Risk and Return: Answers To End-Of-Chapter Questions

CHAPTER 6
Risk and Return
Lecture notes: A more difficult lecture and certainly one where the video back up will help some
students. I like to give the variance covariance matrix and have never found any difficulty in
explaining it, limiting it to two shares etc. does rather beg the question. The matrix is also
central to explaining the random walk and the growth of variance over time by substituting
periods for shares. Perhaps it is worth mentioning the Noble prize for William Sharp.
In the second edition I have redrawn the variance covariance tables making them a little larger
to clarify the pattern. A concluding section has been added reflecting on over 50 years of beta
as well as a section on fat tails or jumps. The aim here is to get away from viewing beta as a
kind of academic mantra to be learnt without questioning.
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 unfavourable event will
occur. For instance, the risk of an asset is essentially the chance that the asset’s
cash flows will be unfavourable 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.
To be used with Financial Management: Theory and Practice, 2e © 2019 Cengage Learning EMEA. All Rights Reserved.
May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part
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.
g. CAPM 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.
¿
h. The expected return on a portfolio. r 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, a stock with a beta greater
than 1 has stock returns that tend to be higher than the market when the market is
up but tend to be below the market when the market is down. The opposite is true
for a stock with a beta less than 1.
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(RPM).
It can also be written in terms of the required market return: r i = rRF + bi(rM - rRF).
m. The slope of the 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.
n. The Fama-French 3-factor model has one factor for the excess market return (the
market return minus the risk free rate), a second factor for size (defined as the
return on a portfolio of small firms minus the return on a portfolio of big firms), and
a third factor for the book-to-market effect (defined as the return on a portfolio of
firms with a high book-to-market ratio minus the return on a portfolio of firms with a
low book-to-market ratio).
o. Most people don’t behave rationally in all aspects of their personal lives, and
behavioural finance assumes that investors have the same types of psychological
behaviours in their financial lives as in their personal lives.
Anchoring bias is the human tendency to “anchor” too closely on recent events
when predicting future events. Herding is the tendency of investors to follow the
crowd. When combined with overconfidence, anchoring and herding can contribute
to market bubbles.
6-2 a. The probability distribution for complete certainty is a vertical line.
b. The probability distribution for total uncertainty is the X axis from - to +.
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
riskier because σA > σB and CVA > CVB.
6-4 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 bj 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.
6-5 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.
6-6 a. The average rate of return for each stock is calculated simply by averaging the
returns over the five-year period. The average return for stock A is
= (−18% + 44% − 22% + 22% + 34%)/5
= 12%
The realized rate of return on a portfolio made up of Stock A and Stock B would be
calculated by finding the average return in each year as
(% of stock A) + (% of stock B)
Then average these annual returns:
Year Portfolio AB’s return,
2009 −21%
2010 34
2011 −13
2012 15
2013 = 12%
b. The standard deviation of returns is estimated as follows:
For Stock A, the estimated  is about 30% (When estimating the standard deviation
from past data istead of probabilities (pi etc) you add up the squared deviations from
the mean (average) and divide by N – 1 as in the answer below, alternatively enter
the data into Excel and use the “=stdev(A1:A5)” type instruction):
(return -
Return Average average)²
-18 12 900
44 12 1024
-22 12 1156
22 12 100
34 12 484
Total 3664
Total
/(N-1) 916
Standard deviation √(916) 30.27%
The standard deviations of returns for Stock B and for the portfolio are similarly
determined, and they are as follows:
Stock A Stock B Portfolio AB
Standard deviation 30% 30% 29%
c. Because the risk reduction from diversification is small (AB falls only from 30 per
cent to 29 per cent), the most likely value of the correlation coefficient is 0.8. If the
correlation coefficient were −0.8, then the risk reduction would be much larger. In
fact, the correlation coefficient between stocks A and B is 0.8.
d. If more randomly selected stocks were added to a portfolio, P would decline to
somewhere in the vicinity of 20%. The value of P would remain constant only if
the correlation coefficient were +1.0, which is most unlikely. The value of P would
decline to zero only if  = −1.0 for some pair of stocks or some pair of portfolios.
6-7 a. b = (0.6)(0.70)+ (0.25)(0.90)+ (0.1)(1.30) +(0.05)(1.50)
= 0.42 + 0.225 + 0.13 + 0.075 = 0.85
b. rf = 6%; RPM = 5%; b = 0.85
rp = 6%+ (5%) (0.85)
= 10.25%
c. bN = (0.5)(0.70) + (0.25)(0.90)+ (0.1)(1.30)+ (0.15)(1.50)
= 0.35 + 0.225 + 0.13 + 0.225
= 0.93; r = 6% + (5%) (0.93)
= 10.65%
6-8 Investment Beta

