Chapter 12 Study Notes

Chapter 12 [Old exam conceptual questions]

1- If portfolio weights are positive: 1) Can the return on a portfolio ever be less than the smallest
return on an individual security in the portfolio? 2) Can the variance of a portfolio ever be
less than the smallest variance of an individual security in the portfolio?
A) 1) yes; 2) yes
B) 1) yes; 2) no
C) 1) no; 2) yes
D) 1) no; 2) no
E) 1) maybe; 2) no

2- You have a portfolio consisting of equal amounts of IBM stock and Treasury bills. If you
replace half of the Treasury bills with more IBM stock, the portfolio expected return will
likely ___________ , all else the same.
A) increase
B) decrease
C) remain unchanged
D) either increase or decrease
E) decrease if IBM is considered a small-cap stock

3- You sell some of your IBM common stock (which tends to move up and down with the
economy as a whole) and replace it with the common stock of Fort Knox Gold Mining,
Inc. (whose shares tend to rise when the economy falls, and vice versa). Your portfolio's
beta should _______________.
A) increase
B) decrease
C) remain unchanged
D) either increase or decrease
E) definitely exceed the beta of the market when all is said and done

4- Aziz Equipment Co. invests in a group of risky projects, which increases the unsystematic
risk of the firm, but does not change the systematic risk of the firm. All else the same,
the expected risk premium on its common stock is most likely to:
A) Increase, because the difference between the expected return on the firm's stock and
the risk-free rate will widen.
B) Decrease, because the difference between the expected return on the firm's stock
and the risk-free rate will narrow.
C) Remain unchanged, because the level of systematic risk is unchanged.
D) Increase or decrease, depending on the internal rate of return of the new projects.
E) None of the above
5- The CAPM shows that the expected return for a particular asset depends on:
I. The amount of unsystematic risk.
II. The reward for bearing systematic risk.
III. The pure time value of money.
A) I only
B) I and II only
C) III only
D) II and III only
E) I, II, and III

6- Which of the following is correct regarding the CAPM?

A) The expected return for a particular asset depends on the pure time value of money
as measured by beta
B) The expected return for a particular asset depends on the amount of systematic risk
as measured by the risk free rate
C) The standard deviation for a particular asset depends on the reward for bearing risk
as measured by beta
D) Implicit in the CAPM is that all risky assets have the same reward to risk ratio
E) The SML and CAPM illustrate that the higher the beta, the lower the expected
return

7- Which one of the following is an example of diversifiable risk?

A) A decrease in the average cost of living
B) An increase in the federal funds rate
C) An increase in the minimum hourly wage
D) A new government regulation on aircraft engines
E) A decrease in federal income taxes on business incomes

8- Suppose the Bank of Canada increased the rate on T-bills. As a result of this action, the
security market line of a risky individual security would:
A) Remain constant.
B) Have an increased slope.
C) Have a decreased slope.
D) Increase in a parallel manner.
E) Decrease in a parallel manner.

9- Which one of the following will decrease the risk of a portfolio that consists of stocks,
Canadian Treasury bills, and gold?
A) Decreasing the number of securities in the portfolio
B) Selling stocks and replacing them with Canadian Treasury bills
C) Selling a 0.90 beta stock and buying a 1.1 beta stock
D) Selling the gold and buying more diversified stocks
E) Selling the large-company stocks and buying small-company stocks
10- An asset that has an expected rate of return above the security market line:
A) Is overpriced.
B) Is underpriced.
C) Is less risky than the market.
D) Has a beta greater than 1.
E) Has a standard deviation equal to 0.

11- Ed Lawrence has $100,000 invested. Of that, $30,000 is invested in IBM stock, $25,000 is
invested in T-bills, and the remainder is invested in corporate bonds. Which of the
following is NOT correct regarding his portfolio weights? (All values are current market
values.)
A) Ed has 30% of his portfolio invested in stocks.
B) Ed has 45% of his portfolio invested in corporate bonds.
C) Ed has 70% of his portfolio invested in assets other than stocks.
D) Ed has 70% of his portfolio invested in risk-free assets.
E) If Ed sells his corporate bonds and buys GM stock with the proceeds, he will end up
with 75% of his portfolio invested in stocks.

