Risk and Return

What is return
Income
Income received
received on on anan investment
investment plusplus any
any
change
changeininmarket
marketprice,
price usually
price
price, usuallyexpressed
expressedas asaa
percent
percentofofthe
theinvestment.
investment.
The
The stock
stock price
price for
for Stock
Stock AA was
was Tk.
Tk.10.00
10.00 per
per
share
share 11 year
year ago.
ago. The
The stock
stock isis currently
currently
trading
trading at at Tk.
Tk. 11.50
11.50 perper share
share and
and
shareholders
shareholders just just received
received aa Tk. Tk. 1.00
1.00
dividend.
dividend What
dividend
dividend. What return
return was
was earned
earned over
over the
the
past
pastyear?
year?
 Return
Return in terms of amount
= Investment proceed – Investment
= (11.50 – 10.00) + 1.00 = 2.50 Tk.

Return in terms of percentage

= (Investment Proceed – Investment) / Investment
(11.50 – 10.00) + 1.00
= x 100 = 25%
10.00
 What is Risk
The variability or the probability of variation
or fluctuation of returns from those that
are expected.

This is possibility of not getting the expected

returns.
 Two Perspectives
We will see risk and return from two perspectives:
 Risk and Return on a stand-alone basis:
 Risk and return on a portfolio context:

Stand-alone Investment: Putting all the investable

funds in one single stock or project.
Portfolio Investment: Dividing the entire funds in
more than one stocks or projects
 Return on a stand-alone basis
• Stand-alone return/ Expected rate of
return/Expected return:
This is the rate of return than an investor
expects by taking investment decision.
This is calculated return based on
historical data or
a probability distribution
• 1 10%
• 2 15%
• 3 8%
Expected return is the
average of the returns of all
the previous years.

• 10
 Probability Distribution
Three things are mentioned in a probability
distribution
 Future uncertain events that may affect the
outcome of an option which are usually
beyond the control of the decision maker.
 Probability of occurrence of the future
uncertain events.
 Outcome or result if a future uncertain event
occurs.
 Example
Demand for Probability of Rate of return on stocks if this
the company’s this demand demand occurs
product occurring
Martin US Electrics
Products

Strong 30% 100% 20%

Normal 40% 15 15

Weak 30% (70) 10

In which company will you invest your money?

 Calculation of Expected rate of return
using a given probability distribution
Expected rate of return, K ˄
K ˄ = ∑ (Ki × Pi )
= (K1 × P1 )+ (K2 × P2 )+ (K3 × P3 )+ (K4 × P4 )+
………… + ( Kn × Pn )
Where,
Ki = Rate of return if i th event occurs.
Pi = Probability of occurrence of i th event.
 Demand for Probability of Rate of return on stocks if this
the company’s this demand demand occurs
product occurring Martin US Electrics
Products

Strong 30% 100% 20%

Normal 40% 15 15
Weak 30% (70) 10
Expected return for Martin Products = 15%

Expected return for US Electric = 15%

 Stand-alone Risk

Year Stock A Stock B

1 120 23
2 - 90 27
3 100 32
4 - 85 36
5 110 38
6 - 95 40
7 90 43
 Stand-alone Risk
More variability in returns of Stock A, Whereas
Stock B’s return increases positively over the
years.
More variability/fluctuation of returns indicates
more risk associated with the stock and vice
versa.
This variation is measured by a statistical tool
named standard deviation.
 Stand-alone Risk
Risk on a stand-alone basis or the riskiness of an
individual stock is measured by the standard
deviation of the returns.
Standard deviation,
 =  ( Ki - K ) × ( Pi )
˄ 2

Standard Deviation,
Deviation , is a statistical measure of
the variability of a distribution around its mean.
 Demand for the Probability of Rate of return on stocks if this
company’s this demand demand occurs
product occurring Martin Products US Electrics

Strong 30% 100% 20%

Normal 40% 15 15
Weak 30% (70) 10

Martin Products = √ (100 – 15)2 *.3 + (15 – 15)2 *.4 + (-70 – 15)2
*.3 = 65.84%

For US Electric =
√ (20 – 15)2 *.3 + (15 – 15)2 *.4 + (10 – 15)2 *.3 = 3.87%
 Taking Investment Decision
Expected rate of return: the higher the better
Risk / Standard deviation: the lower the better

But we have to consider both expected return

and standard deviation at the same time to
take investment decision
 Example 1
Stock Expected Standard
return deviation
Stock A 25% 36%
Stock B 28% 32%
Stock C 35% 28%

Straightforward choice is Stock C that

gives highest return at the lowest risk
 Example 2

Stock Expected return Standard deviation

Stock A 25% 36% 1.44

Stock B 28% 48% 1.71
Stock C 35% 65% 1.85

There is no straight forward choice. We have go for another tool.