€20,000 0.7
35,000 1.3
Total €55,000
(€20,000/€55,000)(0.7) + (€35,000/€55,000)(1.3) = 1.08.
6-9 rf = 4%; rM = 12%; b = 0.8; rs = ?
rs = rf + (rM – rf)b
= 4% + (12% - 4%)0.8
= 10.4%.
6-10 rRF = 5%; RPM = 7%; rM = ?
rM = 5% + (7%)1 = 12% = rs when b = 1.0.
rs when b = 1.7 = ?
rs = 5% + 7%(1.7) = 16.9%.
6-11 Predicted return = ai + bi(rM,t) + ci(rSMB,t) + di(rHML,t)

= 0.0% + 1.2(10%) + (-0.4)(3.2%) + 1.3(4.8%)
= 16.96%
¿
6-12 r = (0.1)(-50%) + (0.2)(-5%) + (0.4)(16%) + (0.2)(25%) + (0.1)(60%)
= 11.40%.
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= 26.69%.
¿
6-13 a. r m= (0.3)(15%) + (0.4)(9%) + (0.3)(18%) = 13.5%.
¿
r j= (0.3)(20%) + (0.4)(5%) + (0.3)(12%) = 11.6%.
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%.
6-14 The detailed solution for the spreadsheet problem is available in the file Ch06-P15 Build
a Model Solution.xls at the textbook’s Web site.
MINI CASE STUDY
Assume that you recently graduated and landed a job as a financial planner with Cicero
Services, an investment advisory company. Your first client recently inherited some assets
and has asked you to evaluate them. The client presently owns a bond portfolio with €1
million invested in zero coupon Treasury bonds that mature in 10 years. The client also has
€2 million invested in the stock of Blandy, Inc., a company that produces meat-and-potatoes
frozen dinners. Blandy’s slogan is “Solid food for shaky times.”
Unfortunately, Congress and the President are engaged in an acrimonious dispute over
the budget and the debt ceiling. The outcome of the dispute, which will not be resolved until
the end of the year, will have a big impact on interest rates one year from now. Your first task
is to determine the risk of the client’s bond portfolio. After consulting with the economists at
your firm, you have specified five possible scenarios for the resolution of the dispute at the
end of the year. For each scenario, you have estimated the probability of the scenario
occurring and the impact on interest rates and bond prices if the scenario occurs. Given this
information, you have calculated the rate of return on 10-year zero coupon for each scenario.
The probabilities and returns are shown below:
Return on a 10-Year Zero

Probability Coupon Treasury Bond
Scenario of Scenario During the Next Year
Worst Case 0.10 −14%
Poor Case 0.20 −4%
Most Likely 0.40 6%
Good Case 0.20 16%
Best Case 0.10 26%
1.00
You have also gathered historical returns for the past 10 years for Blandy, Gourmange
Corporation (a producer of gourmet specialty foods), and the stock market.