12- You are considering two investments. You note that the return on investment A tends to
vary quite widely from its average, definitely more so than does investment B. Based on
this, you believe that:
A) A has a lower variance than B.
B) A has a lower standard deviation than B.
C) A has a higher inflation premium than B.
D) A has a higher return volatility than B.
E) A must be stock in one of the largest Canadian firms while B must be stock in one
of the smallest firms listed on the TSX

13- Suppose that there is a decrease in the rate of T-bills. As a result of this action, the security
market line should:
A) Remain constant.
B) Have an increased slope.
C) Have a decreased slope.
D) Increase in a parallel manner.
E) Decrease in a parallel manner.

14- An asset that has an expected rate of return below the security market line:
A) Is overpriced.
B) Is underpriced.
C) Is less risky than the market.
D) Has a beta greater than 1.
E) Has a standard deviation equal to 0.
15- You are evaluating two stocks, A and B. A financial analyst provides you with the following
information about the two stocks about the security market line.

Stoc Beta Expected Return Information for security market line

k
A 0.8 9.7% Expected market return = 11%
B 0.9 10.2% Risk free rate of return = 4%

Calculate the equilibrium returns for A and B as per the security market line and then check one

A) Both A and B are undervalued

B) A is undervalued; B is overvalued
C) A is overvalued; B is undervalued
D) Both are overvalued
E) None of the above

16- Diversification works because:

I. Unsystematic risk exists.
II. Forming stocks into portfolios reduces the standard deviation of returns for each
stock.
III. Firm-specific risk can be dramatically reduced if not eliminated.
A) I only
B) III only
C) I and II only
D) I and III only
E) I, II, and III

17- Which of the following statements is (are) true concerning risk and return?
I. To accept higher levels of risk, investors must be paid a higher risk premium.
II. Small-company stocks offer a higher return and less risk than large-company stocks.
III. The risk-free rate of return is based on the long-term corporate bond rate.
IV. The higher the standard deviation, the higher the risk.
A) I only
B) II only
C) III and IV only
D) I and II only
E) I and IV only
18- The steeper the slope of the security market line, the
A) Lower the risk-free rate of return.
B) Higher the risk premium.
C) Higher the market beta.
D) Higher the risk-free rate of return.
E) Lower the risk premium.

19- Smith sells some of his ABC common stock (which tends to move up and down with the
economy as a whole) and replaces it with the common stock of XYZ (whose shares tend
to rise when the economy falls, and vice versa). His portfolio's beta should
_______________.
A) increase
B) decrease
C) remain unchanged
D) either increase or decrease
E) definitely exceed the beta of the market when all is said and done

20- Which of the following would be considered an example of systematic risk?

I. Higher quarterly loss than expected for Procter and Gamble
II. Lower consumer spending than expected
III. Higher unemployment, and therefore interest rates, than expected
A) I only
B) II only
C) III only
D) II and III only
E) I and III only

21- In a highly competitive market, all stocks should:

A) Produce the same rate of return.
B) Plot on the same security market line.
C) Have the same beta.
D) Have the same standard deviation.
E) None of the above.

22- Theoretically, a risk-free portfolio could be created by combining risky securities in a

manner that caused the:
A) Portfolio standard deviation to equal one.
B) Expected return of the portfolio to equal the market expected return.
C) Portfolio beta to equal zero.
D) Portfolio beta to equal one.
E) Non-diversifiable risk to be eliminated.
23- Investors are rewarded for the ____ risk they assume.
A) Total
B) Diversifiable
C) Unsystematic
D) Systematic
E) None of the above.