Coefficient of Variation (CV) = Standard deviation / Expected return

CV of Stock A = 1.44 / 1.00

If we want to earn a return of 1 unit from stock A, we have
to take a risk of 1.44 unit.
 Coefficient of Variation (CV)
The ratio of the standard deviation of a
distribution to the expected rate of return of
that distribution.
CV = Standard deviation / Expected return
CV for stock A = 1.44
It is a measure of risk per unit of return.
So, an investment project with lower CV value is
more attractive option
 Risk and return on a portfolio context
Portfolio return:
Stocks Expected return Investment in
Taka
Square Pharma 16.5% 500,000
Dutch Bangla Bank 22.00 800,000
Summit Power 18.00 700,000
Apex Tannery 23.25 10,00,000
Grammen Phone 15.75 15,00,000
Beximco Textile 20.00 20,00,000
 Portfolio Return
Portfolio return = ∑ (˄Ki × Wi )
Where,
˄
Ki = Expected rate of return of stock i in the portfolio
Wi = Weight of stock i in the portfolio

Weight of a stock in the portfolio is the percentage of total

portfolio investment invested in that particular stock
Weight of a stock in the portfolio
= Investment in the stock / Total Portfolio value
 Portfolio Return
Stocks Expected Investment Weight
return
Square 16.5% 500,000 .0769
DBBL 22 800,000 .1231
Summit 18 700,000 .1077
Apex 23.25 10,00,000 .1538
GP 15.75 15,00,000 .2308
Beximco 20 20,00,000 .3077

Portfolio Return
= (16.6 * .0769) + (22 * .1231) +(18 * .1077) + (23.25
* .1538) + (15.75 * .2308) + (20 * .3077) = 19.27%
 Portfolio Return
As the expected return of an individual stock in
the portfolio is multiplied by the respective
weight of the stock in the portfolio, portfolio
return is the weighted average of individual
stocks’ return in the portfolio.
 Portfolio Risk
Portfolio risk is not the weighted average of
individual stocks’ risk.
It is the variation in portfolio return.
So, portfolio return has to be calculated first.
Then, the standard deviation of those portfolio
returns will give measurement of portfolio
risk.
 Year Expected rate of return
Stock A Stock B Stock C
1 40% 28% 32%
2 (10) 20 8
3 35 41 39
4 (5) (17) (14)
5 15 3 12
6 20 8 23

The above three stocks will constitute a portfolio where the

weight of the stocks will be [Link] respectively.
Portfolio return for year 1= (40*.5)+(28*.3)+(32*.2)= 34.80%
∑ (˄Ki × Wi )
Year Expected rate of return Portfolio Return
Stock A Stock B Stock C
1 40% 28% 32% 34.80
2 (10) 20 8 2.60
3 35 41 39 37.60
4 (5) (17) (14) - 10.40
5 15 3 12 10.80
6 20 8 23 17.00
Standard deviation of these portfolio returns in different years will be the measure of portfolio risk
Standard deviation = √{∑( X - X− )2 /(n-1)}
X− = Average= 15.4%
SD= √(34.80-15.4)2 + (2.6-15.4)2 + (37.60-15.4)2 + (-10.4-15.4)2 + (10.80-15.4)2 + (17-15.4)2
Year Expected rate of return Portfolio Return
Stock A Stock B Stock C
1 40% 28% 32% 34.80%
2 (10) 20 8 2.60
3 35 41 39 37.60
4 (5) (17) (14) - 10.40
5 15 3 12 10.80
6 20 8 23 17.00

