Chapter 10: Risk and Return: Lessons from Market History

Questions and Problems:

10.1 The return of any asset is the increase in price, plus any dividends or cash flows, all divided by
the initial price. The return of this stock is:

R = [($104 – $92) + $1.45]/$92

R = 0.1462 or 14.62%

10.2 Using the equation for total return, we find:

R = [($67 – $92) + $1.45]/$92

R = –0.2560 or –25.60%

And the dividend yield and capital gains yield are:

Dividend yield = $1.45/$92

Dividend yield = 0.0158 or 1.58%

Capital loss yield = ($67 – $92)/$92

Capital loss yield = –0.2717 or –27.17%

Here’s a question for you: Can the dividend yield ever be negative?
No, that would mean you were paying the company for the privilege of owning the stock.

10.3 a. The total dollar return is the change in price plus the coupon payment, so:

Total dollar return = ($1,063 – 1,040) + 60

Total dollar return = $83

b. The total nominal percentage return of the bond is:

R = [($1,063 – 1,040) + 60]/$1,040

R = 0.0798 or 7.98%

Notice here that we could have simply used the total dollar return of $83 in the numerator of
this equation.

10.4 We use the Fisher equation:

(1 + R) = (1 + r)(1 + h)

R denotes the nominal return, r denotes the real return, and h denotes the inflation rate

The historical real return on Canada Treasury bills is:

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 rG = 1.0549/1.0365 – 1
rG = 0.0199 or 1.99%

The historical real return on long–term bonds is:

rC = 1.0790/1.0365 – 1
rC = 0.0410 or 4.10%

10.5 The average return is the sum of the returns, divided by the number of returns. The average return
for each stock was:

N 
X =  x i  N =
0.08 + 0.21 − 0.27 + .011 + 0.18 = 0.0620 or 6.20%
 i =1  5

N 
Y =  y i  N =
0.12 + 0.27 − 0.32 + 0.18 + 0.24 = 0.0980 or 9.80%
 i =1  5

We calculate the variance of each stock as:

 N

 X 2 =   ( x i − x )2  (N − 1)
 i =1 
X2 =
1
5 −1

(0.08 − 0.062 )2 + (0.21 − 0.062 )2 + (− 0.27 − 0.062 )2 + (0.11 − 0.062 )2 + (0.18 − .0.062 )2 
= 0.037170

Y 2 =
1
5 −1

(0.12 − 0.098)2 + (0.27 − 0.098)2 + (− 0.32 − 0.098)2 + (0.18 − 0.098)2 + (0.24 − 0.098)2 
= 0.057920

The standard deviation is the square root of the variance, so the standard deviation of each stock
is:
X = (0.037170)1/2
X = 0.1928 or 19.28%

Y = (0.057920)1/2
Y = 0.2407 or 24.07%

10.6 We will calculate the sum of the returns for each asset and the observed risk premium first. Doing
so, we get:

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 Year Common Stocks(%) T–bills(%) Risk Premuim(%)
1973 0.27 4.78 –4.51
1974 –25.93 7.68 –33.61
1975 18.48 7.05 11.43
1976 11.02 9.10 1.92
1977 10.71 7.64 3.07
1978 29.72 7.90 21.82
Sum 44.27 44.15 0.12

a. The average return for common stocks over this period was:

Common stock average return = 44.27%/6

Common stock average return = 7.38%

And the average return for T–bills over this period was:

T–bills average return = 44.15%/6

T–bills average return = 7.36%

b. Using the equation for variance, we find the variance for common stocks over this period
was:

Variance = 1/5[(0.0027 – 0.0738)2 + (–0.2593 – 0.0738)2 + (0.1848 – 0.0738)2

+ (0.1102 – 0.0738)2 + (0.1071 – 0.0738)2 + (0.2972 – 0.0738)2]
Variance = 0.0361346

And the standard deviation for common stocks over this period was:

Standard deviation = (0.00361346)1/2

Standard deviation = 0.1901 or 19.01%

Using the equation for variance, we find the variance for T–bills over this period was:

Variance = 1/5[(0.0478 – 0.0736)2 + (0.0768 – 0.0736)2 + (0.0705 – 0.0736)2

+ (0.091 – 0.0736)2 + (0.0764 – 0.0736)2 + (0.0790 – 0.0736)2]
Variance = 0.000205

And the standard deviation for T–bills over this period was:

Standard deviation = (0.000205)1/2

Standard deviation = 0.01432 or 1.432%

c. The average observed risk premium over this period was:

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 Average observed risk premium = 0.12%/6
Average observed risk premium = 0.02%

The variance of the observed risk premium was:

Variance = 1/5[(–0.0451 – 0.0002)2 + (–0.3361 – 0.0002)2 + (0.1143 – 0.0002)2

+ (0.0192 – 0.0002)2 + (0.0307 – 0.0002)2 + (0.2182 – 0.0002)2]
Variance = 0.035397