Historical Stock Returns
Year Market Blandy Gourmange

1 30% 26% 47%
2 7 15 −54
3 18 −14 15
4 −22 −15 7
5 −14 2 −28
6 10 −18 40
7 26 42 17
8 −10 30 −23
9 −3 −32 −4
10 38 28 75
Average return: 8.0% ? 9.2%
Standard deviation: 20.1% ? 38.6%
Correlation with the
1.00 ? 0.678
market:
Beta: 1.00 ? 1.30
The risk-free rate is 4% and the market risk premium is 5%.

a. What are investment returns? What is the return on an investment that costs
€1,000 and is sold after 1 year for €1,060?
Answer: Investment return measures the financial results of an investment. They may be
expressed in either dollar terms or percentage terms. The dollar return is €1,60 -
€1,000 = €60. The percentage return is €60/€1,000 = 0.06 = 6%.
b. Graph the probability distribution for the bond returns based on the 5 scenarios.
What might the graph of the probability distribution look like if there were an
infinite number of scenarios (i.e., if it were a continuous distribution and not a
discrete distribution)?
Answer: Here is the probability distribution for the five possible outcomes:
A continuous distribution might look like this:
c. Use the scenario data to calculate the expected rate of return for the 10-year zero
coupon Treasury bonds during the next year.
¿
Answer: The expected rate of return, r , is expressed as follows:
Here pi is the probability of occurrence of the ith state, r i is the estimated rate of
return for that state, and n is the number of states. Here is the calculation:
¿
r = 0.1(-14.0%) + 0.2(-4.0%) + 0.4(6.0%) + 0.2(16.0%) + 0.1(26.0%)
= 6.0%.
d. What is stand-alone risk? Use the scenario data to calculate the standard deviation
of the bond’s return for the next year.
Answer: Stand-alone risk is the risk of an asset if it is held by itself and not as a part of a
portfolio. Standard deviation measures the dispersion of possible outcomes, and for
a single asset, the stand-alone risk is measured by standard deviation.
The variance and standard deviation are calculated as follows:

n
∑
2
2
σ = ¿ pi (r i - { ^r i )
i=1
√∑
n
2
σ2 = √ σ2 = ¿ pi (r i - { ^r i ) .
i=1
σ2 = [(0.1) (-0.14 – 0.06)2 + (0.2) (-0.04 – 0.06)2 + (0.4) (0.06 – 0.06)2

+ (0.2) (0.16 – 0.06)2 + (0.1) (0.26 – 0.06)2]
2
σ = 0.0120
σ= √ σ2 = 0.1095 = 10.95%.
e. Your client has decided that the risk of the bond portfolio is acceptable and wishes
to leave it as it is. Now your client has asked you to use historical returns to
estimate the standard deviation of Blandy’s stock returns. (Note: Many analysts
use 4 to 5 years of monthly returns to estimate risk and many use 52 weeks of
weekly returns; some even use a year or less of daily returns. For the sake of
simplicity, use Blandy’s 10 annual returns.)
Answer: The formulas are shown below:
T
∑ r̄ t
t=1
rAvg = T
√
T
2
∑ ( r̄ t − r̄ Avg )
t =1
Estimated σ = S = T −1
Using Excel, the past average returns and standard deviations are:
Market Blandy Gourmange

Average return: 8.0% 6.4% 9.2%
Standard deviation of returns: 20.1% 25.2% 38.6%
f. Your client is shocked at how much risk Blandy stock has and would like to reduce
the level of risk. You suggest that the client sell 25% of the Blandy stock and create
a portfolio with 75% Blandy stock and 25% in the high-risk Gourmange stock. How
do you suppose the client will react to replacing some of the Blandy stock with
high-risk stock? Show the client what the proposed portfolio return would have
been in each of year of the sample. Then calculate the average return and
standard deviation using the portfolio’s annual returns. How does the risk of this
two-stock portfolio compare with the risk of the individual stocks if they were held
in isolation?
Answer: To find historical returns on the portfolio, we first find each annual return for the
portfolio using the portfolio weights and the annual stock returns:
The percentage of a portfolio’s value that is invested in Stock i is denoted by the
“weight” wi. Notice that the sum of all the weights must equal 1. With n stocks in the
portfolio, its return each year will be:
rp = w1r1 + w2r2 + . . . + wnrn