Standard Deviation = 18.56%

This is the riskiness of the portfolio which is expressed as the standard
deviation of portfolio returns in different years.
Can we form a risk-free portfolio?
Stocks Expected return Standard Deviation
Stock A 25% 95%
Stock B 15% 83%

Here both the

stocks are The concept of
extremely risky. correlation
Can a portfolio be coefficient will
formed where come into action
there will be no here
risk?
• Share price index: It indicates the average movement in the share price of all
the stocks traded in the market on that particular day.
• There are 550 listed companies in DSE.
• There was trading of 400 companies and the share price index has increased
by 11.11%.
• The market value of all the traded 400 shares has increase by an average of
11.11%.
• Share price index increased by 11.11% and the mkt value of your company
increased by 15% and vice versa.
• The correlation between share price index and market value of the company
is positive.
• Share price index increased by 11.11% and the mkt value of your company
decreased by 15% and vice versa.
• The correlation between share price index and market value of the company
is negative.
 Correlation Coefficient

A standardized statistical measure of the linear relationship between two

variables.
Its range is from –1.0 (perfect negative correlation), through 0 (no correlation), to
+1.0 (perfect positive correlation).
rAB = +ve, the variables are positively correlated.
rAB = - ve, the variables are negatively correlated.
rAB = + 1.00, the variables are perfectly positively correlated.
rAB = - 1.00, the variables are perfectly negatively correlated.

Return of A = 20% and Return of B = 30% and rAB = - 1.00

After one year return of stock B is 40%, what will be the return of stock A?
 Can we form a risk-free portfolio?
Stocks Expected return SD
Stock A 25% 95%
Stock B 15% 83%

Two assumptions:
The stocks in the portfolio are perfectly negatively correlated. rAB= -1.00
The weight of the stocks in the portfolio will be same.

Year Stock A Stock B Portfolio return SD

1 25 15 (25*.5)+(15*.5)=20
2 60 -20 20
3 10 30 20 0.00
4 - 60 100 20
5 50 -10 20
 Correlation coefficient and
portfolio risk
• If two stocks with perfect positive correlation
are combined in a portfolio, there will be no
change in portfolio risk, i.e. the portfolio will
be as risky as a stock held on a stand-alone
basis.
• But if two stocks with perfect negative
correlation is held together in a portfolio,
portfolio risk will be zero.
 Diversification and the
Correlation Coefficient
Combination
SECURITY E SECURITY F E and F
INVESTMENT RETURN

TIME TIME TIME

Combining securities that are not perfectly,

positively correlated reduces risk.
 Portfolio
Portfolio risk
risk curve
curve and
and types
types of
of risk
risk

Total risk of the portfolio =

portfolio risk

Diversifiable risk/ Unsystematic risk

+ Market risk / Systematic risk

10% Portfolio Risk Curve

8%
6%

50 number of stocks in the portfolio

80
 Systematic and Unsystematic risk
• The portion of the total riskiness of the portfolio
which can be eliminated by diversification or by
adding new stocks in the portfolio is called
diversifiable risk or unsystematic risk.
• The portion of the total riskiness of the portfolio
which can not be eliminated by diversification or by
adding new stocks in the portfolio is called market
risk or systematic risk.
• The source of unsystematic risk is company specific
factors by which other companies may not be
affected, on the other hand, economy-wide or world-
wide factors by which all companies are affected in
the same way are the sources of systematic risk.
 Systematic Risk
Factors such as any kind of changes in
STD DEV OF PORTFOLIO RETURN

nation’s economy, tax reform by the Govt.,

or a change in the world situation like
corona pandemic worldwide can cause
systematic risk.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Unsystematic Risk

Factors unique to a particular company

STD DEV OF PORTFOLIO RETURN

or industry. For example, the death of a

key executive or loss of a governmental
defense contract can cause unsystematic risk.

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 What is Beta?