And the standard deviation of the observed risk premium was:

Standard deviation = (0.035397)1/2

Standard deviation = 0.1881 or 18.81%

10.7 a. To find the average return, we sum all the returns and divide by the number of returns, so:

Arithmetic average return = (0.34 + 0.16 + 0.19 – 0.21 + 0.08)/5

Arithmetic average return = 0.1120 or 11.20%

b. Using the equation to calculate variance, we find:

Variance = 1/4[(0.34 – 0.112)2 + (0.16 – 0.112)2 + (0.19 – 0.112)2 + (–0.21 – 0.112)2

+ (0.08 – 0.112)2]
Variance = 0.041270

So, the standard deviation is:

Standard deviation = (0.041270)1/2

Standard deviation = 0.2032 or 20.32%

10.8 Apply the five–year holding–period return formula to calculate the total return of the stock over
the five–year period, we find:

5–year holding–period return = [(1 + R1)(1 + R2)(1 + R3)(1 + R4)(1 + R5)] – 1

5–year holding–period return = [(1 + 0.1612) × (1 + 0.1211) × (1 + 0.0583) × (1 + 0.2614)
× (1 – 0.1319)] – 1
5–year holding–period return = 0.5086 or 50.86%

10.9 To find the return on the zero coupon bond, we first need to find the price of the bond today.
Since one year has elapsed, the bond now has 29 years to maturity, so the price today is:

P1 = $1,000/1.0929
P1 = $82.15

There are no intermediate cash flows on a zero coupon bond, so the return is the capital gains,
or:
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 R = ($82.15 – 77.81)/$77.81
R = 0.0558 or 5.58%

10.10 The return of any asset is the increase in price, plus any dividends or cash flows, all divided
by the initial price. This preferred stock paid a dividend of $4, so the return for the year was:

R = ($96.12 – 94.89 + 4.00)/$94.89

R = 0.0551 or 5.51%

10.11 Looking at the small stock return history in Table 10.2, we see that the mean return was 13.61
percent, with a standard deviation of 25.55 percent. The range of returns you would expect to
see 68 percent of the time is the mean plus or minus 1 standard deviation, or:

R =  ± 1 = 13.08% ± 25.22% = –12.14% to 38.30%

The range of returns you would expect to see 95 percent of the time is the mean plus or minus 2
standard deviations, or:

R =  ± 2 = 13.08% ± (2 × 25.22%) = –37.36% to 63.52%

10.12 Looking at T–bills return history in Table 10.2, we see that the mean return was 5.71 percent,
with a standard deviation of 3.81percent. The range of returns you would expect to see 68
percent of the time is the mean plus or minus 1 standard deviation, or:

R =  ± 1 = 5.49% ± 3.91% = 1.58% to 9.40%

The range of returns you would expect to see 95 percent of the time is the mean plus or minus 2
standard deviations, or:

R =  ± 2 = 5.49% ± (2 × 3.91%) = –2.33% to 13.31%

10.13Here we know the average stock return, and four of the five returns used to compute the average
return. We can work the average return equation backward to find the missing return. The
average return is calculated as:

0.11 = (0.19 – 0.27 + 0.06 + 0.34 + R)/5

R = 0.23 or 23%

The missing return has to be 23 percent. Now we can use the equation for the variance to find:

Variance = [(0.19 – 0.11)2 + (–0.27 – 0.11)2 + (0.06 – 0.11)2 + (0.34 – 0.11)2 + (0.23 – 0.11)2]/4
Variance = 0.05515

And the standard deviation is:

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 Standard deviation = (0.05515)1/2
Standard deviation = 0.2348 or 23.48%

10.14 The arithmetic average return is the sum of the known returns divided by the number of
returns, so:

Arithmetic average return = (0.34 + 0.18 + 0.29 –0.06 + 0.16 –0.48)/6

Arithmetic average return = 0.0717 or 7.17%

Using the equation for the geometric return, we find:

Geometric average return = [(1 + R1)(1 + R2) …(1 + RT)]1/T – 1

Geometric average return = [(1 + 0.34) × (1 + 0.18) × (1 + 0.29) × (1 – 0.06)
× (1 + 0.16) × (1 – 0.48)](1/6) – 1
Geometric average return = 0.0245 or 2.45%

Remember, the geometric average return will always be less than the arithmetic average return
if the returns have any variation.

