Chapter 6

Risk and Return: The Basics

ANSWERS TO END-OF-CHAPTER QUESTIONS

6-1 a. Stand-alone risk is only a part of total risk and pertains to the risk an investor takes
by holding only one asset. Risk is the chance that some unfavorable event will occur.
For instance, the risk of an asset is essentially the chance that the asset’s cash flows
will be unfavorable or less than expected. A probability distribution is a listing, chart
or graph of all possible outcomes, such as expected rates of return, with a probability
assigned to each outcome. When in graph form, the tighter the probability
distribution, the less uncertain the outcome.

b. The expected rate of return ( ) is the expected value of a probability distribution of

expected returns.

c. A continuous probability distribution contains an infinite number of outcomes and is

graphed from - and +.

d. The standard deviation (σ) is a statistical measure of the variability of a set of

observations. The variance (σ2) of the probability distribution is the sum of the
squared deviations about the expected value adjusted for deviation. The coefficient
of variation (CV) is equal to the standard deviation divided by the expected
return; it is a standardized risk measure which allows comparisons between
investments having different expected returns and standard deviations.

e. A risk averse investor dislikes risk and requires a higher rate of return as an
inducement to buy riskier securities. A realized return is the actual return an investor
receives on their investment. It can be quite different than their expected return.

f. A risk premium is the difference between the rate of return on a risk-free asset and the
expected return on Stock i which has higher risk. The market risk premium is the
difference between the expected return on the market and the risk-free rate. [ Risk
premium depends on business risk, financial risk, liquidity risk, country risk and
exchange rate risk]

g. CAPM [Capita Asset Pricing Model] is a model based upon the proposition that any
stock’s required rate of return is equal to the risk free rate of return plus a risk
premium reflecting only the risk remaining after diversification. [ rs = required
return of security = RFR + Beta (Rm - RFR); here Rm -RFR is the risk premium]
 h. The expected return on a portfolio. p, is simply the weighted-average expected
return of the individual stocks in the portfolio, with the weights being the fraction
of total portfolio value invested in each stock. The market portfolio is a portfolio
consisting of all stocks.

i. Correlation is the tendency of two variables to move together. A correlation

coefficient (ρ) of +1.0 means that the two variables move up and down in perfect
synchronization, while a coefficient of -1.0 means the variables always move in
opposite directions. A correlation coefficient of zero suggests that the two variables
are not related to one another; that is, they are independent.

j. Market risk is that part of a security’s total risk that cannot be eliminated by
diversification. It is measured by the beta coefficient. Diversifiable risk is also
known as company specific risk, that part of a security’s total risk associated with
random events not affecting the market as a whole. This risk can be eliminated by
proper diversification. The relevant risk of a stock is its contribution to the riskiness
of a well-diversified portfolio.

k. The beta coefficient is a measure of a stock’s market risk, or the extent to which the
returns on a given stock move with the stock market. The average stock’s beta
would move on average with the market so it would have a beta of 1.0.

l. The security market line (SML) represents in a graphical form, the relationship
between the risk of an asset as measured by its beta and the required rates of return
for individual securities. The SML equation is essentially the CAPM, r i = rRF + bi(rM -
rRF).

m. The slope of the security market line (SML) equation is (r M - rRF), the market risk
premium. The slope of the SML reflects the degree of risk aversion in the economy.
The greater the average investors aversion to risk, then the steeper the slope, the
higher the risk premium for all stocks, and the higher the required return.

6-3 Security A is less risky if held in a diversified portfolio because of its lower beta and
negative correlation with other stocks. In a single-asset portfolio, Security A would be
more risky because σA > σB and CVA > CVB.

6-5 The risk premium on a high beta stock would increase more.

RPj = Risk Premium for Stock j = (rM - rRF)bj.

If risk aversion increases, the slope of the SML will increase, and so will the market risk
premium (rM – rRF). The product (rM – rRF)bj is the risk premium of the jth stock. If b j is
low (say, 0.5), then the product will be small; RP j will increase by only half the increase
 in RPM. However, if bj is large (say, 2.0), then its risk premium will rise by twice the
increase in RPM.

6-6 According to the Security Market Line (SML) equation, an increase in beta will increase
a company’s expected return by an amount equal to the market risk premium times the
change in beta. For example, assume that the risk-free rate is 6 percent, and the market
risk premium is 5 percent. If the company’s beta doubles from 0.8 to 1.6 its expected
return increases from 10 percent to 14 percent. Therefore, in general, a company’s
expected return will not double when its beta doubles.
 SOLUTIONS TO END-OF-CHAPTER PROBLEMS[ Risk and return]

6.1 Investment Beta ( it is measurement of systematic risk]

$35,000 0.8
40,000 1.4
Total $75,000

Portfolio Beta = Summation of [Wi*Beta] = ($35,000/$75,000)(0.8) + ($40,000/$75,000)(1.4) =

1.12.

