Chapter 7

Risk and return

Solutions to questions
1.

It is suggested that investors behave as though they are risk-averse when an investment
involves a significant proportion of their wealth. However, investors may exhibit riskseeking behaviour where an investment involves only a small outlay, but offers a small
probability of a very large return. For a risk-averse investor, the standard deviation (or
variance) of the return distribution is a relevant measure of risk if returns are normally
distributed.

2.

Purchasing securities with rates of return that are less than perfectly positively correlated,
provides an investor with the benefit of risk reduction. The amount of risk reduction that
can be achieved by adding a new security to an existing portfolio increases as the
correlation between the expected returns on the new security and the expected returns on
the existing portfolio decreases.

3.

The combination of two assets whose returns are perfectly negatively correlatedthat is,
1,2 = 1.0can produce a portfolio with zero variance. However, in practice, it is
unlikely that two (or more) such securities can be found.

4.

This statement is not necessarily true. For example, assume that we have all of our
wealth invested in a very low-risk asset. We then sell off half of the initial portfolio and
invest these proceeds into a relatively high-risk asset. The total risk of the resultant
portfolio may well have increased, even where the returns of the constituent assets are
less than perfectly correlated. This highlights the point that we do not demonstrate the
benefits of diversification by comparing the risk of the diversified portfolio with the risk
of the portfolio prior to the addition of the new assets. Instead, a diversification benefit is
demonstrated by comparing the risk of the portfolio with the weighted average risk of the
individual assets. Provided that the returns of the new assets are less than perfectly
correlated with the returns of the initial portfolio, the risk of the portfolio will be less
than the weighted average risk of all assets in the portfolio.

5.

These terms are explained in the chapter.

6.

The total risk of a portfolio (or a security) is measured by the standard deviation (or
variance) of its returns. The total risk of a portfolio can be reduced by increasing the
number of securities in the portfolio.
The systematic risk of a security is measured by its beta value. This is the relevant
measure of a securitys risk for an investor who holds the security as part of an efficient

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portfolio. Systematic risk is that component of a securitys total risk that cannot be
diversified away, and it is totally dependent on market factors.
Unsystematic risk is the difference between a securitys total risk and its systematic risk,
and it is that part of total risk that is specific to the security. Unsystematic risk is
sometimes referred to as the securitys diversifiable risk, as it can be completely
removed by holding the security as part of an efficient portfolio.
7.

Discussion in the chapter indicates that a securitys unsystematic risk can be removed by
diversification. It is suggested, therefore, that the market will not compensate an investor
for unsystematic risk. As a result, the market price of securities will reflect only their
systematic risk. As it is assumed that managements objective is to maximise the market
value of the companys shares, then the impact of any financial decision on the
companys systematic risk is an important consideration for the financial decision-maker.
Managers should also ensure that proposed investments by a company offer expected
returns that are adequate, given the investments systematic risk.

8.

There are few, if any, shares with negative betas, because the returns on most businesses
are positively related to the state of the economy that is reflected in the returns on the
market portfoliothat is, when the economy is growing strongly, the profitability of
most companies will increase, and the prices of their shares will increase. Conversely,
during a recession or depression, the profitability of most companies will fall, as will the
prices of their shares and the value of the market portfolio. Therefore, the returns on
most shares will be positively correlated with the returns on the market portfolio, which
means that most shares will have positive betas.

9.

The statement is false. It is true that diversification is good for investors, but investors
can easily diversify their portfolios by purchasing the shares of several companies.
Therefore, diversification at the company level does not create any new investment
opportunity, and there is no reason for investors to pay a premium for the shares of
companies that diversify.