n
∑ w i r̄ i
= i=1
The portfolio return each year will be:
r P ,t =w Blandy ( r Blandy ,t ) +w Gour. ( r Gour .,t )
r P ,t =0.75 ( r Blandy ,t ) + 0.25 ( r Gour .,t )
Following is a table showing the portfolio’s return in each year. It also shows the
average return and standard deviation during the past 10 years.
Stock Returns
Year Blandy Gourmange Portfolio

1 26% 47% 31.3%
2 15% -54% -2.3%
3 -14% 15% -6.8%
4 -15% 7% -9.5%
5 2% -28% -5.5%
6 -18% 40% -3.5%
7 42% 17% 35.8%
8 30% -23% 16.8%
9 -32% -4% -25.0%
10 28% 75% 39.8%
Average return: 6.4% 9.2% 7.1%
Standard deviation of returns: 25.2% 38.6% 22.2%
Notice that the portfolio risk is actually less than the standard deviations of the
stocks making up the portfolio.
The average portfolio return during the past 10 years can be calculated as average
return of the 10 yearly returns. But there is another way—the average portfolio
return over a number of periods is also equal to the weighted average of the stock’s
average returns:
n
∑ w i r̄ Avg,i
rAvg,p = i = 1
This method is used below:
rAvg,p = 0.75(6.4%) + 0.25(9.2%) = 7.1%
Note, however, that the only way to calculate the standard deviation of
historical returns for a portfolio is to first calculate the portfolio’s annual
historical returns and then calculate its standard deviation. A portfolio’s
historical standard deviation is not the weighted average of the individual
stocks’ standard deviations! (The only exception occurs when there is zero
correlation among the portfolio’s stocks, which would be extremely rare.)
g. Explain correlation to your client. Calculate the estimated correlation between

Blandy and Gourmange. Does this explain why the portfolio standard deviation
was less than Blandy’s standard deviation?
Answer: Loosely speaking, the correlation (ρ) coefficient measures the tendency of two
variables to move together. The formula, shown below, is complicated, but it is easy
to use Excel to calculate the correlation.
[ ][ ]
T T T
∑ (r̄i,t − r̄i,Avg)( r̄j,t − r̄ j,Avg)¿√¿ ∑ ( r̄i,t − r̄i,Avg)2 ∑ (r̄ j,t − r̄j,Avg)2 ¿
t=1 t=1 t=1
Estimated ρi,j = R = ¿
Using Excel, the correlation between Blandy (B) and Gourmange (G) is:
Est. ρB,G = 0.11
A correlation coefficient of +1 means that the stocks always move together; a