24- In a competitive market the reward to risk ratio can be expressed as:
A) [E(RA) - Rf] / ßA > [E(RB) - Rf] / ßB
B) [E(RA) - Rf] / ßA = [E(RB) - Rf] / ßB
C) [E(RA) - Rf] = ßA
D) E(RA) = E(RB)
E) None of the above

25- The principle of diversification states that spreading an investment over a number of assets
will eliminate:
A) All of the risk.
B) All of the systematic risk and part of the unsystematic risk.
C) All of the unsystematic risk and part of the systematic risk.
D) Most of the systematic risk.
E) Most of the unsystematic risk.

26- The expected return on an individual asset depends only on that asset's ____ risk.
A) Total
B) Incremental
C) Systematic
D) Unsystematic
E) Portfolio
Use the following to answer the questions 27-29:

Standard Beta
Deviation
Security X 0.33 1.42
Security Y 0.29 1.03
Security Z 0.41 1.15

27- Which security has the greatest expected return?

A) Y because it has the largest standard deviation.
B) X because it has the largest beta coefficient.
C) Z because it has the highest ratio of standard deviation to beta.
D) Y because it has the lowest beta coefficient, and therefore the lowest risk.
E) None of the above.

28- Which of the following is correct?

A) Security X has the greatest diversifiable risk because it has the largest beta.
B) Security X has the greatest total risk because it has the largest beta.
C) Security Y has the lowest total risk because it has the lowest beta.
D) An equally-weighted portfolio of XYZ will have the same systematic risk as the
market portfolio.
E) None of the above.

29- Which security has the greatest systematic risk?

A) Z because it has the largest standard deviation.
B) X because it has the largest beta coefficient.
C) Z because it has a high beta and the largest standard deviation.
D) Y because it has the greatest diversifiable risk.
E) None of the above.

30- Total risk equals _________________.

A) market risk plus firm-specific risk
B) firm-specific risk plus diversifiable risk
C) systematic risk minus unsystematic risk
D) diversifiable risk plus unsystematic risk
E) market risk plus non-diversifiable risk

Chapter 12 [Old exam Problems]

1- A portfolio has an expected return of 13.12%. The portfolio is comprised of 60%
stock A and 40% stock B. The risk-free rate of return is 4% and the market risk
premium is 8%. The beta of stock B is 0.87. What is the expected return of stock A?
Solution:
E(Rp) = Rf + bp[E(RM) – Rf]
13.12% = 4% + (bp) 8%
9.12% = (bp) 8% → bp = (9.12%)/(8%) = 1.14
bp = w A bA + w B bB
1.14 = 0.6 bA + 0.4 (0.87) → 1.14 = 0.6 bA + 0.348 → 0.6 bA = 0.792 → bA = 1.32
E(RA) = Rf + bA[E(RM) – Rf]
E(RA) = 4% + 1.32 (8%) = 4% + 10.56% = 14.56%

2- If an individual plans to invest $3,000 in Stock A and $2,000 in Stock B. Based on

the following information calculate the expected return and standard deviation for the
portfolio.

State of Economy Probability of Return on Stock Return on Stock B

State of Economy A
Boom 0.1 25% 18%
Growth 0.2 10% 20%
Normal 0.5 15% 4%
Recession 0.2 -12% 0%

Solution:
wA = 3000/5000 = 0.6 and wB = 2000/5000 = 0.4

Rp(Boom)= 0.6 (25%) + 0.4 (18%) = 15% + 7.2% = 22.2%

Rp(Growth)= 0.6 (10%) + 0.4 (20%) = 6% + 8% = 14%

Rp(Normal)= 0.6 (15%) + 0.4 (4%) = 9% + 1.6% = 10.6%

Rp(Recession)= 0.6 (-12%) + 0.4 (0%) = -7.2%

E(Rp) = µ = 0.1 (22.2%) + 0.2 (14%) + 0.5 (10.6%) + 0.2 (-7.2%)