10. Mincos employees should not endorse the funds investment policy because it involves
the failure to diversify. The wealth of the funds members is already dependent on the
prosperity of the mining industry, in that they are employees of a mining company. If
their superannuation fund also invests heavily in mining company shares, many members
will have most of their wealth invested in one industry. Therefore, their risk can be
reduced by investing in a wider range of industries.
11. Hailstorms tend to be localised, and are likely to affect only a small proportion of farms
in any given time period. Therefore, the risk of hail damage to each crop is largely
independent of the risk of such damage to other crops. In effect, an insurance company is
able to diversify away much of the risk associated with claims for hail damage. However,
when a flood occurs, it may affect a large area, so that most or all of the flood-prone land
is flooded at the same time. Therefore, an insurance company that offered flood
insurance could expect that whenever a flood occurred, it would have a large number of
costly claims at the same time. It would be much more difficult to reduce this risk by
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diversification, and rather than face the prospect of many simultaneous payouts,
insurance companies may decide not to offer insurance against the risk of flood.
12. Both types of models are based on the principles that investors require compensation for
taking on risk, and that the market will only reward investors for bearing risks that
cannot be eliminated by diversification. The major difference is that in the CAPM, the
market portfolio is identified as ultimately the single source of risk, whereas, with other
models, there are additional risk factors that are accounted for. For example, the FamaFrench three factor model of expected returns is provided in equation 7.16 on page 196,
and is specified as:
E(Rit) Rft = iM[E(RMt) Rft] + iS E(SMBt) + iH E(HMLt)

As is apparent from the equation above, the first factor, reflecting the sensitivity of asset
is returns to the returns from the market portfolio, is identical to that specified in the
CAPM. In addition to this, an assets expected return is also linked to the sensitivity of
its returns to the size factor which is measured by the returns on Small Minus Big firms
(SMB), and to the book-to-market factor which is measured by the returns on High
Minus Low (HML) book-to-market ratio firms.
13. The use of a simple benchmark equity index, such as the S&P/ASX 200 Index, to assess
the performance of a portfolio is only really ever appropriate when the portfolio being
assessed is a diversified portfolio of shares that closely matches the risk profile of the
benchmark index.
14. As described in Section 7.8 (and illustrated in Example 7.3) the Sharpe ratio and the
Treynor ratio each measure the risk-return performance of a portfolio using alternative
measures of risk. The Sharpe ratio assumes that the relevant measure of risk is the total
risk of the portfolio as measured by the ex-post standard deviation of returns of the
portfolio over the investment period. Consequently, the Sharpe ratio is only an
appropriate tool for performance measurement when dealing with well-diversified
portfolios. Conversely, the Treynor ratio utilises the ex-post systematic risk of the
portfolio is benchmarking the risk-return performance of the portfolio against a market
proxy and is a more appropriate tool to use when assessing the performance of an
individual asset or undiversified portfolio (although of course it is still a suitable measure
of performance for well-diversified portfolios).

Solutions to problems

1.

(a) A risk-averse investor requires a higher return to compensate for additional risk. In
this situation, Mr Barlin would prefer either X or Z to Y.
(b) A risk-neutral investor ignores risk when making investment decisions. In this case,
Mr Barlin would rank Z first, and then rank X and Y equally.

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(c) A risk-seeking investor obtains utility from both expected return and risk. Therefore,
Mr Barlin would prefer Z to Y and, in turn, prefer Y to X.
2.

(a) 2p

= w12 12 + w22 22 + 2w1 w2 1,2 1 2

1, 2 = +1.0:
2p

= (0.4)2 (0.2)2 + (0.6)2 (0.10)2 + 2(0.4)(0.6)(1.0)(0.2)(0.1)

= 0.0196 (p = 0.14 or 14%)

(b) 1, 2 = 0.5:

2p

= (0.4)2 (0.2)2 + (0.6)2(0.1)2 + 2(0.4)(0.6)(0.5)(0.2)(0.1)

= 0.0148 (p = 0.1217 or 12.17%)

(c)

1, 2 = 0:
2p

= (0.4)2 (0.2)2 + (0.6)2(0.1)2

= 0.0100 (p = 0.1 or 10%)

(d) 1, 2 = 0.5:

2p

= (0.4)2 (0.2)2 + (0.6)2(0.1)2 + 2(0.4)(0.6)(0.5)(0.2)(0.1)

= 0.0052 (p = 0.0721 or 7.21%)

3.

