Fundamentals of Finance

Tutorial 4

Practical applications of methods

that link risk and returns

Question 1

A game of chance offers the following odds and payoffs. Each play of the game costs $100,
so the net profit per play is the payoff less than $100.

Probability Payoff Net Profit

0.10 $500 $400
0.50 $100 $0
0.40 $0 –$100

a. What is the expected cash payoff and expected rate of return?

b. Calculate the variance and standard deviation of this rate of return.

Solution:

a.

Expected cash payoff = (.10 × $500) + (.50 × $100) + (.40 × $0)

= $100

Expected rates of return:

($500 – 100) / $100 = 400%

($100 – 100) / $100 = 0%
($0 – 100) / $100 = –100%
 Fundamentals of Finance – Tutorial 4 Solutions

Expected rate of return = (.10 × 400%) + (.50 × 0%) + (.40 × –100%)

Expected rate of return = 0%

Variance = .10(400% – 0)2 + .50(0% – 0)2 + .40(–100% – 0)2

Variance = 20,000

Standard deviation = 20,000.1/2

Standard deviation = 141.42%

Question 2

You are an investment manager who holds a diversified portfolio. You are considering
adding the following two stocks to your portfolio. Which of these stocks is the safer
investment?

Standard Deviation Beta

Lonesome Gulch Mine 42% 0.10
Amalgamated Copper 31% 0.66

Solution:

In the context of a well-diversified portfolio, the only risk characteristic of a single

security that matters is the security’s contribution to the overall portfolio risk. This
contribution is measured by beta. Lonesome Gulch is the safer investment for a
diversified investor because its beta of .10 is lower than the beta of Amalgamated
Copper of .66. For a diversified investor, the standard deviations, which measure
total risk, are irrelevant.

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Question 3

As a portfolio manager, you are considering an investment in Ford and Harley Davidson.
After some research, you have the following historical data on the risk characteristics of
Ford and Harley Davidson.

Ford Harley Davidson US Market

Beta 1.26 0.96
Standard Deviation (%) 18.9 23.1 9.5

The correlation between Ford’s and Harley Davidson’s returns is 0.30.

a. What is the standard deviation of a portfolio invested half in each share?

b. What is the standard deviation of a portfolio that invested one-third in Ford, one-
third in Harley Davidson, and one-third in Treasury bills?

c. What is the approximate standard deviation of a portfolio composed of 100 stocks

with betas of 1.26 like Ford? How about 100 stocks like Harley Davidson?

Solution:
In general:
σP = (x12s12 + x22s22 + 2x1x2r12s1s2)0.5

a.
sP = (.52 × .1892 + .52 × .2312 + 2 × .5 × .5 × .30 × .189 × .231)0.5
sP = .169763 = 0.1698 (rounded), or 16.98%

b.

The easiest way to think of this portfolio is a two-asset portfolio containing

one-third T-Bills and two-thirds of the portfolio in Part a. (half Ford and half
Harley Davidson). Because the risk of T-bills is zero, the portfolio standard
deviation is two-thirds of the standard deviation computed in Part (a) above:

sP = ((1/3)2 × 0 + (2/3)2 × 0.16982 + 2(1/3) × (2/3) × 0.1698 × 0)0.5

= (2/3) ×0.1698 = .1132, or 11.32%

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c.

With 100 stocks, the portfolio is well diversified. Hence, the portfolio
standard deviation depends almost entirely on the average covariance of the
securities in the portfolio (measured by beta) and on the standard deviation
of the market portfolio. Thus, for a portfolio made up of 100 stocks each with
Ford’s beta of 1.26, the portfolio standard deviation is approximately:

sP = 1.26 × 9.5% = 11.97%

For stocks like Harley Davidson, the approximate standard deviation is:

sP = 0.96 × 9.5% = 9.12%.

To calculate the standard deviation (SD) of a security from its beta and the
market standard deviation, you can use the concept of beta as a measure of
the security's volatility relative to the market. Beta is a measure of the
sensitivity of the security's returns to the returns of the market.

Question 4

You are a wealth manager. One of your clients has $10 million invested in long-term
corporate bonds. This bond portfolio’s expected annual rate of return is 9%, and the annual
standard deviation is 10%.

