the market but moves in the opposite direction as the market.
d. See graph for new SML.
rA = 9% + [1.5  (12% − 9%)] = 13.50%
 rB = 9% + [0.75  (12% − 9%)] = 11.25%
rC = 9% + [2.0  (12% − 9%)] = 15.00%
rD = 9% + [0  (12% − 9%)] = 9.00%
rE = 9% + [−0.5  (12% − 9%)] = 7.50%
e. The steeper slope of SMLb indicates a higher risk premium than SMLd for these market conditions.
When investor risk aversion declines, investors require lower returns for any given risk level (beta).

P8-31. Ethics problem

LG 1; Intermediate
Investors expect managers to take risks with their money, so it is clearly not unethical for managers to
make risky investments with other people’s money. However, managers have a duty to communicate
truthfully with investors about the risk that they are taking. Portfolio managers should not take risks that
they do not expect to generate returns sufficient to compensate investors for the return variability