2p = w A2 A2 + wB2 B2 + 2 w A wB A, B A B

(a) A,B = +1.0:

2p
p

= (0.4)2 (0.08)2 + (0.6)2 (0.12)2 + 2(0.4)(0.6)(1.0)(0.08)(0.12)

= 0.010816
= 0.104 or 10.4%

(b) A,B =

2
p

0.4:

= (0.4)2 (0.08)2 + (0.6)2 (0.12)2 + 2(0.4)(0.6)(0.4)(0.08)(0.12)

= 0.008051
= 0.089728 or 8.97%

(c) A,B = 0:
2p

= (0.4)2 (0.08)2 + (0.6)2 (0.12)2 + 2(0.4)(0.6)(0)(0.08)(0.12)

= 0.006208
= 0.078791 or 7.88%

(d) A,B = 1.0:

2p

= (0.4)2 (0.08)2 + (0.6)2 (0.12)2 + 2(0.4)(0.6)(1)(0.08)(0.12)

= 0.001600
= 0.04 or 4%

Comment:
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The risk of a portfolio depends significantly on the correlation between the returns on the
assets in the portfolio. When the correlation is +1, the standard deviation of the portfolio
is the weighted average of the standard deviations of the individual assets. When the
correlation is less than +1, the standard deviation of the portfolio is less than the
weighted average of the standard deviations of the individual assets. The question
illustrates the fact that the benefits of diversification arise from combining assets whose
returns are less than perfectly positively correlated.
4.

5.

(a) E(RL ) =
=
E(RM) =
=
2
L
=
=
L
=
=
2
M
=
=
M
=
=
(b) L, M =
=
=

0.5(0.12) + 0.5(0.24)
0.06 (or 6%)
0.4(0.12) + 0.6(0.24)
0.096 (or 9.6%)
0.5(0.12 0.06)2 + 0.5(0.24 0.06)2
0.0324
0.0324
0.18 or 18%
0.4(0.12 0.096)2 + 0.6(0.24 0.096)2
0.0311
0.0311
0.1764 or 17.64%

(a) E(Rp) =
=
2p
=
=
p =
=

(1/3) 0.15 + (2/3) 0.21

0.19 or 19%
(1/3)2 (0.18)2 + (2/3)2(0.25)2 + 2(1/3)(2/3)(0.5)(0.18)(0.25)
0.0414
0.0414
0.2034 (or 20.34%)

L,MLM
0.75(0.18) (0.1764)
0.0238

(b) The expected rate of return in each case is 19%.

1,2 = 0:
2p
= (1/3)2 (0.18)2 + (2/3)2 (0.25)2 + 2(1/3)(2/3)(0)(0.18)(0.25)

p
1, 2

2
p

= 0.0314
= 0.1772 (or 17.72%)
= 1.0:
= (1/3)2 (0.18)2 + (2/3)2 (0.25)2 + 2(1/3)(2/3)(1.0)(0.18)(0.25)
= 0.0514
= 0.2267 (or 22.67%)

(c) By investing in two shares that are less than perfectly correlated, Harry has achieved
a diversification benefit. This is demonstrated by the fact that the risk of his portfolio
(20.34%) is less than the weighted average risk of the individual assets in the
portfolio (22.67%).
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6.

(a) E(R1) =
=
=
=
2
1
=
=
=
1
=

wAE(RA) + wBE(RB)
0.4 E(RA) + 0.6E(RB)
0.4(12.5) + 0.6(16)
14.6%
w A2 A2 + wB2 B2 + 2 w A wB AB A B
(0.4)2(40)2 + (0.6)2(45)2 + 2(0.4)(0.6)(0.2)(40)(45)
1 157.8
34.026%

(b) E(R2) =
=
=
2
2
=

w A E ( R A ) + wB E ( RB ) + wC E (RC )
0.6(12.5) + 0.225(16.0) + 0.175(20)
14.6%
w A2 A2 + wB2 B2 + wC2 C2 + 2 w A wB A, B A B + 2 w A wC A,C A C

CHAPTER 7

+ 2 wB wC B ,C B C

= (0.6)2 (40)2 + (0.225)2 (45)2 + (0.175)2(60)2

+ 2(0.6)(0.225)(0.2)(40)(45) + 2(0.6)(0.175)(0.35)(40)(60)
+ 2(0.225)(0.175)(0.1)(45)(60)
= 1 083.628
= 32.9185%

Comment: (a) and (b)

Both portfolios have the same expected return, but Portfolio 2 has the lower risk, despite
the fact that asset C has the highest standard deviation of the three assets. Portfolio 2 is
more diversified than Portfolio 1, because it contains all three assets.
(c) E(R3) =
=
=
2
3
=

wAE(RA) + wBE(RB) + wFE(RF)