= 2.22% + 2.8% + 5.3% + (-1.44%) = 8.88%

σp²= 0.1 (0.222 - 0.0888)² + 0.2 (0.14 – 0.0888)² + 0.5 (0.106 – 0.0888)² + 0.2 (-0.072 – 0.0888)²

= 0.1 (0.1332)² + 0.2 (0.0512)² + 0.5 (0.0172)² + 0.2 (-0.1608)²

σp²= 0.0076177 → σp= 8.73%

 3- Stock A has a beta of 1.6 and an expected return of 16%. The risk-free asset currently
earns 5%.
i- What is the expected return on a portfolio that is equally invested in both
stock A and the risk-free asset?
ii- If a portfolio of stock A and the risk-free asset has a beta of 0.6, what are
the portfolio weights?
iii- If a portfolio of stock A and the risk-free asset has an expected return of
11%, what is this portfolio’s beta?
Solution:
i- E(Rp) = 0.5 (16%) + 0.5 (5%) = 8% + 2.5% = 10.5%
ii- βp = wA βA + wfβf = 0.6 = wA (1.6) + wf (0) → wA = 0.6/1.6 = 0.375 = 37.5% →
wf = 62.5%
iii- E(Rp) = 11% = wA (16%) + wf (5%), since wA + wf = 1 thus wf= 1 - wA
11%= wA (16%) + (1 - wA) (5%) → wA = 6%/11% = 0.5454 = 54.54%
βp = wA βA + wf βf = 0.5454 (1.6) + 0 = 0.873

4- If an individual plans to invest $6,000 in Stock A and $4,000 in Stock B. Based on

the following information calculate the expected return and standard deviation for the
portfolio.

State Probability Return on A Return on B

Boom 0.3 12% -2%
Normal 0.6 8% 2%
Bust 0.1 4% 6%

Solution:
wA = 6,000/10,000 = 0.6 and wB = 4,000/10,000 = 0.4

E(Rp(Boom))= 0.6 (12%) + 0.4 (-2%) = 7.2% + (-0.8%) = 6.4%

E(Rp(Normal))= 0.6 (8%) + 0.4 (2%) = 4.8% + 0.8% = 5.6%
E(Rp(Bust))= 0.6 (4%) + 0.4 (6%) = 2.4% + 2.4% = 4.8%
E(Rp) = µ = 0.3 (6.4%) + 0.6 (5.6%) + 0.1 (4.8%) = 1.92% + 3.36% + 0.48% = 5.76%

σp² = 0.3 (0.064 – 0.0576)² + 0.6 (0.056 – 0.0576)² + 0.1 (0.048 -0.0576)²
= 0.3 (0.00004096) + 0.6 (0.00000256) + 0.1 (0.1 (0.00009216)
= 0.000012288 + 0.000001536 + 0.000009216 = 0.00002304
σp = 0.0048 =0.48%
 5- What is the beta for the following portfolio?
Stock A B C D E
Investment ($) 15,000 10,000 25,000 12,500 17,500
Beta 0.6 0.9 1.6 1.1 0.0

A) 0.80
B) 0.88
C) 0.90
D) 0.93
E) 0.98

Solution:
Total $ amount invested = $15,000 + $10,000 + $25,000 + $12,500 +$17,500 = $80,000
wA = $15,000 / $80,000 = 0.1875
wB = $10,000 / $80,000 = 0.125
wC = $25,000 / $80,000 = 0.3125
wD = $12,500 / $80,000 = 0.15625
wE = $17,500 / $80,000 = 0.21875

m
β P =∑ w j β j
j=1
bP = 0.1875 (0.6) + 0.125 (0.9) + 0.3125 (1.6) + 0.15625 (1.1) + 0.21875 (0)
= 0.1125 + 0.1125 + 0.5 + 0.17188 + 0 = 0.89688

6- Assume the risk-free return is 5% and the expected return on the market is 12%. Common
stock X has a beta of 2. If the beta for a portfolio of these two assets is 1.3 what are the weights
for each asset? What is the expected return for this portfolio?
A) 0.45, 0.55, 14.1%
B) 0.35, 0.65, 20.6%
C) 0.6, 0.4, 19%
D) 0.65, 0.35, 14.1%
E) None of the above