You try to persuade your client to invest in an index fund that closely tracks the Standard &
Poor’s 500 Index. The index has an expected return of 14%, and its standard deviation is
16%.

a. Suppose your client invests all her funds in a combination of the index fund and
Treasury bills. Can the client improve her expected rate of return without changing
the risk of his portfolio? The Treasury bill yield is 6%.

b. Could you do even better by investing equal amounts in the corporate bond
portfolio and the index fund? The correlation between the bond portfolio and the
index fund is +0.1.

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Solution

a. The current portfolio provides an expected return of 9% with an annual

standard deviation of 10%. First, we find the portfolio weights for a
combination of risky-free Treasury bills (Security 1: standard deviation = 0
percent) and the index fund (Security 2: standard deviation = 16 percent) that
achieves 10 percent. In general, for a 2-security portfolio:
sP2 = x12s12 + 2x1x2s1s2r12 + x22s22
.102 = 0 + 0 + x22(.162)
x2 = .625

Second, since all funds are to be invested, we know that x1 + x2 =1.

x1 = (1 – .625)
x1 =.375

Given these weights, the portfolio return is:

rp = x1r1 + x2r2
rp = .375(.06) + .625(.14)
rp = .110, or 11.0%

Therefore, the client can improve her expected rate of return without
changing the risk of her portfolio.

b. With equal amounts in the corporate bond portfolio (Security 1) and the
index fund (Security 2), the expected return is:

rp = x1r1 + x2r2
rp = .5(.09) + .5(.14)
rp = .115, or 11.5%

σP2 = x12s12 + 2x1x2s1s2r12 + x22s22

sP2 = .52(.10)2 + 2(.5)(.5)(.10)(.16)(.10) + .52(.16)2

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sP2 = .0097
sP = .0985, or 9.85%

Therefore, she can do even better by investing equal amounts in the corporate
bond portfolio and the index fund. Her expected return increases to 11.5%, and
the standard deviation of his portfolio decreases to 9.85%.

Summary rp sP
100 % bonds 9% 10%
62.5% index fund + 37.5% Treasury bills 11% 10%
50% bonds + 50% index fund 11.5% 9.85%

Question 5

You are an analyst with a fund management company. The fund manager is worried about
changes in the expected returns of the fund’s investments caused by an increase in the risk-
free rate of return. She has asked you to estimate returns assuming Treasury rates of 6%.
Treasury rates are currently 2%.

You have the following data on the market risk and expected returns of each of the holdings
in the fund based on current Treasury rates of 2%.

Stock Beta Expected Return

United States Steel 3.01 23.1
Amazon 1.47 12.3
Southwest Airlines 1.35 11.5
The Travelers Companies 1.26 10.8
Tesla 0.94 8.6
ExxonMobil 0.82 7.7
Johnson & Johnson 0.81 7.7
Coca-Cola 0.70 6.9
Consolidated Edison 0.11 2.8
Newmont 0.10 2.7

You now assume that the Treasury bill rate is 6% and that the expected market return
remains constant.

a. What is the expected return for Johnson & Johnson?

b. Find the highest expected return offered by one of these stocks.

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c. Find the lowest expected return offered by one of these stocks.

d. If risk-free rates increase, do stocks offer a higher or lower expected return?

Solution

First, work out the expected market return (rm) assuming a 2% return on Treasury Bills (rf)
Generally: r - rf = β(rm – rf)

Solve for rm
rm = (r -rf)/ β + rf

Second, using any of the stocks listed in the table gives a market return (rm) of approx. 9%.

a. r = .06 + .81(.09 – .06) = .0843, or 8.43%

b. r = .06 + 3.01(.09 – .06) = .1503, or 15.03%

c. r = .06 + 0.10(.09 – .06) = .0630, or 6.30%

d. Generally, that depends on the beta of the stock. The risk-free rate increases
and the market risk premium decreases by the same percentage (4%).

If beta >1, expected returns decrease and

if beta <1 expected returns increase.

Stock Beta Expected Expected

Return Return
rf rate =2% rf rate =6%
United States Steel 3.01 0.2307 0.1503
Amazon 1.47 0.1229 0.1041
Southwest Airlines 1.35 0.1145 0.1005
The Travelers Companies 1.26 0.1082 0.0978
Tesla 0.94 0.0858 0.0882
ExxonMobil 0.82 0.0774 0.0846
Johnson & Johnson 0.81 0.0767 0.0843
Coca-Cola 0.70 0.0690 0.0810
Consolidated Edison 0.11 0.0277 0.0633
Newmont 0.10 0.0270 0.0630