correlation coefficient of −1 means that the stocks always move oppositely to one
another. A correlation coefficient of 0 means that there is no relationship between
the stocks’ movements. The correlation coefficient of 0.11 means that sometime
when Blandy is up, Gourmange is down, and vice versa. This makes the total risk of
the portfolio less than the risk of holding either stock by itself.
h. Suppose an investor starts with a portfolio consisting of one randomly selected
stock. As more and more randomly selected stocks are added to the portfolio,
what happens to the portfolio’s risk?
Answer: The standard deviation gets smaller as more stocks are combined in the portfolio,
while rp (the portfolio’s return) remains constant. Thus, by adding stocks to your
portfolio, which initially started as a 1-stock portfolio, risk has been reduced.
In the real world, stocks are positively correlated with one another--if the economy
does well, so do stocks in general, and vice versa. Correlation coefficients between
stocks generally range from +0.5 to +0.7. The average correlation between stocks is
about 0.35. A single stock selected at random would on average have a standard
deviation of about 35 percent. As additional stocks are added to the portfolio, the
portfolio’s standard deviation decreases because the added stocks are not perfectly
positively correlated. However, as more and more stocks are added, each new stock
has less of a risk-reducing impact, and eventually adding additional stocks has
virtually no effect on the portfolio’s risk as measured by σ. In fact, σ stabilizes at
about 20 percent when 40 or more randomly selected stocks are added. Thus, by
combining stocks into well-diversified portfolios, investors can eliminate almost
one-half the riskiness of holding individual stocks. (Note: it is not completely
costless to diversify, so even the largest institutional investors hold less than all
stocks. Even index funds generally hold a smaller portfolio which is highly correlated
with an index such as the S&P 500 rather than hold all the stocks in the index.)
The implication is clear: investors should hold well-diversified portfolios of stocks
rather than individual stocks. (In fact, individuals can hold diversified portfolios
through mutual fund investments.) By doing so, they can eliminate about half of the
riskiness inherent in individual stocks.
i. 1. Should portfolio effects influence how investors think about the risk of individual
stocks?
Answer: Portfolio diversification does affect investors’ views of risk. A stock’s stand-alone
risk as measured by its σ or CV, may be important to an undiversified investor, but it
is not relevant to a well-diversified investor. A rational, risk-averse investor is more
interested in the impact that the stock has on the riskiness of his or her portfolio
than on the stock’s stand-alone risk. Stand-alone risk is composed of diversifiable
risk, which can be eliminated by holding the stock in a well-diversified portfolio, and
the risk that remains is called market risk because it is present even when the entire
market portfolio is held.
i. 2. If you decided to hold a one-stock portfolio and consequently were exposed to

more risk than diversified investors, could you expect to be compensated for all of
your risk; that is, could you earn a risk premium on that part of your risk that you
could have eliminated by diversifying?
Answer: If you hold a one-stock portfolio, you will be exposed to a high degree of risk, but
you won’t be compensated for it. If the return were high enough to compensate
you for your high risk, it would be a bargain for more rational, diversified investors.
They would start buying it, and these buy orders would drive the price up and the
return down. Thus, you simply could not find stocks in the market with returns high
enough to compensate you for the stock’s diversifiable risk.
j. According to the Capital Asset Pricing Model, what measures the amount of risk
that an individual stock contributes to a well-diversified portfolio? Define this
measurement.
Answer: Market risk, which is relevant for stocks held in well-diversified portfolios, is defined
as the contribution of a security to the overall risk of the portfolio. It is measured by
a stock’s beta coefficient. The beta of Stock i, denoted by bi, is calculated as:
bi =
( )
σi
ρ
σ M iM
A stock’s beta can also be estimated by running a regression with the stock’s returns on the y
axis and the market portfolio’s returns on the x axis. The slope of the regression line
gives the same result as the formula shown above.
k. What is the Security Market Line (SML)? How is beta related to a stock’s required
rate of return?
Answer: Here is the SML equation:
ri = rRf + RPM bi.