Solution
bp = w x bx + w f bf
 since bf = 0 then bp = wx bx
1.3 = wx (2) → wx = 1.3 / 2 = 0.65 = 65%,

wx + wf = 1 since the weights of the portfolio have to add up to 1

wf = 1 - wx = 1 – 0.65 = 0.35= 35%

E(Rp) = Rf + bp[E(RM) – Rf]

E(Rp) = 5% + 1.3 [12% - 5%] = 5% + 9.1% = 14.1%

7- You own a portfolio that is invested 50% in a risk-free asset and 50% in a stock that is equally
as risky as the market. The risk-free asset has an expected return of 5%. Your portfolio
has an expected return of 8.80%. What is the expected return on the market?
A) 11.60%
B) 11.75%
C) 12.30%
D) 12.35%
E) 12.60%

Solution
bp = wi bi + wf bf = 0.5 (1) = 0.5
E(Rp) = Rf + bp[E(RM) – Rf]
8.8% = 5% + 0.5 [E(RM) – 5%]
3.8% = 0.5 [E(RM) – 5%]
7.6% = E(RM) – 5%
E(RM) = 12.6%

8- An investor has a portfolio with an expected return of 11.19%. The portfolio is evenly
invested in a stock and a risk-free asset. The market has an expected return of 17% and
the risk-free asset has an expected return of 3%. What is the beta of the stock?
A) 0.98
B) 1.17
C) 1.43
D) 1.62
E) 1.94
Solution
E(Rp) = Rf + bp[E(RM) – Rf]
11.19% = 3% + bp[17% - 3%]
8.19% = bp[14%]
bp = 8.19% / 14% = 0.585

m
β P =∑ w j β j
j=1

bp = w i bi + w f bf
0.585 = 0.5 bi → bi = 0.585 / 0.5 = 1.17

9- What is the expected return on a portfolio that is invested 30% in stock A and 70% in stock B,
given the following information?

Economic State Probability of State Return on Stock A Return on Stock

B
Normal 80% 8% 6%
Boom 20% 15% 7%

A) 5.28%
B) 6.60%
C) 7.16%
D) 7.43%
E) 7.90%

Solution
wA = 0.3, wB = 0.7
m
E( R P )= ∑ w j E( R j )
j=1

E(Rnormal) = 0.3 (8%) + 0.7 (6%) = 2.4% + 4.2% = 6.6%

E(Rboom) = 0.3 (15%) + 0.7 (7%) = 4.5% + 4.9% = 9.4%
E(RP) = 0.8 (6.6%) + 0.2 (9.4%) = 5.28% + 1.88% = 7.16%

10- Stock A has a beta of 1.5 and an expected return of 10%. Stock B has a beta of 1.1 and an
expected return of 8%. The current market price for stock A is $20 and the current market price
for stock B is $30. The expected return for the market is 7.5%. What is the risk free rate? What
is the expected return on a portfolio consisting of 100 shares of stock A, 60 shares of stock B and
$2,200 worth of T-bills?
A) 2.5%, 7.2%
B) 2.5%, 7.9%
C) 2.5%, 6.1%
D) 2.5%, 6.7%
E) None of the above

Solution
E(RA) = Rf + bA[E(RM) – Rf]
10% = Rf + 1.5 [7.5% - Rf]
10% = Rf + 11.25% - 1.5 Rf
0.5 Rf = 1.25%
Rf = 1.25% / 0.5 = 2.5%

Investment in Stock A: 100 shares * $20 per share = $2,000

Investment in Stock B: 60 shares * $30 = $1,800
Investment in Risk Free Asset: $2,200
Total Investment = $2,000 + $1,800 + $2,200 = $6,000

wA = $2,000 / $6,000 = 0.333333

wB = $1,800 / $6,000 = 0.3
wf =$2,200 / $6,000 = 0.3667

E(RP) = 0.333333 (10%) + 0.3 (8%) + 0.366667 (2.5%)