10.15 To calculate the arithmetic and geometric average returns, we must first calculate the return
for each year. The return for each year is:

R1 = ($64.83 – 61.18 + 0.72)/$61.18 = 0.0714 or 7.14%

R2 = ($72.18 – 64.83 + 0.78)/$64.83 = 0.1254 or 12.54%
R3 = ($63.12 – 72.18 + 0.86)/$72.18 = – 0.1136 or –11.36%
R4 = ($69.27 – 63.12 + 0.95)/$63.12 = 0.1125 or 11.25%
R5 = ($76.93 – 69.27 + 1.08)/$69.27 = 0.1262 or 12.62%

The arithmetic average return was:

RA = (0.0714 + 0.1254 – 0.1136 + 0.1125 + 0.1262)/5

RA = 0.0644 or 6.44%

And the geometric average return was:

RG = [(1 + 0.0714) × (1 + 0.1254) × (1 – 0.1136) × (1 + 0.1125) × (1 + 0.1262)]1/5 – 1

RG = 0.0601 or 6.01%

10.16 We will calculate the sum of the returns for each asset first. Doing so, we get:

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 Year T–bill return(%) Inflation(%)
1973 4.78 9.36
1974 7.68 12.3
1975 7.05 9.52
1976 9.1 5.87
1977 7.64 9.45
1978 7.9 8.44
1979 11.01 9.69
1980 12.23 11.2
Sum 67.39 75.83

a. The average return for T–bills over this period was:

Average return = 67.39/8

Average return = 8.42%

And the average inflation rate was:

Average inflation = 75.83/8

Average inflation = 9.48%

b. Using the equation for variance, we find the variance for T–bills over this period was:

Variance = 1/7[(0.0478 – 0.0842)2 + (0.0768 – 0.0842)2 + (0.0705 – 0.0842)2

+ (0.091 – 0.0842)2 + (0.0764 – 0.0842)2 + (0.079 – 0.0842)2
+ (0.1101 – 0.0842)2 + (0.1223 − 0.0842)2]
Variance = 0.00054628

And the standard deviation for T–bills was:

Standard deviation = (0.00054628)1/2

Standard deviation = 0.0234 or 2.34%
The variance of inflation over this period was:

Variance = 1/7[(0.0936 – 0.0948)2 + (0.123 – 0.0948)2 + (0.0952 – 0.0948)2

+ (0.0587 – 0.0948)2 + (0.0945 – 0.0948)2 + (0.0844 – 0.0948)2
+ (0.0969 – 0.0948)2 + (0.1120 − 0.0948)2]
Variance = 0.00035836

And the standard deviation of inflation was:

Standard deviation = (0.00035836)1/2

Standard deviation = 0.0189 or 1.89%

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 c. The statement that T–bills have no risk refers to the fact that there is only an extremely small
chance of the government defaulting, so there is little default risk. Since T–bills are short
term, there is also very limited interest rate risk. However, as this example shows, there is
inflation risk, i.e. the purchasing power of the investment can actually decline over time even
if the investor is earning a positive return.

10.17 To find the return on the coupon bond, we first need to find the price of the bond today. The
bond now has six years to maturity, so the price today is:

P1 = $70 × 𝐴60.055 + $1,000/1.0556

P1 = $1,074.93

You received the coupon payments on the bond, so the nominal return was:

R = ($1,074.93 – $1,080.50 + $70)/$1,080.50

R = 0.0596 or 5.96%

And using the Fisher equation to find the real return, we get:

r = (1.0596/1.032) – 1
r = 0.0267 or 2.67%

10.18 Looking at the bond return history in Table 10.2, we see that the mean return was 7.90 percent,
with a standard deviation of 9.48 percent.

You can use the z–statistic and the cumulative standard normal distribution table to find the
answer. Doing so, we find:

z = (X – µ)/

z = (–3.3% – 7.90%)/9.48% = –1.1814

Using the NORMDIST function in Excel, we find a probability of 11.87%, or:

Pr (R < –3.3%) = Pr (Z < –1.1814)  11.87%

The range of returns you would expect to see 95 percent of the time is the mean plus or minus
2 standard deviations, or:

95% level: R =  ± 2 = 7.90% ± (2 × 9.48%) = –11.06% to 26.86%

The range of returns you would expect to see 99 percent of the time is the mean plus or minus
3 standard deviations, or:

99% level: R =  ± 3 = 7.90% ± (3 × 9.48%) = –20.54% to 36.34%

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10.19 The mean return for small stocks was 13.08 percent, with a standard deviation of 25.22 percent.
Doubling your money is a 100% return, so if the return distribution is normal, we can use the z–
statistic. So:

z = (X – µ)/

z = (100% – 13.08%)/25.22% = 3.4465 standard deviations above the mean

Pr (R > 100%) = Pr (Z > 3.4465) = 1 – Pr (Z < 3.4465)

Using the NORMDIST function in Excel, we find a probability of 0.03%, or about once every
3,333 years.

Tripling your money, the z–statistic would be:

z = (200% – 13.08%)/25.22% = 7.4116 standard deviations above the mean.

This corresponds to a probability of close to zero percent.