(0.048)(12.5) + (0.75)(16) + (0.202)(9.9)
14.6%
w A2 A2 + wB2 B2 + wF2 F2 + 2 w A wB A, B A B + 2 w A wF A, F A F
+ 2 wB wF B , F B F

= (0.048)2 (40)2 + (0.75)2 (45)2 + 0 + 2(0.048)(0.75)(0.2)(40)(45) + 0 + 0

= 1 168.67
= 34.186%

Comment: (a) (b) and (c):

All three portfolios have the same expected return, but they differ in risk. Portfolio 3 has
the highest risk despite the fact that it includes an investment in the risk-free asset F.
Portfolio 3 is not well diversified, because 75 per cent of the portfolio is invested in one
asset and this largely accounts for its greater risk. This highlights the point that the
benefits of diversification are dependent not only on the correlation between assets, but
also on the relative weights invested in the assets.
(d) E(R4) =
=
=
2
4
=

wAE(RA) + wBE(RB) + wCE(RC)

(1/3)(12.5) + (1/3)(16.0) + (1/3)(20.0)
16.16%
(1/3)2 (40)2 + (1/3)2 (45)2 + (1/3)2(60)2 + 2(1/3)(1/3)(0.2)(40)(45)

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+ 2(1/3)(1/3)(0.35)(40)(60) + (1/3)(1/3)(0.1)(45)(60)
= 1 129.444
= 33.607%

Comment:
Portfolio 4 has a higher expected return, and lower risk, than Portfolios 1 and 3. All riskaverse investors will prefer Portfolio 4 to Portfolios 1 and 3. Portfolio 4 has a higher risk,
and a higher expected return, than Portfolio 2. Depending on the investors preferences, a
risk-averse investor may prefer Portfolio 2 or Portfolio 4. Note also that Portfolio 4 is
well diversified, because it contains the three risky assets in equal proportions. Because
of its better diversification, Portfolio 4 is probably close to the efficient frontier.
(e) E(R5) = wA E(RA) + wB E(RB) + wC E(RC) + wF E(RF)
= (0.25)(12.5) + (0.25)(16) + (0.25)(20) + (0.25)(9.9)
= 14.6%
Portfolio 5 is equivalent to a combination of Portfolio 4 (75%) plus the risk-free
asset F (25%). Therefore, its standard derivation can be calculated as:

52 = w24 24
= (0.75 )2 (33.60 )2
= 635.312

5 = 25.205%
Comment:
Portfolio 5 effectively consists of Portfolio 4 plus the risk-free asset. It has the same
expected return as Portfolios 1, 2 and 3, but a much lower risk. The results show that a
favourable risk-return combination can be obtained by combining a well-diversified
portfolio of risky assets with an investment in the risk-free asset.
7.

(a) E(Ri) = Rf + i[E(RM) Rf]

= 0.08 + 1.25 (0.06)
= 0.155 or 15.5%
(b) 0.11 = 0.08 + 0.75 (E(RM ) 0.08)
E(RM) = 0.12 or 12%
(c) 0.14
i

8.

= 0.10 + i(0.05)
= 0.8

(a) Portfolio of A and B

12
= wA E(RA) + wB E(RB) but wB = (1 wA)
12 = wA(10.8) + (1 wA)(15.6)
wA = 0.75, wB = 0.25
a2
= w A2 A2 + wB2 B2 + 2 wA wB Cov( R A , RB )
= (0.75)2 (324) + (0.25)2 (289) + 2(0.75) (0.25) (60)

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= 222.8125
= 14.9269%

(b) Portfolio of B and F

12
= wB (15.6) + (1 wB)(6)
wB
= 0.625
2B
= wB2 2B
= (0.625)2 (289)
= 112.89
b
= 10.625%
(c) Portfolio of M and F
12
= wB(14) + (1 wM) (6)
wM = 0.75
c2
= WM2 M2
= (0.75)2 (80)
c
= 6.708%
Pricing of assets A and B.
The CAPM is:
E(R) + Rf + (E(RM) Rf)
= 6 + (14 6)
= 6 + 8
For asset A:
E(RA)
= 6 + 8 A where
Cov( R A , RM )
A
=
Var ( RM )
48
=
80
= 0.6
E(RA) = 6 + 8(0.6)
= 10.8%
10.8% agrees with the data given. Therefore, asset A is priced according to the
CAPM.
For asset B:

