ASSET PRICING AND FINANCIAL MARKETS

CHAPTER 7 – RISK, RETURN AND STOCK MARKETS

TUTORIAL ANSWERS

Question 1
Tom is looking to invest in three shares in a portfolio. Share X = $2,000; Share Y = $5,000; and
Share Z = $3,000. The expected returns on each of the shares is as follows: Share X = 15%;
Share Y = 10%; Share Z = 20%.
What is the Expected Return of Tom’s portfolio?
ANSWER:
Information given in the Question
 Investment ∈ Share X=$ 2,000
 Investment ∈ ShareY =$ 5,000
 Investment ∈ Share Z=$ 3,000
 Total Investment ∈Share X , Y Z=$ 2,000+ $ 5,000+ $ 3,000=$ 10,000
$ 2,000
 x X =Weighting of Share X= =.2=20 %
$ 10,000
$ 5,000
 x Y =Weighting of ShareY = =.5=50 %
$ 10,000
$ 3,000
 x Z =Weighting of Share Z= =.3=30 %
$ 10,000
 μ X =Expected Return∈ Share X=15 %=.15
 μY =Expected Return∈Share Y =10 %=.10
 μZ =Expected Return∈ Share Z=20 %=.20

FORMULA FOR EXPECTED RETURN OF PORTFOLIO

E ( R p ) =x 1∗μ1 + x 2∗μ2 + x n∗μn

E ( R p ) =x X ∗μ X + x Y ∗μY + x Z∗μ Z

E ( R p ) =.20∗.15+.50∗.10+ .30∗.20

E ( R p ) =.03+.05+.06=.14=14 %

Question 2
Sam has a portfolio as follows:
Asset Class Amount Expected Returns
Stocks $50,000 7%
Real Estate $300,000 4%
Cash and Liquidity $150,000 1%
Total $500,000

Calculate the Expected Return of Sam’s portfolio?

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ANSWER:
Information from Question
 Investment ∈ Stocks=$ 50,000
 Investment ∈ Real Estate=$ 300,000
 Investment ∈Cash∧Liquidity=$ 150,000

Total Investment ∈Stocks , Real Estate∧Cash∧Liquidity=$ 50,000+ $ 300,000+ $ 150,000=$ 500,000

$ 50,000
 x S =Weighting of Stocks= =.1=10 %
$ 500,000
$ 300,000
 x ℜ=Weighting of Real Estate= =.6=60 %
$ 500,000
$ 150,000
 x CL=Weighting of Cash∧Liquidity= =.3=30 %
$ 500,000

 μS =Expected Return∈ Stocks=7 %=.07

 μ ℜ= Expected Return∈ Real Estate=4 %=.04
 μCL=Expected Return∈Cash∧Liquidity=1 %=.01
FORMULA FOR EXPECTED RETURN OF PORTFOLIO
E ( R p ) =x 1∗μ1 + x 2∗μ2 + x n∗μn

E ( R p ) =x S∗μ S + x ℜ∗μ ℜ + xCL∗μCL

E ( R p ) =.10∗.07+.60∗.04+.30∗.01

E ( R p ) =.007+.024 +.003=.034=3.4 %

Question 3
Stocks X and Y have expected returns of 12% and 20% respectively. Their returns standard
deviation are 25% and 40%.
a) If the stocks returns are uncorrelated, workout the mean return and the return standard
deviation of the portfolio which places 1/3 on X and 2/3 on Y.
b) Using the same weights, work out the portfolio risk and return under the assumption that:
i) The returns have perfect positive correlation = +1
ii) The returns have perfect negative correlation = -1
c) Use your preceding answers to illustrate the effects of diversification on portfolio risk.

ANSWER:
a.
Information from Question
 μ X =Expected Return∈ Stock X =12 %=.12
 μY =Expected Return∈Stock Y =20 %=.2
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 x X =Weighting of Stock X = =.333=33.3 %
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 2
 x Y =Weighting of Stock Y = =.667=66.7 %
3
 σ X =Standard Deviation X=25 %
 σ Y =Standard Deviation Y =40 %
 However, as the Stock Returns are ‘Uncorrelated’, that means ‘Correlation Coefficient =
ρ1 , 2 = ‘0’ ‘Zero’.