E(RP) = 3.33333% + 2.4% + 0.916668% = 6.64998%

11- A stock has a beta of 1.2 and an expected return of 12%. The market is expected to yield
11%. What is the security market line intercept point?
A) 0%
B) 1.20%
C) 3.5%
D) 5.00%
E) 6.00%
Solution
E(R) = Rf + b[E(RM) – Rf]
12% = Rf + 1.2 [11% - Rf]
12% = Rf + 13.2% - 1.2 Rf
1.2% = 0.2 Rf
Rf = 1.2% / 0.2 = 6%

12- A stock has a beta of 1.4 and an expected return of 16%. The risk-free rate is 5%. What is the
slope of the Security Market Line?
A) 7.86%
B) 7.98%
C) 8.23%
D) 8.67%
E) 8.98%

Solution
E(R) = Rf + b[E(RM) – Rf]
16% = 5% + 1.4[E(RM) – Rf]
11% = 1.4[E(RM) – Rf]
[E(RM) – Rf] = 11% / 1.4 = 7.857143%

13- A stock has a beta of .8 and an expected return of 6%. The risk-free rate is 3%. What is the
expected return on the market?
A) 3.50%
B) 3.75
C) 4.50%
D) 5.25%
E) 6.75%

Solution
E(R) = Rf + b[E(RM) – Rf]
6% = 3% + 0.8 [E(RM) – 3%]
3% = 0.8 [E(RM) – 3%]
3.75% = E(RM) – 3%
E(RM) = 6.75%

14- A stock has a beta of 1.4. The expected return on the market is 8% and the T-bill is yielding
2%. What is the expected return on the stock?
A) 8.40%
B) 9.65%
C) 10.40%
D) 11.65%
E) 13.20%

Solution
E(R) = Rf + b[E(RM) – Rf] = 2% + 1.4 [8% - 2%] = 2% + 1.4 [6%] = 2% + 8.4% = 10.4%

15- What is the expected return on a portfolio that is invested 40% in stock A and 60% in stock
B, given the following information?

Economic State Probability of Return on Stock A Return on Stock B

State
Normal 70% 12% 5%
Recession 30% -10% 8%

A) 5.40%
B) 5.70%
C) 6.40%
D) 7.80%
E) 8.10%

Solution
wA = 0.4, wB = 0.6
m
E( R P )= ∑ w j E( R j )
j=1

E(Rnormal) = 0.4 (12%) + 0.6 (5%) = 4.8% + 3% = 7.8%

E(Rrecession) = 0.4 (-10%) + 0.6 (8%) = -4% + 4.8% = 0.8%
E(RP) = 0.7 (7.8%) + 0.3 (0.8%) = 5.46% + 0.24% = 5.7%
16- You have 15% of your portfolio invested in stock A, 25% in stock B, 40% in stock C, and
20% in stock D. The expected returns on these four stocks are 18%, 3%, 9%, and -12%,
respectively. What is the expected return on the portfolio?
A) 4.65%
B) 5.25%
C) 5.60%
D) 7.55%
E) 9.45%

Solution
m
E( R P )= ∑ w j E( R j )
j=1

E(Rp) = 0.15 (18%) + 0.25 (3%) + 0.4 (9%) + 0.2 (-12%)

= 2.7% + 0.75% + 3.6% - 2.4% = 4.65%

17- What is the portfolio weight of stock B given the following information?

Stock Number of shares owned Value per share

A 150 $15.00
B 100 $25.00
C 200 $12.00

A) 31%
B) 33%
C) 34%
D) 35%
E) 36%

Solution
$ amount invested in Stock A = 150 shares * $15 per share = $2,250
$ amount invested in Stock B = 100 shares * $25 per share = $2,500
$ amount invested in Stock C = 200 shares * $12 per share = $2,400
Total $ amount invested = $7,150
wB = $2,500 / $7,150 = 0.34965 = 34.965%
Use the following to answer questions 18-22:

State Probability Return on A Return on B

Boom 0.6 0.15 0.08
Bust 0.4 0.05 0.20

18- What is the expected return on security B?

