Tutorial & Computer Lab – Week 5

Parrino et al. Chapter 7

Instructions

• Spend the first 50 min on these tutorial questions

• Spend the remaining 40 min on working through the Computer Lab questions at
the end of this document (students may work in groups of up to 3 people)

Note: Tutors may not be able to cover all tutorial questions/excel exercises during the
tutorial time. Students are expected to complete all remaining exercises as part of their own
self-study.

1. Explain the relationship between risk and return.

2. Describe the two components of a total holding period return, and calculate this return for an
asset.

3. Discuss which type of risk matters to investors and why.

4. Given that you know the risk as well as the expected return for two shares, discuss what
process you might utilise to determine which of the two shares is a better buy. You may
assume that the two shares will be the only assets held in your portfolio.

5. Expected returns: You have chosen biology as your college major because you would like to
be a medical doctor. However, you find that the probability of being accepted into medical
school is about 18 per cent. If you are accepted into medical school, then your starting salary
when you graduate will be $346 085 per year. However, if you are not accepted, then you
would choose to work in a zoo, where you will earn $42 530 per year. Without considering the
additional educational years or the time value of money, what is your expected starting salary
as well as the standard deviation of that starting salary?

6. Single-asset portfolios: Shares A, B, and C have expected returns of 17.12 per cent, 12.62 per
cent, and 11.34 per cent, respectively, while their standard deviations are 41.54 per cent,
26.55 per cent, and 34.63 per cent, respectively. If you were considering the purchase of each
of these shares as the only holding in your portfolio, then which share should you choose?

7. CAPM: Describe the Capital Asset Pricing Model (CAPM) and what it tells us.
8. Calculating the variance and standard deviation: You are considering purchasing shares in Lake
Awoonga Scenic Tours Ltd. You have observed the following returns on this share over the last
four years:

Year 1 2 3 4
Return – 8% 3% 16% 5%

What is the expected return and standard deviation of the return on Awoonga Scenic Tours
shares?

9. Calculating the variance and standard deviation: Sandra is considering investing in a share and
is aware that the return on that investment is particularly sensitive to how the economy is
performing. Her analysis suggests that four states of the economy can affect the return on the
investment. Using the table of returns and probabilities below, find the expected return and
the standard deviation of the return on Sandra’s investment.

Probability Return

Boom 0.3 25.00%

Good 0.4 15.00%

Level 0.2 10.00%

Slump 0.1 -5.00%

10. Portfolios with more than one asset: Given the returns and probabilities for the three possible
states listed here, calculate the covariance between the returns of Share A and Share B. For
convenience, assume that the expected returns of Share A and Share B are 11.75 per cent and
18 per cent, respectively.

Probability Return(A) Return(B)

Good 0.30 0.30 0.50

OK 0.50 0.10 0.10

Poor 0.2 -0.25 -0.30

11. Compensation for bearing systematic risk: You have constructed a diversified portfolio of
shares such that there is no unsystematic risk. Explain why the expected return of that
portfolio should be greater than the expected return of a risk-free security.
 12. David is going to purchase two shares to form the initial holdings in his portfolio. Iron share
has an expected return of 14 per cent, while Copper share has an expected return of 28 per
cent. If David plans to invest 30 per cent of his funds in Iron and the remainder in Copper, then
what will be the expected return from his portfolio? What if David invests 70 per cent of his
funds in Iron shares?

Computer Lab Exercise

Download acst6003-week5-computer-lab.docx Excel file from iLearn (under Week 5

tutorial). The file contains monthly data for 10 year government bond rate (risk-free), All
Ordinaries Share price index (market), and share prices for BHP, Qantas and Commonwealth
bank over the period 2000 – 2020.
1. Add a new sheet called “returns” and compute monthly returns for the All Ordinaries,
𝑃𝑃𝑡𝑡
BHP, QAN and CBA using the following formula 𝑅𝑅𝑡𝑡 = �𝑃𝑃 − 1�. Compute a monthly
𝑡𝑡−1
𝑅𝑅𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎,𝑡𝑡
10 year bond rate as follows: 𝑅𝑅𝑟𝑟𝑓𝑓,𝑡𝑡 = � �
12

2. Compute 𝐸𝐸(𝑅𝑅), 𝜎𝜎 𝑎𝑎𝑎𝑎𝑎𝑎 𝐶𝐶𝐶𝐶 for each of the returns series. Also compute the correlation
coefficient and covariance between each return series and the market. Comment on your
analysis.
3. Create a new sheet called “excess returns” and compute excess returns for the market,
𝑒𝑒
i.e., market risk premium as 𝑅𝑅𝑚𝑚.𝑡𝑡 = 𝑅𝑅𝑚𝑚,𝑡𝑡 − 𝑅𝑅𝑟𝑟𝑟𝑟,𝑡𝑡 where 𝑅𝑅𝑚𝑚,𝑡𝑡 is the return on the All
Ords computed in 1, and 𝑅𝑅𝑟𝑟𝑟𝑟,𝑡𝑡 indicates the monthly return on the 10 yea bond rate
computed in 1. Also compute the excess return for each of BHP, QAN and CBA as
follows: 𝑅𝑅𝑡𝑡𝑒𝑒 = 𝑅𝑅𝑡𝑡 − 𝑅𝑅𝑟𝑟𝑟𝑟,𝑡𝑡
4. Estimate the CAPM betas for each of the BHP, QAN and CBA using excess returns by
estimating the following regressions:
𝑅𝑅𝑡𝑡𝑒𝑒 = 𝛼𝛼 + 𝛽𝛽𝑅𝑅𝑚𝑚,𝑡𝑡
𝑒𝑒
− 𝜇𝜇𝑡𝑡

You will need to use Regression model in excel to run this model. In Excel click Data
Analysis  Regression  For Y range highlight each of the BHP, QAN and CBA (one
at a time) for X range highlight (excess return on All Ords).
5. Comment on the three estimated beta coefficients, i.e., for BHP, QAN and CBA.