An index of systematic risk.

risk This is the tool to measure
systematic risk of a stock.
The tendency of one stock to move up and down with
the movement of the entire market either in the same
direction or in the opposite direction is reflected in the
beta coefficient value of the stock.
It measures the sensitivity of a stock’s returns to changes
in returns on the market portfolio.
If a portfolio contains all the stocks outstanding in the
market, that portfolio is called market portfolio.
 Characteristic Lines and
Different Betas
RETURN Beta > 1
ON STOCK (aggressive)
Beta = 1
Each characteristic
line has a Beta < 1
different slope. (defensive)

RETURN ON MARKET
PORTFOLIO
 Calculating Bata for Individual
Stock
Year Return on Return on Return on Rate of return on
Stock A Stock B Stock C market portfolio/
Market return

2016 10% 10% 10% 10%

2017 30% 20% 15% 20%

2018 (30%) (10%) 0 (10%)

 Stock’s return
Slope= Rise/Run (20,30)
= Change in Y-axis value / Change in x-
axis value Line of Stock A
(20, 20)
Line of Stock B
Slope= (Y1 – Y2) / (X1 – X2) (20, 15)
Line of Stock C

(-10, 0) Market return

The slope value of the line drawn for

stock A will give the value of beta
(-10, -10) coefficient of stock A
Slope of the line for stock C = 0.5
Beta coefficient for stock C = 0.5 Slope of the line for stock A = 2.00
Beta coefficient for stock A = 2,00

Slope of the line for stock B = 1.00

(-10, -30) Beta coefficient for stock B = 1.00
Slope = (Y1 – Y2) / (X1 – X2)
= Stock’s return/ Market return

Beta coefficient of stock A = + 2.00 /1.00

If market return increases by 1%, the return of

stock A will increase by 2% and again if market
return decreases by 1%, the return of stock A
will decrease by 2%.

Beta coefficient of stock D = - 2.5

If market return increases by 1%, the return of

stock D will decrease by 2.5% and again if
market return decreases by 1%, the return of
stock D will increase by 2.5%.
 Portfolio Beta coefficient
• Portfolio beta is the weighted average of
individual stocks’ beta held in the portfolio.

Portfolio Beta = ∑ (Bi × Wi )

Where,
Bi = Beta coefficient of stock i in the portfolio
Wi = Weight of stock i in the portfolio
 Portfolio Beta
Stock Investment Beta coefficient Weight
A 160 million 0.50 .31
B 120 million 2.00 .23
C 100 million 4.00 .19
D 80 million 1.50 .15
E 60 million 3.25 .12

Portfolio Beta = (0.50 *.31) + (2.00 *.23) + (4.00

*.19) + (1.50 *.15) + (3.25 *.12) = 1.99
Relationship between risk and rate
of return
• Normally the relationship between risk and
return is positive.
• We will use Capital Asset Pricing Model
(CAPM) to illustrate the relationship.
Capital Asset Pricing Model (CAPM)
• CAPM describes the relationship between required rate of
return and systematic risk of investing in a security. CAPM
mainly quantifies the relationship between required rate of
return and systematic risk.

• It was developed by William F. Sharpe, who was an American

Economist and he was awarded Nobel prize in Economics in
the year 1990 for advocating CAPM.
 CAPM - Assumptions

The model will assume the following things:

1. K^I = Expected rate of return on stock i
This is the calculated return based on historical data or a probability
distribution. With the same probability distribution, all investors in
the market are expected to come out with the same expected
return. This is the probable return that an investor can get.

2. Ki = Required rate of return on stock i

This is the rate of return required by the investors to invest his or
her money. This depends on risk perception of the investors. So this
will vary from investor to investor.

If expected return of a stock is higher than required return, the stock must be
purchased.
 CAPM - Assumptions
3. KRF = Risk free rate of return
This is the rate of return on investment where there is no risk.
This is the rate of return on short term Government bond
which is considered to be risk free.

4. KM = Market return or expected rate of return on a

market portfolio /Average rate of return on a market
portfolio.
5. Bi = Beta coefficient of stock i
Now we will discuss the model in three stages.
 CAPM – 1 stage
st