ri = rRf + (rM − rRf)bi.
The SML asserts that because investing in stocks is risky, an investor must expect to
get at least the risk-free rate of return plus a premium to reflect the additional risk
of the stock. The premium is for a stock begins with the premium required to hold
an average stock (RPM) and is scaled up or down depending on the stock’s beta.
l. Calculate the correlation coefficient between Blandy and the market. Use this and
the previously calculated (or given) standard deviations of Blandy and the market
to estimate Blandy’s beta. Does Blandy contribute more or less risk to a well-
diversified portfolio than does the average stock? Use the SML to estimate
Blandy’s required return.
Answer: Using the formula for correlation or the Excel function, CORREL, Blandy’s correlation
with the market (ρB,M) is:
ρB,M = 0.481
bi =
( ) ( )
σi
σM
ρiM =
0. 252
0. 201
(0 . 481 )
= 0.6
Blandy’s beta is less than 1, so it contributes less risk than that of an average
stock.
Suppose the risk-free rate is 4% and the market risk premium is 5%. The required
rate of return on Blandy is
ri = rRF + bi (RPM)
ri = 4% + 0.60(5%) = 7%
m. Show how to estimate beta using regression analysis.
Answer: Betas are calculated as the slope of the “characteristic” line, which is the regression
line showing the relationship between a given stock’s returns and the stock market’s
returns. The graph below shows this regression as calculated using Excel.
n. 1. Suppose the risk-free rate goes up to 7%. What effect would higher interest rates
have on the SML and on the returns required on high-risk and low-risk securities?
Answer: The SML is shifted higher, but the slope is unchanged.
Here we have plotted the SML for betas ranging from 0 to 2.0. The base case SML is
based on = 4% and = 5%. If interest rates increase by 3 percentage points,
with no change in risk aversion, then the entire SML is shifted upward (parallel to
the base case SML) by 3 percentage points. Now, = 7%, = 12%, and all
securities’ required returns rise by 3 percentage points. Note that the market risk
premium, − , remains at 5 percentage points.
n. 2. Suppose instead that investors’ risk aversion increased enough to cause the
market risk premium to increase to 8%. (Assume the risk-free rate remains
constant.) What effect would this have on the SML and on returns of high- and
low-risk securities?
Answer: When investors’ risk aversion increases, the SML is rotated upward about the y-
intercept, which is rRF. Suppose rRF remains at 4 percent, but now rM increases to 12
percent, so the market risk premium increases to 8 percent. The required rate of
return will rise sharply on high-risk (high-beta) stocks, but not much on low-beta
securities.
o. Your client decides to invest €1.4 million in Blandy stock and €0.6 million in
Gourmange stock. What are the weights for this portfolio? What is the portfolio’s
beta? What is the required return for this portfolio?
Answer: The portfolio’s beta is the weighted average of the stocks’ betas:
bp = 0.7(bBlandy) + 0.3(bGour.)
= 0.7(0.60) + 0.3(1.30)
= 0.81.
There are two ways to calculate the portfolio’s expected return. First, we can use the
portfolio’s beta and the SML:
rp = rRF + bp (RPM)
= 4.0% + 0.81%(5%) = 8.05%.
Second, we can find the weighted average of the stocks’ expected returns:
n
∑ w i ri
rp = i=1
= 0.7(7.0%) + 0.3(10.5%)
= 8.05%.
p. Jordan Jones (JJ) and Casey Carter (CC) are portfolio managers at your firm. Each
manages a well-diversified portfolio. Your boss has asked for your opinion
regarding their performance in the past year. JJ’s portfolio has a beta of 0.6 and
had a return of 8.5%; CC’s portfolio has a beta of 1.4 and had a return of 9.5%.
Which manager had better performance? Why?
Answer: To evaluate the managers, calculate the required returns on their portfolios using
the SML and compare the actual returns to the required returns, as follows:
Portfolio Manager
JJ CC
Portfolio beta = 0.7 1.4
Risk-free rate = 4% 4%
Market risk premium = 5% 5%
Portfolio required return = 7.50% 11.00%
Portfolio actual return = 8.50% 9.50%
Over (Under) Performance = 1.00% -1.50%
Notice that JJ’s portfolio had a higher return than investors required (given the risk
of the portfolio) and CC’s portfolio had a lower return than expected by investors.
Therefore, JJ had the better performance.
q. What does market equilibrium mean? If equilibrium does not exist, how will it be
established?
Answer: Market equilibrium means that marginal investors (the ones whose trades
determine prices) believe that all securities are fairly priced. This means that the
market price of a security must equal the security’s intrinsic value (intrinsic value
reflects the size, timing, and risk of the future cash flows):
Market price = Intrinsic value
Market equilibrium also means that the expected return a security must equal its
required return (which reflects the security’s risk).
r^ = r
If the market is not in equilibrium, then some assets will be undervalued and/or
some will be overvalued. If this is the case, traders will attempt to make a profit by
purchasing undervalued securities and short-selling overvalued securities. The
additional demand for undervalued securities will drive up their prices and the lack
of demand for overvalued securities will drive down their prices. This will continue
until market prices equal intrinsic values, at which point the traders will not be able
to earn profits greater than justified by the assets’ risks.
Web Appendix 6B
Calculating Beta Coefficients with a Financial Calculator
Solutions to Problems
6B-1 a. r̄ Y (%)
40