10.20 It is impossible to lose more than 100 percent of your investment. Therefore, return distributions
are truncated on the lower tail at –100 percent.

10.21 Using the z–statistic, we find:

z = (X – µ)/

z = (0% – 10.17%)/16.31% = –0.6235

Using the NORMDIST function in Excel, we get :

Pr (R < 0%) = Pr (Z < –0.6235)  26.65%

10.22 For each of the questions asked here, we need to use the z–statistic, which is:

z = (X – µ)/

a. z1 = (10% – 7.90%)/9.48% = 0.2215

The probability of a return greater than 10 percent is 1 minus the probability of a return less
than 10 percent.

Using the NORMDIST function in Excel, we get:

Pr (R >10%) = 1 – Pr (R < 10%) = 1 – Pr (Z < 0.2215) = 58.76%

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 For a return less than 0 percent:

z2 = (0% – 7.90%)/9.48 = – 0.8333

Using the NORMDIST function in Excel, we get :

Pr (R < 0%) = Pr (Z < –0.8333) = 20.23%

b. The probability that T–bill returns will be greater than 10 percent is:

z3 = (10% – 5.49%)/3.91% = 1.1535

Using the NORMDIST function in Excel, we get

Pr (R > 10%) = 1 – Pr (R < 10%) = 1 – Pr (Z < 1.1535) ≈ 12.44%

And the probability that T–bill returns will be less than 0 percent is:

z4 = (0% – 5.49%)/3.91% = –1.4041

Pr (R < 0%) = Pr (Z < –1.4041)  8.01%

c. The probability that the return on long–term corporate bonds will be less than –2.83 percent
is:

z5 = (– 2.83% – 7.90%)/9.48% = –1.1319

Using the NORMDIST function in Excel:

Pr (R< – 2.83%) = Pr (Z < – 1.1319)  12.88%

And the probability that T–bill returns will be greater than 11.01 percent is:

z6 = (11.01% – 5.49%)/3.91% = 1.4118

Using the NORMDIST function in Excel

Pr (R > 11.01%) = 1 – Pr (R < 11.01%) = 1 – Pr (Z < 1.4118)  7.90%

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MINI–CASE: A Job at Deck Out My Yacht Corporation

1. The biggest advantage the mutual funds have is instant diversification because the funds have a
large number of assets in the portfolio. By holding mutual funds, an investor has limited
exposure to firm–specific risk.

2. The advantage of the actively managed fund is the possibility of outperforming the market,
which the fund has done in six of the last eight years. However, most mutual funds do not
outperform the market for an extended period of time, and finding the funds that will
outperform the market in the future beforehand is a daunting task. One factor that makes
outperforming the market even more difficult is the management fee charged by the fund. The
actively managed fund charges 1.50% in expenses compared with only 0.15% for the passive
fund.

3. The returns are the most volatile for the small cap fund because the stocks in this fund are the
riskiest. This does not imply the fund is bad, just that the risk is higher, and therefore, the
expected return is higher. You would want to invest in this fund if your risk tolerance is such
that you are willing to take on the additional risk in expectation of a higher return.
The higher expenses of the fund are expected. In general, small cap funds have higher
expenses, in large part due to the greater cost of running the fund, including researching
smaller stocks.

4. The Sharpe ratio for each of the mutual funds and the company stocks are:

M&M TSX Composite Index Fund = (9.18% – 5.49%) / 20.43% = 0.1806

M&M Small–Cap Fund = (14.12% – 5.49%) / 25.13% = 0.3434
M&M Large Company Stock Fund = (8.58% – 5.49%) / 23.82% = 0.1297
M&M Bond Fund = (6.45% – 5.49%) / 9.85% =0.0975
Company Stock = (16% – 5.49%) / 65% = 0.1617

The Sharpe ratio is most applicable for a diversified portfolio and least applicable for the
company stock. The problem with the Sharpe ratio is that it fails when applied to investments
that do not have a Normal distribution of returns

5. This is a very open–ended question. The asset allocation depends on the risk tolerance of the
individual. However, most students will be young, so in this case, the portfolio allocation
should be more heavily weighted toward stocks.

In any case, there should be little, if any, money allocated to the company stock. The principle
of diversification indicates that an individual should hold a diversified portfolio. Investing
heavily in company stock does not create a diversified portfolio. This is especially true since
income comes from the company as well. If times get bad for the company, employees face
layoffs, or reduced work hours. So, not only does the investment perform poorly, but income
may be reduced as well. We only have to look at employees of Enron or WorldCom to see the
potential for problems with investing in company stock. At most, 5 to 10 percent of the
portfolio should be allocated to company stock.

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Age is a determinant in the decision. Older individuals should be less heavily weighted
toward stocks. A commonly used rule of thumb is that an individual should invest 100
minus their age in stocks. Unfortunately, this rule of thumb tends to result in an
underinvestment in stocks.

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