• In the 1st stage, the investor will not take any

risk. So the only investment option available
to the investor is the short term Government
bond where no risk is perceived.
• As the investor does not take any risk, the
required rate of return will be exactly equal to
the risk free rate of return.
• So, Ki = KRF
 CAPM – 2nd stage
• In this stage, the investor will take some risk
and will decide to invest in market portfolio.
• As the investor takes some risk, he will require
a return which must be higher than KRF. So,
the required rate of return, Ki must be higher
than KRF. This additional return expectation is
the compensation for taking risk. This
compensation is termed as risk premium.
• So, the required return for the investor will be
Ki = KRF+ Risk premium
 CAPM – 2nd stage Contd….
• In the assumption, we have declared KM as the
rate of return for investing in market portfolio.
So, required rate of return in this stage, Ki can
be replaced by KM .
• We can now write
KM = KRF + Risk premium
Risk Premium = (KM – KRF )
 CAPM – 2nd stage Contd….
• This risk premium depends on the degree of risk that the
investor is taking. As beta coefficient is the measure of risk,
we can say risk premium depends on the beta coefficient of
the investment.
• So the risk adjusted premium has to be calculated by
multiplying the risk premium with the corresponding beta
coefficient value.

• So, risk premium will be

Risk Premium = (KM – KRF) × Beta coefficient
 CAPM –3 rd stage
• Now the investor will invest in a single stock on a stand-alone basis, say in
stock i.
• So, the required rate of return will be
Ki = KRF+ Risk premium
We will now put the risk premium value derived in stage 2.
Ki = KRF+ (KM – KRF) × Beta coefficient of stock i
Ki = KRF+ (KM – KRF) × Bi
Ki = 9.5% +( 12 – 9.5) *2.75 =
KRF = 9.5% and KM = 12%
16.38%
Beta of stock ABC = 2.75

Ki = Required rate of return (KM – KRF) = Market risk premium

KRF = Risk free rate of return
KM = Market return or expected return on market portfolio
Bi = Beta coefficient of the stock
CAPM quantifies risk-return relation by the above formula
 Security Market Line (SML)
• If the outcome equation of the CAPM is
graphically plotted with risk (Beta) in X-axis
and return (Required return) in Y-axis, we will
get a line which is called Security Market Line.
• SML graphically illustrates the relationship
between risk and return.
 Developing SML
The outcome equation of CAPM is often called
SML equation.
SML equation, Ki = KRF+ (KM – KRF) × Bi
It is assumed that KM and KRF remains constant
for short term period. Let us assume that KM
and KRF will remain constant at 11% and 6%
respectively.
Therefore, SML equation, Ki = 6%+ (11% – 6%) × Bi
Ki = 6% + 5% × Bi
 Developing SML
Now we will take different values of Bi and find the corresponding Ki value.
Ki = 6% + 5% × Bi

If Bi = 0; Ki = 6%
If Bi = 0.5; Ki = 8.5%
If Bi = 1.0; Ki = 11%
These values
If Bi = 1.5; Ki = 13.5% will now be
plotted in graph
If Bi = 2.0; Ki = 16% to get SML
If Bi = 2.5; Ki = 18.5%
If Bi = 3.0; Ki = 21%
Required rate of return (Ki)

Security Market Line (SML)

Beta/Risk
 Security Market Line

A
Required Return

B Risk
RM
Premium
Rf
Risk-free
Return
M = 1.0
Systematic Risk (Beta)
Does SML represents a single stock
or the whole market?
SML always represents the entire market or a
cluster of stocks in an industry
Because
A range of beta values are used to develop SML
and within the range, all stocks in a market
are usually included.
• As a line contains a number of points on the
line, SML for a market will have the same
number of points exactly equal to the number
of stocks outstanding in the market.
• Each point on the SML represents the risk-
return combination, i.e. the horizontal line
drawn from the point will tell the extent of
riskiness associated with the stock and the
vertical line drawn from the point will tell the
required rate of return from the stock.
 The Slope of SML
• The slope of SML represents the degree of risk
aversion (the tendency to avoid risk) or the
degree of risk preference (the tendency to
take risk) in the economy.
• Risk aversion will vary according to the shape
of the SML which is dictated by the slope of
the SML.
• Shape of the SML Degree of risk
aversion
 Slope of SML and risk aversion

The degree
of risk
aversion
will
1.00 decrease 1.00

Here the slope of SML is high and Here the slope of SML is low
hence the line is stiff and hence the line is flat
 Slope of SML and risk aversion
• When the slope is high, increase of return is
much higher than the increase in risk. So,
investors will be more interested to take risk
and hence the tendency of the investors to
avoid risk will decrease, i.e. investors will take
more risk.
• The higher slope of SML or a stiff-shaped SML
represents decreased degree of risk aversion
in the economy and vice versa.
Detecting overpriced and underpriced stock using SML