FORMULA FOR EXPECTED RETURN OF PORTFOLIO

E ( R p ) =x 1∗μ1 + x 2∗μ2 + x n∗μn

E ( R p ) =x X ∗μ X + x Y ∗μY

E ( R p ) =.333∗.12+.667∗..2 0

E ( R p ) =.04+.1333=.1733=17.33 %

FORMULA FOR VARIANCE OF THE PORTFOLIO

 However, as the Stock Returns are ‘Uncorrelated’, that means ‘Correlation
Coefficient = ρ1 , 2 = ‘0’ ‘Zero’.

σ 2p=( x 2X∗σ 2X ) + ( x 2Y ∗σ 2Y ) +2∗x X∗xY ∗ρ X , Y ∗σ X∗σ Y

σ 2p=( .3332∗.252 ) + ( .6672∗.42 ) +2∗.333∗.667∗0∗.25∗.40

2
σ p=( .11∗.0625 ) + ( .44∗.16 )+ 0

2
σ p=.0069+.0704
2
σ p=.0773

FORMULA FOR STANDARD DEVIATION OF THE PORTFOLIO

Standard Deviation of the Portfolio=σ p=√ σ p

2

Standard Deviation of the Portfolio=σ p=√ .0773

Standard Deviation of the Portfolio=σ p=.2780=27.80 %

ANSWER
b (i)

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Perfect Positive Correlation = +1

σ 2p=( x 2X∗σ 2X ) + ( x 2Y ∗σ 2Y ) +2∗x X∗xY ∗ρ X , Y ∗σ X∗σ Y

σ 2p=( .3332∗.252 ) + ( .6672∗.42 ) +2∗.333∗.667∗1∗.25∗.40

2
σ p=( .11∗.0625 ) + ( .44∗.16 )+¿ .0444

2
σ p=.0069+.0704+ .0444

2
σ p=.1217

FORMULA FOR STANDARD DEVIATION OF THE PORTFOLIO

Standard Deviation of the Portfolio=σ p=√ σ 2p

Standard Deviation of the Portfolio=σ p=√ .1217

Standard Deviation of the Portfolio=σ p=.3489=34.89 %

ANSWER
b (ii)
Perfect Positive Correlation = -1

σ 2p=( x 2X∗σ 2X ) + ( x 2Y ∗σ 2Y ) +2∗x X∗xY ∗ρ X , Y ∗σ X∗σ Y

σ 2p=( .3332∗.252 ) + ( .6672∗.42 ) +2∗.333∗.667∗−1∗.25∗.40

2
σ p=( .11∗.0625 ) + ( .44∗.16 )+(−.0444)

2
σ p=.0069+.0704+(−.0444)

2
σ p=.0329

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FORMULA FOR STANDARD DEVIATION OF THE PORTFOLIO

Standard Deviation of the Portfolio=σ p=√ σ 2p

Standard Deviation of the Portfolio=σ p=√ .0329

Standard Deviation of the Portfolio=σ p=.1814=18.14 %

ANSWER
c
 When the Correlation Coefficient is ‘Uncorrelated’ being ‘0’ ‘Zero’ the Standard
Deviation of the Portfolio being the Risk of the Portfolio is = 27.80%
 When the Correlation Coefficient is Perfectly Positive +1 the Standard Deviation of the
Portfolio being the Risk of the Portfolio is = 34.89%
 When the Correlation Coefficient between Stock X and Stock Y is Perfectly Negatively
Correlated -1 the Standard Deviation of the Portfolio being the Risk of the Portfolio is the
lowest being = 18.14%

 What we can learn from this is that:

o when we choose Stocks in our Portfolio that have a Perfectly Negative

Correlation -1, where in if one stock goes up, then the other goes down
o we can see the benefits of Diversification being implemented and
o the Standard Deviation of our Portfolio being the Risk of our Portfolio being
Reduced from 34.89% with positive correlation +1
o to 27.80% being ‘uncorrelated’ ‘0’ ‘zero’ and
o finally achieving our goal of Diversification and reducing risk with negative
correlation of -1 to 18.14%,
o the lowest risk in the portfolio and also the lowest risk compared to just
individually investing in Stock A which has a standard deviation of 25% and
Stock B which has a standard deviation of 40%.