A) 0.080
B) 0.100
C) 0.110
D) 0.128
E) 0.138

Solution:
n
E( R )=∑ pi Ri
i =1

E(RB) = 0.6 (8%) + 0.4 (20%) = 4.8% + 8% = 12.8%

19- What is the standard deviation of security A?

A) 0.0002
B) 0.0006
C) 0.0490
D) 0.0545
E) 0.0600

Solution:
n
E( R )=∑ pi Ri
i =1
E(RA) = 0.6 (15%) + 0.4 (5%)
= 9% + 2% = 11%
n
σ =∑ pi (R i−E (R ))2
2

i=1
σA² = 0.6 (0.15 - 0.11)² + 0.4 (0.05 - 0.11)²
= 0.6 (0.04)² + 0.4 (-0.06)²
= 0.6 (0.0016) + 0.4 (0.0036)
= 0.00096 + 0.00144 = 0.0024
σA = 0.04899

20- What is the expected return on a portfolio that is 40% invested in A and 60% invested in B?
A) 0.100
B) 0.110
C) 0.121
D) 0.128
E) 0.138

Solution
m
E( R P )= ∑ w j E( R j )
j=1

E(Rboom) = 0.4 (15%) + 0.6 (8%) = 6% + 4.8% = 10.8%

E(Rbust) = 0.4 (5%) + 0.6 (20%) = 2% + 12% = 14%
E(RP) = 0.6 (10.8%) + 0.4 (14%) = 6.48% + 5.6% = 12.08% = 0.128

21- What is the expected return on a portfolio that is equally-weighted amongst A, B, and the
risk-free asset? The expected return on the risk-free asset is 4%.
A) 0.089
B) 0.093
C) 0.101
D) 0.118
E) 0.138

Solution
m
E( R P )= ∑ w j E( R j )
j=1
E(Rboom) = (1/3) (15%) + (1/3) (8%) + (1/3) (4%) = 27% / 3 = 9%
E(Rbust) = (1/3) (5%) + (1/3) (20%) + (1/3) (4%) = 29% / 3 = 9.66667%
E(RP) = 0.6 (9%) + 0.4 (9.66667%) = 9.26667% = 0.0926667

22- What is the standard deviation of a portfolio with one-quarter of the funds in A?
A) 0.0008
B) 0.0065
C) 0.0089
D) 0.0103
E) 0.0320

Solution
wA = 0.25, wB = 0.75
m
E( R P )= ∑ w j E( R j )
j=1

E(Rboom) = 0.25 (15%) + 0.75 (8%) = 3.75% + 6% = 9.75%

E(Rbust) = 0.25 (5%) + 0.75 (20%) = 1.25% + 15% = 16.25%
E(RP) = 0.6 (9.75%) + 0.4 (16.25%) = 5.85% + 6.5% = 12.35%
n
σ =∑ pi (R i−E (R ))2
2

i=1

σP² = 0.6 (0.0975 - 0.1235)² + 0.4 (0.1625 - 0.1235)²

= 0.6 (-0.026)² + 0.4 (0.039)²
= 0.6 (0.000676) + 0.4 (0.001521)
= 0.0004056 + 0.0006084 = 0.001014
σP = 0.031843
23- What is the expected market return if the expected return on asset A is 16% and the risk-free
rate is 7%? Asset A has a beta of 1.2.
A) 9.5%
B) 14.5%
C) 16.5%
D) 17.5%
E) 20.5%

Solution:
E(RA) = Rf + bA[E(RM) – Rf]
16% = 7% + 1.2 [E(RM) – 7%]
9% = 1.2 [E(RM) – 7%]
7.5% = E(RM) – 7% → E(RM) = 14.5%