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Chapter 5 - Risk and Return

This document summarizes 5 chapters about risk and return from a finance textbook. It includes examples calculating beta, required rates of return using CAPM, standard deviation and probability distributions, international investment returns in different currencies, and analyzing stocks with different betas in changing market conditions. The key concepts covered are risk measurement using beta, required returns, variance and standard deviation of returns, currency exchange rates, and how different stocks' returns may react to market movements based on their betas.

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Layla Main
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105 views

Chapter 5 - Risk and Return

This document summarizes 5 chapters about risk and return from a finance textbook. It includes examples calculating beta, required rates of return using CAPM, standard deviation and probability distributions, international investment returns in different currencies, and analyzing stocks with different betas in changing market conditions. The key concepts covered are risk measurement using beta, required returns, variance and standard deviation of returns, currency exchange rates, and how different stocks' returns may react to market movements based on their betas.

Uploaded by

Layla Main
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Chapter 5 – Risk and Return

5-1 Beta and CAPM Currently under consideration is a project with a beta, b, of 1.50. At this

time, the risk-free rate of return, RF, is 7%, and the return on the market portfolio of assets,

km, is 10%. The project is actually expected to earn an annual rate of return of 11%.

a. If the return on the market portfolio were to increase by 10%, what would you

expect to happen to the project’s required return? What if the market return were to

decline by 10%?

b. Use the capital asset pricing model (CAPM) to find the required return on this

investment.

c. On the basis of your calculation in part b, would you recommend this investment?

Why or why not?

d. Assume that as a result of investors becoming less risk-averse, the market return

drops by 1% to 9%. What impact would this change have on your responses in parts

b and c?

5-2 Rate of return Douglas Keel, a financial analyst for Orange Industries, wishes to

estimate the rate of return for two similar-risk investments, X and Y. Keel’s research

indicates that the immediate past returns will serve as reasonable estimates of future

returns. A year earlier, investment X had a market value of $20,000, investment Y of

$55,000. During the year, investment X generated cash flow of $1,500 and investment Y

generated cash flow of $6,800. The current market values of investments X and Y are

$21,000 and $55,000, respectively.


a. Calculate the expected rate of return on investments X and Y using the most

recent year’s data.

b. Assuming that the two investments are equally risky, which one should Keel

recommend? Why?

5-3 Normal probability distribution. Assuming that the rates of return associated with a

given asset investment are normally distributed and that the expected return, k, is 18.9%

and the coefficient of variation, CV, is .75, answer the following questions.

a. Find the standard deviation of returns, k.

b. Calculate the range of expected return outcomes associated with the following

probabilities of occurrence:

(1) 68%,

(2) 95%,

(3) 99%.

c. Draw the probability distribution associated with your findings in parts a and b.

5-4 International investment returns. Joe Martinez, a U.S. citizen living in Brownsville,

Texas, invested in the common stock of Telmex, a Mexican corporation. He purchased 1,000

shares at 20.50 pesos per share. Twelve months later, he sold them at 24.75 pesos per

share. He received no dividends during that time.

a. What was Joe’s investment return (in percentage terms) for the year, on the basis

of the peso value of the shares?


b. The exchange rate for pesos was 9.21 pesos per $US1.00 at the time of the

purchase. At the time of the sale, the exchange rate was 9.85 pesos per $US1.00.

Translate the purchase and sale prices into $US.

c. Calculate Joe’s investment return on the basis of the $US value of the shares.

d. Explain why the two returns are different. Which one is more important to

Joe? Why?

5-5 Betas and risk rankings. Stock A has a beta of .80, stock B has a beta of 1.40, and stock

C has a beta of -.30.

a. Rank these stocks from the most risky to the least risky.

b. If the return on the market portfolio increased by 12%, what change would you

expect in the return for each of the stocks?

c. If the return on the market portfolio decreased by 5%, what change would you

expect in the return for each of the stocks?

d. If you felt that the stock market was just ready to experience a significant decline,

which stock would you probably add to your portfolio? Why?

e. If you anticipated a major stock market rally, which stock would you add to your

portfolio? Why?

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