 Hence from this we can conclude that Investing in a Portfolio with the characteristics of
Negative Correlation -1 between the stocks/asset gives us the highest diversification
benefits by reducing risk to the lowest possible manner.

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Question 4
Using the same information as in Question 3, and assuming that the stocks returns are perfectly
negatively correlated, compute the portfolio weights for X and Y that must hold if the portfolio is
to have zero risk.

ANSWER:
For the portfolio to have ‘0’ ‘Zero Risk’ we need ‘Standard Deviation of the Portfolio σ p=0

 Now, Assume weight on Stock X = x X

 Thus, weight on Stock Y = x 2Y =(1−x X ) (Portfolio of 2 Assets)
 The Stock Returns are Perfectly Negatively Correlated ρ X .Y =−1

Hence, we have the Formula for Standard Deviation of Portfolio

σ p=√ x 2X∗σ 2X + x 2Y ∗σ 2Y + 2∗x X∗x Y ∗σ X∗σ Y ∗ρ X ,Y

σ p=√ x X∗σ X +¿ ¿
2 2

0=√ x 2X∗.252 +¿ ¿

√¿ ¿

x X∗( .25 )=( 1−x X )∗(.4 )

.25 x X +.4 x X =.4

.65 x X =.4

.4
x X= =.6154
.65

x Y =(1−x X )=1−.6154=.3846
Thus:
 Weighting on Stock X (x X ) is .6154 = 61.54%

 Weighting on Stock Y (x ¿¿ Y )¿ is .3846 = 38.46%

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Question 5
Below are some data on the percentage return on stock Z on the market portfolio (M) in 5
consecutive years:
Z M
1 12 6
2 -5 0
3 25 5
4 7 10
5 6 15

a) Compute the beta on stock Z with respect to the market (to two decimal places)
b) What does this beta imply for the manner in which Z’s return vary as the market return
varies?
ANSWER:
12+ (−5 ) +25+7 +6
Mean Return on Stock Z (RZ )=
5

12−5+25+ 7+6
Mean Return on Stock Z (RZ )= =9 %
5

6+0+5+ 10+15
Mean Return on Market Portfolio(R M )= =7.2 %
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Formula to Calculate Sample Standard Deviation

√
N
1
S= ∑ ¿¿¿
n−1 i=1

Using the Formula above, hence we can calculate the Sigma for Stock Z σ z and Sigma for
Market Portfolio σ M

√
N
1
σ Z= ∑ ¿¿¿
n−1 i=1

σ Z=
√ 1
5−1
¿¿

√
N
1
σ M= ∑ ¿¿¿
n−1 i=1

σ M=
√ 1
5−1
¿¿

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Formula to Calculate the Sample Covariance Cov(Z , M )

Cov(Z , M ) =
∑ ( R Z−R Z ) ( R M −R M )
n−1

Using the formula above, hence we can calculate Cov(Z , M )

( 12−9 )( 6−7.2 ) + (−5−9 ) ( 0−7.2 ) + ( 25−9 ) ( 5−7.2 )+ (7−9 )( 10−7.2 )+ ( 6−9 ) (15−7.2)
Cov Z , M =
5−1

Cov Z , M =8.25

Thus, the beta on Stock Z with respect to the Market

Cov Z , M
β Z= 2
σM

8.25
β Z= 2
5.6303

β Z =0.26

 Here the Beta is Positive, which means that return on stock Z goes in the same direction
with the Market’s changes.
 For every 1% increase (decrease) in the Market Portfolio, we will expect Stock Z’s return
to rise (fall) by 0.26%

Question 6
What is the beta of each of the stocks shown in the below Table?

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Answer:

The beta of each stock is given by the slope of the line, or the rise divided by the run. The run is
the range of the market returns while the rise is the range of the stock returns.