All stocks in the market place must lie on the

SML for long term period.
But for short term, some stocks may lie above
the SML or below the SML.
If such case happens, market forces (demand
and supply condition) will play their part and
stock will come back on the SML.
 Security Market Line
Stock A
20%
Required Return

50 stocks with beta

18% 2.00. They belong to
same risk class
15%

13%
Rf Stock B

2.00
Systematic Risk (Beta)
 CONTD…….

• If a stock stays above the SML, say Stock A,

here stock A gives higher return than all other
stocks in the same risk class. All the stocks
with same beta value are giving a return of
15% whereas, stock A, although having the
same beta, is giving a return of 20% .
• We know stock price and return are negatively
correlated, i.e. when stock price increases, the
return of the stock will decrease.
 CONTD…….

• As stock A gives higher return in comparison to all

other stocks in the same risk class and as stock price
and return are inversely related, we can say that the
price of the stock A is lower than all other stocks in
the same risk class.
• So stock A can be termed as underpriced or
undervalued in the market.
• All the investors will rush to purchase the
underpriced stock. So the demand of the stock will
increase and so will its price.
 CONTD…….

• With the increase in price of stock A, the rate

of return will start falling because of the
negative relationship between stock price and
rate of return.
• This process will continue until the stock
comes back on the SML.
 CONTD…….

• If a stock stays below the SML, say Stock B,

here stock B gives lower return than all other
stocks in the same risk class. All the stocks
with same beta value are giving a return of
18% whereas, stock B, although having the
same beta, is giving a return of 13% .
• We know stock price and return are negatively
correlated, i.e. when stock price increases, the
return of the stock will decrease.
 CONTD…….

• As stock B gives lower return in comparison to all

other stocks in the same risk class and as stock price
and return are inversely related, we can say that the
price of the stock B is higher than all other stocks in
the same risk class.
• So stock B can be termed as overpriced or
overvalued in the market.
• Investors will not purchase overpriced stock, rather if
they have such stock in their portfolio, they will sell
the stock as quick as possible. So its supply will
increase and with the increase in supply, the price
will decrease.
 CONTD…….

• With the decrease in price of stock B, the rate

of return will start to increase, because of the
negative relationship between stock price and
rate of return.
• This process will continue until the stock
comes back on the SML.
 Required Formula

Expected rate of return, K ˄ = ∑ (Ki × Pi )

Standard deviation, SD = √ ∑ ( Ki - K ˄ )2 × ( Pi )
CV = Standard deviation / Expected return
Standard deviation = √∑( X - X− )2 /(n-1)
Portfolio return = ∑ (˄Ki × Wi )
Slope/ Beta coefficient value = (Y1 – Y2) / X1 – X2)
Portfolio Beta = ∑ (Bi × Wi )
SML equation, Ki = KRF+ (KM – KRF) × Bi
 Problem: ST 2
a) Holding company’s Beta = ∑ (Bi × Wi )

= 0.85
b) Risk free rate, KRF = 6%
Market risk premium, (KM – KRF) = 5%
Required rate of return, Ki = KRF+ (KM – KRF) × Bi
= 6 +5*0.85 = 10.25%

c) New portfolio beta after adapting the strategic changes = 0.93

New required rate of return for the shareholders = 6 +5*0.93 = 10.65%
 Problem 5.1
• Expected rate of return, K ˄ = 11.4%
• Standard deviation SD = √ ∑ ( Ki - K ˄ )2 × ( Pi )
= √ {( -50 – 11.4)2 *0.1 + ( -5 – 11.4)2 *0.2 + ( 16 – 11.4)2
*0.4 + ( 25– 11.4)2 *0.2 + ( 60 – 11.4)2 *0.1 }