30
20
 

10 


  r̄ M (%)
-30 -20 -10 10 20 30 40

b = Slope = 0.62. However, b will depend on students’ freehand line. Using a

calculator, we find b = 0.6171 ≈ 0.62.
b. Because b = 0.62, Stock Y is about 62% as volatile as the market; thus, its relative risk
is about 62% that of an average stock.
c. 1. Stand-alone risk as measured by  would be greater, but beta and hence

systematic (relevant) risk would remain unchanged. However, in a 1-stock
portfolio, Stock Y would be riskier under the new conditions.
2. CAPM assumes that company-specific risk will be eliminated in a portfolio, so the

risk premium under the CAPM would not be affected. However, if the scatter
were wide, we would not have as much confidence in the beta, and this could
increase the stock's risk and thus its risk premium.
d. 1. The stock's variance and  would not change, but the risk of the stock to an
investor holding a diversified portfolio would be greatly reduced, because it
would now have a negative correlation with rM.
2. Because of a relative scarcity of such stocks and the beneficial net effect on
portfolios that include it, its “risk premium” is likely to be very low or even
negative. Theoretically, it should be negative.
e. The following figure shows a possible set of probability distributions. We can be

reasonably sure that the 100-stock portfolio comprised of b = 0.62 stocks as
described in Condition 2 will be less risky than the “market.” Hence, the distribution
for Condition 2 will be more peaked than that of Condition 3.
Kr 100
Kr Y
Kr M
9.8
We can also say on the basis of the available information that Y is smaller than M;
Stock Y’s market risk is only 62% of the “market,” but it does have company-specific
risk, while the market portfolio does not, because it has been diversified away.
However, we know from the given data that Y = 13.8%, while M = 19.6%. Thus, we
have drawn the distribution for the single stock portfolio more peaked than that of
the market. The relative rates of return are not reasonable. The return for any stock
should be
ri = rRF + (rM – rRF)bi.
Stock Y has b = 0.62, while the average stock (M) has b = 1.0; therefore,
ry = rRF + (rM – rRF)0.62 < rM = rRF + (rM – rRF)1.0.
A disequilibrium exists—Stock Y should be bid up to drive its yield down. More

likely, however, the data simply reflect the fact that past returns are not an exact
basis for expectations of future returns.
f. The expected return could not be predicted with the historical characteristic line
because the increased risk should change the beta used in the characteristic line.
g. The beta would decline to 0.53. A decline indicates that the stock has become less
risky; however, with the change in the debt ratio the stock has actually become
riskier. In periods of transition, when the risk of the firm is changing, the beta can
yield conclusions that are exactly opposite to the actual facts. Once the company's
risk stabilizes, the calculated beta should rise and should again approximate the true
beta.
6B-2 a.
r i (%)
35
Stock A
30
25
Stock B
20
15
10
r M (%)
5 10 15 20 25 30 35
-5
The slope of the characteristic line is the stock’s beta coefficient.

Rise Δr i
=
Slope = Run Δ r̄ M .
29 .00−15 .20
SlopeA = BetaA = 29 .00−15 .20 = 1.0.
20 .00−13 .10
SlopeB = BetaB = 29 .00−15 .20 = 0.5.
b. r^ M = 0.1(-14%) + 0.2(0%) + 0.4(15%) + 0.2(25%) + 0.1(44%)