6-3 rRF = 5%; RPM = Risk premium = Rm -Rrf = 6%; rM = Market return = ?
[ CAPM Model: rs = return of shares = rfr + Beta ( Rm -rfr)

rM = rfr + beta of market ( Rm -rfr) = 5% + 1(6%) = 11%.

rs when b = 1.2 = ?

rs = rfr + beta ( Rm -rfr) = 5% + 1.2*6% = 12.2%.

6.4: r = Sum of [Probability of * Possible return]

= Expected return = (0.1)(-50%) + (0.2)(-5%) + (0.4)(16%) + (0.2)(25%) + (0.1)
(60%)
= 11.40%.= expected return

σ2 = (-50% - 11.40%)2(0.1) + (-5% - 11.40%)2(0.2) + (16% - 11.40%)2(0.4)

+ (25% - 11.40%)2(0.2) + (60% - 11.40%)2(0.1)
σ2 = 712.44; σ = standard deviation = sqrt(σ2) = 26.69%.

CV = coefficient of variation = stdev/expected return = = 2.34. [ CV is a

relative measure of risk [ Use it when there is scale problem or there is huge size difference
of investments of two stocks]. CV 2.34 implies that for every one Taka average return risk
is 234%. The lower the CV, the better.
6-5 a. m = sum (wi*ri) = (0.3)(15%) + (0.4)(9%) + (0.3)(18%) = 13.5%.

= (0.3)(20%) + (0.4)(5%) + (0.3)(12%) = 11.6%.

j

b. σM = [(0.3)(15% - 13.5%)2 + (0.4)(9% - 13.5%)2 + (0.3)(18% -13.5%)2]1/2

= = 3.85%.

σJ = [(0.3)(20% - 11.6%)2 + (0.4)(5% - 11.6%)2 + (0.3)(12% - 11.6%)2]1/2

= = 6.22%.

c. CVM = coefficient of variation of market = = 0.29.

CVJ = coefficient of variation of a security (j) = = 0.54.

[ Lower the CV, the better]

6-6 a. rA = rRF + (rM - rRF)bA

12% = 5% + (10% - 5%)bA
12% = 5% + 5%(bA)
7% = 5%(bA)
1.4 = bA.

b. rA = 5% + 5%(bA)
rA = 5% + 5%(2)
rA = 15%.

6-7 a. ri = rRF + (rM - rRF)bi = 9% + (14% - 9%)1.3 = 15.5%.

b. 1. rRF increases to 10%:

rM increases by 1 percentage point, from 14% to 15%.

ri = rRF + (rM - rRF)bi = 10% + (15% - 10%)1.3 = 16.5%.

2. rRF decreases to 8%:

rM decreases by 1%, from 14% to 13%.

ri = rRF + (rM - rRF)bi = 8% + (13% - 8%)1.3 = 14.5%.

c. 1. rM increases to 16%:
 ri = rRF + (rM - rRF)bi = 9% + (16% - 9%)1.3 = 18.1%.

2. rM decreases to 13%:

ri = rRF + (rM - rRF)bi = 9% + (13% - 9%)1.3 = 14.2%.

6-8 [ Page 259] Old portfolio beta = (b) + (1.00)

1.12 = 0.95b + 0.05
1.07 = 0.95b
1.13 = b.

New portfolio beta = Summation (wi*beta) = 0.95(1.13) + 0.05 (1.75) = 1.16.

6-9 Portfolio beta = Summation (wi*beta)

= (1.50) + (-0.50) + (1.25) + (0.75)
= 0.1)(1.5) + (0.15)(-0.50) + (0.25)(1.25) + (0.5)(0.75)
= 0.15 - 0.075 + 0.3125 + 0.375 = 0.7625.

According CAPM model, the return of the portfolio ( Rp) is:

rp = rRF + (rM - rRF)(bp) = 6% + (14% - 6%)(0.7625) = 12.1%.
6-10 First, calculate the beta of what remains after selling the stock:

bp = 1.1 = ($100,000/$2,000,000)0.9 + ($1,900,000/$2,000,000)bR

1.1 = 0.045 + (0.95)bR
bR (Beta of remaining stocks) = 1.1105.

bN = (0.95)1.1105 + (0.05)1.4 = 1.125.

See Page number 258, ST (2).

…………………………………..

Wa = 40%, Wb = 60%
Ra = 10%, Rb = 12%
Stdev(a) = 7%;
Stdev(b) = 11%

Correlation(a,b) = -0.7 [ If two securities correlation is negative, it indicates that we can

diversify the unsystematic risk; If two securities correlation is very strongly positive, it indicates
that we can not diversify the unsystematic risk;
Decision: If the correlation is <1 to -1; we can diversify the unsystematic risk]

Return = Wa*Ra + Wb*Rb = .4*.1 + 0.6*0.12 = 4% + 7.2% = 11.2%

Portfolio Risk (Variance)

= Wa^2*Variance(a)+ Wb^2*Variance(b)+2wa*wb*stdev(a)*stdev(b)*correlation (a,b)

= 0.4^2*0.07^2+ 0.6^2*0.11^2+ 2*0.4*0.6*.07*.0.11*(-0.7)

[ The lower the correlation, the lower the portfolio risk for a given amount return]

…………..
A, B, C

AB; BC; CA