= 26.69%

CV = Standard deviation / Expected return

= 26.69 / 11.4 = 2.34

If we want to earn a return of 1% or I unit from this stock, we have to take a risk of 2.34% or
2.34 unit.
 Problem 5.9
• Value of each stock in the portfolio= 7500
• Total portfolio value = 7500*20 = 150,000
• Weight of each stock in the portfolio = 7500/150,000 = 0.05
• Portfolio beta given = 1.12
• Portfolio Beta = ∑ (Bi × Wi )
= (B1*W1) + (B2*W2) + (B3*W3)+ …….+(B20*W20)
1.12 = (1.00 * 0.05) + (B19 * 0.05 * 19)
1.12 = .05 + (B19 * .95)
(B19 * .95) = 1.12 - .05
B19 = 1.07 /.95 = 1.1263
where B19 is the beta of rest of the 19 stocks in the portfolio
New beta of the portfolio = ∑ (Bi × Wi )
= (1.75 * 0.05) + (1.1263 * 0.05 * 19)
= 1.1574
 Problem 5.11
• Value of each stock in the portfolio= 100,000
• Total portfolio value = 100,000*20 = 20,000,000
• Weight of each stock in the portfolio = 100,000/20,000,000 = 0.05
• Portfolio beta given = 1.1
• Portfolio Beta = ∑ (Bi × Wi )
= (B1*W1) + (B2*W2) + (B3*W3)+ …….+(B20*W20)
1.1 = (0.9 * 0.05) + (B19 * 0.05 * 19)
B19 = 1.1105
where B19 is the beta of rest of the 19 stocks in the portfolio
New beta of the portfolio = ∑ (Bi × Wi )
= (1.4 * 0.05) + (1.1105 * 0.05 * 19)
= 1.125
 Problem 14
a) Risk free rate of return, KRF = 6%
Expected Market Return, KM = ∑ (KM * Corresponding probability value)
= ( 7* 0.1) + ( 9* 0.2) + (11*0.4) + (13 * 0.2) + (15* 0.1) = 11%
SML equation, Ki = KRF+ (KM – KRF) × Bi
= 6% + (11% - 6%) × Bi
Ki = 6% + 5% × Bi
Estimated Equation for Security Market Line is Ki = 6% + 5% × Bi
b) Beta coefficient of the fund = ∑ (Bi × Wi )
= (0.5 * 160/500) + (2.0 * 120/500) + (4.0 * 80/500) + (1.0 * 80/500) + (3.0 *
60/500) = 1.80

Required rate of return for the next period = 6% + (11% - 6%) × B i

= 6% + 5% * 1.80 = 15%
 • Investment required in the new stock = 50 million
• Expected rate of return of the new stock = 15%
• Beta coefficient for the new stock = 2.0
Required rate of return for the new stock using the SML equation,
Ki = KRF+ (KM – KRF) × Bi = 6% + (11% - 6%) * 2.0 = 16%
As the required rate of return is higher
than the expected rate of return, the
SML new stock stays below the SML which
16% indicates that the new stock is
overvalued. As the new stock is
overvalued or overpriced, the new stock
should not be purchased.
2.0
The fund will be indifferent in purchasing the stock when expected rate of return
is exactly equal to the required rate of return of 16%. When these two returns are
equal, the stock will stay on the SML that indicates that the stock is perfectly
priced with its riskiness.
 Stock’s return
Problem: 5.16
a) (15, 20)

Slope= (Y1-Y2)/(X1-X2)

Market return

(-12, -16)

The value of slope drawn for stock X = 1.33

Beta coefficient of stock X = 1.33
 Stock’s return

(15, 11)

Market return

(-12, -5)

The value of slope drawn for stock Y = 0.59

Beta coefficient of stock Y = 0.59
 b)
b) Risk free rate of return KRF = 6%
Market risk premium, (KM – KRF) = 5%
Required rate of return for stock X = KRF + (KM – KRF) * Beta
= 6% + 5% * 1.33 = 12.65%
Required rate of return for stock Y = KRF + (KM – KRF) * Beta
= 6% + 5% * 0.59 = 8.95%

c) Weight of stock X and Stock Y are 80% and 20% respectively.

Portfolio Beta = ∑ (Bi × Wi ) = (1.33 * 0.8) + (0.59 * 0.2) = 1.182
Required rate of the return of the portfolio = KRF + (KM – KRF) * Beta
= 6% + 5% * 1.182 = 11.91%
d) Expected rate of return of stock X = 22%
Required rate of return of stock X = 12.65%
As the expected return of stock X is higher than the required return of
12.65%, the stock stays above the SML and hence it is undervalued.