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Tutorial 8 Questions

Uploaded by

k63.2412580003
Copyright
© © All Rights Reserved
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FINM 2412 Financial Management for Business

Tutorial 8 Questions

1. Three stocks have the following risk-return characteristics:

Stock Expected Return Standard Deviation

A 20% 38%

B 12% 15%

C 15% 28%

(a) If there is no risk-free asset, do any of these three stocks clearly dominate any other
in terms of risk and return?

Now assume there is a risk-free asset with a guaranteed return of 5% p.a. You can now
form a portfolio consisting of one risky asset plus the risk-free asset. You are willing to bear
a standard deviation of 25% p.a. for your portfolio.

(b) For a portfolio comprising Stock A and the risk-free asset, what weights will you
assign to each in order to get the desired level of risk? What is the expected return
on this portfolio? Repeat this for Stock B, then Stock C.

(c) Which of the three portfolios from part (b) is dominant? (Hint: There is a clear
winner.)

COMMENTARY:

 This question illustrates how the introduction of a risk-free asset enables us to


clearly identify the dominant asset. We could not do this in part (a) when there was
no risk-free asset.
 The answers do not depend on my desired level of risk (standard deviation of 25%
p.a. above). If you re-do the entire question with a desired level of risk of 10% p.a.
standard deviation, you'll still get the same dominant asset.
 To see why one asset dominates, plot the risk-return characteristics of the three
assets on the usual graph. Draw a line connecting each asset with the risk-free
asset. The dominant asset is the one with the steepest slope.

1
2. Consider the following information for Stocks 1 and 2:

Stock Expected Return Standard Deviation

1 20% 40%

2 12% 20%

The correlation between the returns of these two stocks is 0.3.

(a) How will you divide your money between Stocks 1 and 2 if your aim is to achieve a
portfolio with an expected return of 18% p.a.? That is, what are the weights assigned
to each stock? Also, take note of the risk (i.e., standard deviation) of this portfolio.

Now assume that in addition to the two risky stocks, there is a risk-free investment with a
guaranteed return of 5% p.a. This gives you the opportunity to use the risk-free asset in
your portfolio.

(b) You create a portfolio with 79.65% of your funds invested in Stock 1 and 20.35%
invested in the risk-free asset. Calculate the expected return and standard deviation
of this portfolio.

(c) How does the portfolio in part (b) compare to the portfolio in part (a)? Which portfolio
do you prefer? Why?

(d) Calculate the weights in the risk-free asset and Stock 2 that are required to achieve
a portfolio with the same risk as in parts (a) and (b). How does its expected return
compare? (Hint: you will have to borrow at the risk-free rate and invest the proceeds
in Stock 2 to get the desired risk for this portfolio.)

(e) Finally, consider a third risky asset: Stock 3. Stock 3 has an expected return of 15%
p.a. and standard deviation of 25% p.a. Does the combination of the risk-free asset
and Stock 3 dominate the combinations previously examined?

3. Assume the following data:

 the expected return on the market is 13% p.a.,


 the variance of the return on the market is 0.14, and
 the risk-free rate is 6% p.a.
Your task is to determine a discount rate appropriate for a single company, BHP. If the
variance of BHP’s return is 0.30 and its beta is 1.20, what is the expected return of BHP?

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