CITY UNIVERSITY OF HONG KONG
DEPARTMENT OF ACCOUNTANCY
Risk and Rates of Return – Suggested Solutions
Question 1
In a single-asset portfolio, Security A would be more risky because σA > σB and
CVA > CVB. Security A is less risky if held in a diversified portfolio because of its negative
correlation with other stocks. We will expect rational investors will held a diversified portfolio and
so Security A, which has a smaller beta should be less risky.
Question 2
a. ri = rRF + (rM - rRF)bi = 9% + (14% - 9%)1.3 = 15.5%.
b. 1. rRF increases to 10%:
rM increases by 1 percentage point, from 14% to 15%.
ri = rRF + (rM - rRF)bi = 10% + (15% - 10%)1.3 = 16.5%.
2. rRF decreases to 8%:
rM decreases by 1%, from 14% to 13%.
ri = rRF + (rM - rRF)bi = 8% + (13% - 8%)1.3 = 14.5%.
c. 1. rM increases to 16%:
ri = rRF + (rM - rRF)bi = 9% + (16% - 9%)1.3 = 18.1%.
2. rM decreases to 13%:
ri = rRF + (rM - rRF)bi = 9% + (13% - 9%)1.3 = 14.2%.
Question 3
a. rM = 0.1(7%) + 0.2(9%) + 0.4(11%) + 0.2(13%) + 0.1(15%) = 11%.
rRF = 6%. (given)
Therefore, the SML equation is
ri = rRF + (rM - rRF)bi = 6% + (11% - 6%)bi = 6% + (5%)bi.
b. First, determine the fund’s beta, bF. The weights are the percentage of funds invested in each
stock.
A = $160/$500 = 0.32
B = $120/$500 = 0.24
C = $80/$500 = 0.16
D = $80/$500 = 0.16
E = $60/$500 = 0.12
1
bF = 0.32(0.5) + 0.24(2.0) + 0.16(4.0) + 0.16(1.0) + 0.12(3.0)
= 0.16 + 0.48 + 0.64 + 0.16 + 0.36 = 1.8.
Next, use bF = 1.8 in the SML determined in Part a:
rF= 6% + (11% - 6%)1.8 = 6% + 9% = 15%.
c. rN = Required rate of return on new stock = 6% + (5%)2.0 = 16%.
An expected return of 15 percent on the new stock is below the 16 percent required rate of
return on an investment with a risk of b = 2.0. Since rN = 16% > r̂ N = 15%, the new stock
should not be purchased. The expected rate of return that would make the fund indifferent to
purchasing the stock is 16 percent.
Question 4
The answers to a, b, c, and d are given below:
rA rB Portfolio
2004 (18.00%) (14.50%) (16.25%)
2005 33.00 21.80 27.40
2006 15.00 30.50 22.75
2007 (0.50) (7.60) (4.05)
2008 27.00 26.30 26.65
Mean 11.30 11.30 11.30
Std. Dev. 20.79 20.78 20.13
Coef. Var. 1.84 1.84 1.78
e. A risk-averse investor would choose the portfolio over either Stock A or Stock B alone, since
the portfolio offers the same expected return but with less risk. This result occurs because
returns on A and B are not perfectly positively correlated (rAB = 0.88).
Question 5
a. The portfolio expected return, rp, equals a weighted average of the individual stock's expected
returns.
rp = (0.20)(16%) + (0.30)(14%) + (0.15)(20%) + (0.25)(12%) +
(0.10)(24%) = 15.8%
b. The portfolio beta, bp, equals a weighted average of the individual stock betas
bp = (0.20)(1.00) + (0.30)(0.85) + (0.15)(1.20) + (0.25)(0.60) +
(0.10)(1.60) = 0.945
c. Security market line equation is:
ri = rRF + (rM - rRF)bi = 7% + (15.5% - 7%)bi = 7% + (8.5%)bi.
2
d. (1) As the expected rate of inflation increases, a premium must be added to the real risk-free
rate of return to compensate investors for the loss of purchasing power that results from
inflation. However, a change in the risk-free rate also causes a change in the required market
return, resulting in a relatively stable market risk premium. In conclusion, inflation causes the
SML to go upward with the same slope.
(2) As risk aversion increases, the risk premium increases. So investors will demand a higher
market risk premium while the risk free rate remains the same as change of risk aversion will
not affect the risk-free rate. This causes the slope of the SML to become steeper.
e.
Stock Beta ri = 7% + (8.5%)bi. Expected return (given)
1 1.00 15.5% 16%
2 0.85 14.2% 14%
3 1.20 17.2% 20%
4 0.60 12.1% 12%
5 1.60 20.6% 24%
A "winner" may be defined as a stock that falls above the security market line, which means
these stocks are expected to earn a return exceeding what should be expected given their beta
or systematic risk. These stocks include 1, 3, and 5. "Losers" would be those stocks falling
below the security market line, which are represented by stocks 2 and 4 ever so slightly.