BetaA = (0 – 20) / (–10 – 10) = 1

BetaB = (–20 – 20) / (–10 – 10) = 2

BetaC = (–30 – 0) / (–10 – 10) = 1.5

BetaD = (15 – 15) / (–10 – 10) = 0

BetaE = (10 – (–10) / (–10 – 10) = –1

Question 7
There are few, if any, real companies with negative betas. But suppose you found one with
β = – 0.25.
a. How would you expect this stock’s rate of return to change if the overall market rose by an
extra 5%? What if the market fell by an extra 5%?
b. You have $1 million invested in a well-diversified portfolio of stocks. Now you receive an
additional $20,000 bequest. Which of the following actions will yield the safest overall
portfolio return?
i. Invest $20,000 in Treasury bills (which have β = 0).
ii. Invest $20,000 in stocks with β = 1.
iii. Invest $20,000 in the stock with β = –.25.
Explain your answer.

Answer:
a-1. Change in stock’s rate of return = .05 × –.25 = –.0125, or –1.25%

a-2. Change in stock’s rate of return = –.05 × –.25 = .0125, or 1.25%

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b. “Safest” implies lowest risk. Assuming the well-diversified portfolio is invested in
typical securities, the portfolio beta is approximately one. The largest reduction in beta is
achieved by investing the $20,000 in a stock with the negative beta.

Question 8
Suppose that Treasury bills offer a return of about 6% and the expected market risk premium is
8.5%. The standard deviation of Treasury-bill returns is zero and the standard deviation of
market returns is 20%. Use the formula for portfolio risk to calculate the standard deviation of
portfolios with different proportions in Treasury bills and the market. (Note: The covariance of
two rates of return must be zero when the standard deviation of one return is zero.) Graph the
expected returns and standard deviations.

Answer:
For a two-security portfolio, the formula for portfolio risk is:

σP2= x1212 + x2222 + 2x1x21212

If security one is Treasury bills and security two is the market portfolio, then 1 is zero, and 2 is 20%.
Therefore:

σP2 = x2222 = x22 × .202

σP = .20x2

Portfolio expected return = x1(.06) + x2(.06 + .085)

Portfolio expected return = .06x1 + .145x2

Expected Standard
Portfolio x1 x2
Return Deviation
1 1.0 .0 .060 .000
2 .8 .2 .077 .040
3 .6 .4 .094 .080
4 .4 .6 .111 .120
5 .2 .8 .128 .160
6 .0 1.0 .145 .200

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 Portfolio Risk & Return
.16
.14
.12
Expected Return

.10
.08
.06
.04
.02
.00
.00 .05 .10 .15 .20 .25
Standard Deviation

Question 9
Here are some historical data on the risk characteristics of Ford and Harley Davidson:
Assume the standard deviation of the return on the market was 9.5%.
a. The correlation coefficient of Ford’s return versus Harley Davidson is 0.30. What is the
standard deviation of a portfolio invested half in each share?
b. What is the standard deviation of a portfolio invested one-third in Ford, one-third in
Harley Davidson, and one-third in risk-free Treasury bills?
c. What is the standard deviation if the portfolio is split evenly between Ford and Harley
Davidson and is financed at 50% margin, that is, the investor puts up only 50% of the total
amount and borrows the balance from the broker?
d. 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?

Answer:
a. In general:
σP = (x1212 + x2222 + 2x1x21212).5
Thus:
P = (.52 × .1892 + .52 × .2312 + 2 × .5 × .5 × .30 × .189 × .231).5
P = .169763 = 0.1698 (rounded), or 16.98%

b. One of these securities, T-bills, has zero risk and, hence, zero standard deviation. Thus:

P = [(1/3)2 × .1892 + (1/3)2 × .2312 + 2 × (1/3) × (1/3) × .30 × .189 ×

.231].5
P = .1132, or 11.32%

Another way to think of this portfolio is that it is comprised of one-third T-Bills and two-thirds a portfolio
which is 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:

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 P = (2/3) × 16.98% = 11.32%

c. With 50% margin, the investor invests twice as much money in the portfolio as he had to begin
with. Thus, the risk is twice that found in Part (a) when the investor is investing only his own
money:

P = 2  16.9763% = 33.9525% = 33.95% (rounded)

d. With 100 stocks, the portfolio is well diversified, and 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:

P = 1.26  9.5% = 11.97%

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

P = 0.96  9.5% = 9.12%

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