96
80
= 1.2
=

Therefore, the CAPM gives:

E(RB)
= 6 + 8(1.2)
= 15.6%, which agrees with the data given, and shows that B is priced
according to the CAPM.
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Comments:
All three portfolios have an expected return of 12%. As the CAPM holds in this
market, all three portfolios should have the same beta. This is shown below:
First portfolio [part (a)]:
portfolio beta

= wAA + wBB
= (0.75)(0.6) + (0.25)(1.2)
= 0.75

Second portfolio [part (a)]: = wBB + wFF

= (0.625)(1.2) + (0.375)(0)
portfolio beta
= 0.75
Third portfolio [part (a)]:
portfolio beta

= wMM + wFF
= (0.75)(1) + (0.25)(0)
= 0.75

However, the standard deviations of the portfolios differ because of the different
levels of diversification. The first two portfolios are poorly diversified. Because the
CAPM holds, the diversifiable risk in the first two portfolios is not rewarded with
increased expected return.
9.

(a) E(RP) = wBHZE(RBHZ) + wANBE(RANB)

= 0.3(9) + 0.7(13)
= 11.8%
(b) P2

2
2
2
2
= wBHZ
BHZ
+ w ANB
ANB
+ 2 wBHZ w ANB BHZ , ANB BHZ ANB

= (0.3)2 (8)2 + (0.7)2 (48)2+ 2(0.3)(0.7)(0.8)(8)(48)

= 1 263.73
= 35.55%

(c) You should point out to your client that the benefits of diversification are not
measured by comparing the risk of your portfolio prior to the addition of new assets,
with the risk of the portfolio after the their addition. Instead, we can demonstrate a
diversification benefit by comparing the risk of a portfolio with the weighted
average risk of the individual assets. In this case, the standard deviation of the
portfolios returns (P =35.55%) is slightly less than the weighted average of the
assets individual standard deviations (AVERAGE= (0.3)(8)+(0.7)(48) = 36%).
10. The weight of the investment in Outlook Publishing is $3 million of $8 million, or 0.375
of the portfolio. The weight of the investment in Russell Computing is 0.675. Using
Equation 7.4, the variance of the returns on the portfolio will be:

2p = (0.375)2(0.4)2 + (0.675)2(0.25)2 + 2(0.375)(0.675)(0.7)(0.4)(0.25)

= 0.086414

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The standard deviation of portfolio returns, p, is, therefore, 0.2939625 or 29.39625%,

and the standard deviation on the investment is $8 million 0.2939625 = $2.3517
million. The value at risk of the portfolio is $2.3517 million multiplied by 2.327 (i.e. the
critical value from a standard normal distribution that equates to a 1% probability of the
abnormally bad market conditions) = $5.4724 million. This calculation assumes that
returns follow a normal probability distribution.
11. (a) The simple benchmark index appears to have outperformed the Fort Knox Fund by
2% over the year. This measure of course fails to account for any differences in the risk
profile of the fund and the benchmark index.
(b) The Sharpe ratios for the Fort Knox Fund and the S&P/ASX 200 index are calculated
as follows:
rP r f

S F o rtK n o x =

SS&P / ASX 200 =

rP rf

0 .1 0 0 .0 3
= 0 .4 6 6 7
0 .1 5

0.12 0.03
= 0.3000
0.30

As the Sharpe ratio for the fund exceeds that of the indexthe fund appears to have
outperformed the index.

(c) The Treynor ratios for the Fort Knox Fund and the S&P/ASX 200 index are
calculated as follows:

T F o rtK n o x =

rP r f

TS&P / ASX 200 =

P
rP rf

0 .1 0 0 .0 3
= 0 .9 3 3 3
0 .7 5

0.12 0.03
= 0.9000
1

As the Treynor ratio for the fund exceeds that of the benchmark index, this final result
confirms the suggestion that the fund has outperformed the index after allowing for the
differences in systematic risk between the two assets.

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