= -1.4% + 0% + 6% + 5% + 4.4% = 14%.
The graph of the SML is as follows:
ri SML
E(r M) = 14%
r RF = 9%
b
1.0
The equation of the SML is thus:

ri = rRF + (rM – rRF)bi = 9% + (14% – 9%)bi = 9% + (5%)bi.
c. Required rate of return on Stock A:

rA = rRF + (rM – rRF)bA = 9% + (14% – 9%)1.0 = 14%.
Required rate of return on Stock B:

rB = 9% + (14% – 9%)0.5 = 11.50%.
d. Expected return on Stock C = r^C = 18%.
Return on Stock C if it is in equilibrium:
rC = rRF + (rM – rRF)bC = 9% + (14% – 9%)2 = 19%  18% = r^C .
A stock is in equilibrium when its required return is equal to its expected return. Stock C’s
required return is greater than its expected return; therefore, Stock C is not in
equilibrium. Equilibrium will be restored when the expected return on Stock C is
driven up to 19%. With an expected return of 18% on Stock C, investors should sell
it, driving its price down and its yield up.

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CHAPTER 6

Risk and Return

ANSWERS TO END-OF-CHAPTER QUESTIONS

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

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

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

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

6-2 a. The probability distribution for complete certainty is a vertical line.

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

= (−18% + 44% − 22% + 22% + 34%)/5

calculated by finding the average return in each year as

Then average these annual returns:

Year Portfolio AB’s return,

b. The standard deviation of returns is estimated as follows:

determined, and they are as follows:

Stock A Stock B Portfolio AB

Standard deviation 30% 30% 29%

fact, the correlation coefficient between stocks A and B is 0.8.

d. If more randomly selected stocks were added to a portfolio, P would decline to

= 0.42 + 0.225 + 0.13 + 0.075 = 0.85

b. rf = 6%; RPM = 5%; b = 0.85

rp = 6%+ (5%) (0.85)

c. bN = (0.5)(0.70) + (0.25)(0.90)+ (0.1)(1.30)+ (0.15)(1.50)

= 0.35 + 0.225 + 0.13 + 0.225

= 0.93; r = 6% + (5%) (0.93)

6-8 Investment Beta

(€20,000/€55,000)(0.7) + (€35,000/€55,000)(1.3) = 1.08.

6-9 rf = 4%; rM = 12%; b = 0.8; rs = ?

rM = 5% + (7%)1 = 12% = rs when b = 1.0.

6-11 Predicted return = ai + bi(rM,t) + ci(rSMB,t) + di(rHML,t)

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

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

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

Return on a 10-Year Zero

Year Market Blandy Gourmange

The risk-free rate is 4% and the market risk premium is 5%.

A continuous distribution might look like this:

The variance and standard deviation are calculated as follows:

σ2 = [(0.1) (-0.14 – 0.06)2 + (0.2) (-0.04 – 0.06)2 + (0.4) (0.06 – 0.06)2

Answer: The formulas are shown below:

Market Blandy Gourmange

rp = w1r1 + w2r2 + . . . + wnrn

g. Explain correlation to your client. Calculate the estimated correlation between

A correlation coefficient of +1 means that the stocks always move together; a

i. 2. If you decided to hold a one-stock portfolio and consequently were exposed to

Answer: Here is the SML equation:

ri = rRf + RPM bi.

Answer: The SML is shifted higher, but the slope is unchanged.

b = Slope = 0.62. However, b will depend on students’ freehand line. Using a

c. 1. Stand-alone risk as measured by  would be greater, but beta and hence

2. CAPM assumes that company-specific risk will be eliminated in a portfolio, so the

e. The following figure shows a possible set of probability distributions. We can be

ry = rRF + (rM – rRF)0.62 < rM = rRF + (rM – rRF)1.0.

A disequilibrium exists—Stock Y should be bid up to drive its yield down. More

The slope of the characteristic line is the stock’s beta coefficient.

b. r^ M = 0.1(-14%) + 0.2(0%) + 0.4(15%) + 0.2(25%) + 0.1(44%)

The graph of the SML is as follows:

The equation of the SML is thus:

c. Required rate of return on Stock A: