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Chapter 13: Return, Risk and the SML (13 Questions)

Q1) What are the portfolio weights for a portfolio that has 145 shares of Stock A that sell for $45 per share and 110 shares
of Stock B that sell for $27 per share?

Answer: The portfolio weight of an asset is total investment in that asset divided by the total portfolio value. First, you
need to find the portfolio value.

Total value = Investment in stock A + Investment in stock B + …..+ Investment in Stock X

Total value =

The portfolio weight for each stock is:

WeightA = Total investment in an asset (e.g., stock A) / Total portfolio value =

WeightB = Total investment in an asset (e.g., stock B) / Total portfolio value =

Q2) You own a portfolio that has $2,950 invested in Stock A and $3,700 invested in Stock B. If the expected returns on
these stocks are 8% and 11%, respectively, what is the expected return on the portfolio?

Answer: The expected return of a portfolio is the sum of the weight of each asset times the expected return of each asset.
Total value of the portfolio = Investment in stock A + Investment in stock B + …..+ Investment in Stock X

Total value =

Expected return on portfolio [E(Rp)] = Sum of the weight of each asset x Expected return of each asset

E(Rp) =

Q3) You own a portfolio that is 35% invested in Stock X, 20% in Stock Y, and 45% in Stock Z. The expected returns on
these three stocks are 9%, 17%, and 13%, respectively. What is the expected return on the portfolio?

Answer: The expected return of a portfolio is the sum of the weight of each asset times the expected return of each asset.
Expected return on portfolio [E(Rp)] = Sum of the weight of each asset x Expected return of each asset

E(Rp) =

Q5) Based on the following information, calculate the expected return:

Answer: The expected return of an asset is the sum of the probability of each return occurring times the probability of that
return occurring.
n
Expected Return = Sum of possible returns x Their Probabilities = E ( R )   pi Ri
i 1
E(R) =
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Q6) Based on the following information, calculate the expected return:

Answer: The expected return of an asset is the sum of the probability of each return occurring times the probability of that
return occurring.
n
Expected Return = Sum of possible returns x Their Probabilities = E ( R )   pi Ri
i 1
E(R) =

Q7) Based on the following information, calculate the expected return and standard deviation for the two stocks:

Answer: The expected return of an asset is the sum of the probability of each return occurring times the probability of that
return occurring. So, the expected return of each stock asset is:
n
Expected Return = Sum of possible returns x Their Probabilities = E ( R )   pi Ri
i 1
E(RA) =

E(RB) =

To calculate the standard deviation, you first need to calculate the variance. To find the variance, you need to find the
squared deviations from the expected return. You then multiply each possible squared deviation by its probability, then
add all of these up. The result is the variance.
n
σ 2   pi [ Ri  E ( R)]2
i 1

 A2 =

A = (2).50 =

 B2 =

B = (2).50 =
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Q8) A portfolio is invested 15% in Stock G, 55% in Stock J, and 30% in Stock K. The expected returns on these stocks are
8%, 14%, and 18%, respectively. What is the portfolio's expected return? How do you interpret your answer?

Answer: The expected return of a portfolio is the sum of the weight of each asset times the expected return of each asset.
Expected return on portfolio [E(Rp)] = Sum of the weight of each asset x Expected return of each asset

E(Rp) =

If we own this portfolio, we would expect to get a return of 14.30%.

Q9) Consider the following information:

a. What is the expected return on an equally weighted portfolio of these three stocks?
b. What is the variance of a portfolio invested 20% each in A and B and 60% in C?

Answer: a. To find the expected return of the portfolio, You need to find the return of the portfolio in each state of the
economy. This portfolio is a special case since all three assets have the same weight.

Expected return in an equally weighted portfolio = Sum of the returns on each asset / Number of assets

Boom: E(Rp) =
Bust: E(Rp) =
n
Expected Return = Sum of possible returns x Their Probabilities = E ( Rp)   pi Ri
i 1
E(Rp) =

b. This portfolio does not have an equal weight in each asset. We still need to find the return of the portfolio in each
state of the economy.

Expected return on portfolio E(Rp) = w1 x r1 + w2 x r2 + ……………+wn x rn

w = Weight in each asset; r = Return of the portfolio in each state of the economy

Boom: E(Rp) =

Bust: E(Rp) =
n
Expected return of the portfolio: E ( Rp)   pi Ri
i 1

E(Rp) =

To find the variance, you need to find the squared deviations from the expected return. You then multiply each
possible squared deviation by its probability, than add all of these up. The result is the variance. So, the variance
and standard deviation of the portfolio is:
n
σ 2   pi [ Ri  E ( R)]2
i 1

 =
p
2
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Q11) You own a stock portfolio invested 35% in Stock Q, 25% in Stock R, 30% in Stock S, and 10% in Stock T. The betas
for these four stocks are .84, 1.17, 1.11, and 1.36, respectively. What is the portfolio beta?

Answer: Portfolio beta (βp) = Sum of the weight of each asset x Beta of each asset

p =

Q13) A stock has a beta of 1.05, the expected return on the market is 10%, and the risk-free rate is 3.8%. What must the
expected return on this stock be?

Answer: CAPM states the relationship between the risk of an asset and its expected return. CAPM is:

E(Ri) = Rf + [E(RM) – Rf] × i =

E(Ri) = Expected return on security i; Rf = Risk free rate of return; E(RM) = Expected rate of return on market portfolio; i =
Beta of security i

Q14) A stock has an expected return of 10.2 percent, the risk-free rate is 4.5%, and the market risk premium is 7.5%.
What must the beta of this stock be?

Answer: You are given the values for the CAPM except for the  of the stock. You need to substitute these values into
the CAPM, and solve for the  of the stock.

One important thing you need to realize is that you are given the market risk premium.

Market risk premium = Expected return on the market - Risk-free rate

You must be careful not to use this value as the expected return of the market.

CAPM, E(Ri) = Rf + [E(RM) – Rf] × i

E(Ri) = Expected return on security i; Rf = Risk free rate of return; E(RM) = Expected rate of return on market portfolio; i =
Beta of security i

E(Ri) = .102 = .045+ .075i

i =
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Q23) Consider the following information about three stocks:

a. If your portfolio is invested 40% each in A and B and 20% in C, what is the portfolio expected return? The variance?
The standard deviation?
b. If the expected T-bill rate is 3.80%, what is the expected risk premium on the portfolio?
c. If the expected inflation rate is 3.50%, what are the approximate and exact expected real returns on the portfolio?
What are the approximate and exact expected real risk premiums on the portfolio?
Answer: a. You need to find the return of the portfolio in each state of the economy. To do this, you need to multiply
the return of each asset by its portfolio weight and then sum the products to get the portfolio return in each state
of the economy.
n
E ( R )   pi Ri
i 1
Boom: E(Rp) =

Normal: E(Rp) =

Bust: E(Rp) =
n
Expected Return on Portfolio = Sum of possible returns x Their Probabilities = E ( R )   pi Ri
i 1
E(Rp) =
n
σ 2   pi [ Ri  E ( R)]2
i 1

2p =

p = (2p).50 =
b. Risk premium is the return of a risky asset, minus the risk-free rate. T-bills are often used as the risk-free rate.

Risk premium (RPi) = E(Rp) – Rf =

c. The approximate expected real return is the expected nominal return minus the inflation rate, so:

Approximate expected real return = Expected nominal return - Inflation rate =

To find the exact real return, we will use the Fisher equation. Doing so, we get:

1 + E(Ri) = (1 + h)[1 + e(ri)]; 1.0954 = (1.0350)[1 + e(ri)]

h = Inflation; e(ri) = Expected real return

Expected real return, e(ri) =

The approximate real risk premium is the approximate expected real return minus the risk-free rate, so:

Approximate expected real risk premium = Expected return - Risk-free rate =

Exact expected real risk premium = Approximate expected real risk premium / (1+ Inflation rate)