JUSTINE JAY C.

LOPE
2011-39205 BA 141 HW #3 P8-17: Total, nondiversifiable and diversifiable risk a. Plot the data on a graph b. Divide the total portfolio risk into diversifiable and nondiversifiable risk
16 Portfolio standard deviation 14 12 10 8 6 4 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Number of securities Portfolio Standard deviation

c. The nondiversifiable risk is considered as the relevant risk because this is the portion of the total risk that cannot be eliminated through diversification. Investors are solely concerned to nondiversifiable risk because the diversifiable risk can be easily eliminated through diversification. P8-18: Graphical derivation of beta a. Characteristic line of Asset A and Asset B
35 30 25 20 15 10 5 -15 -11 -7 0 -3 -5 -10 -15 1 5 9 13 17 y = 1.3787x + 8.0959 y = 0.7907x + 6.242 Asset A Asset B

b. Based on the characteristic lines of Asset A and B, we can estimate that the beta coefficient of Asset A is 0.79 while the beta coefficient of Asset B is 1.378 c. Asset Bs higher beta (1.378) indicates that it is more risky than asset A (0.790). P8-20: Interpreting beta a. If the market return increased by 15%, the assets return is expected to increase by 18% (=1.2*15%) b. If the market return decreased by 8%, the assets return is expected to decrease by 9.6% (=1.2*8%) c. If the market return did not change, the assets return will stay the same.

d. The asset is more risky than the market. As the basis of comparison, we can assume the market return has a 1 beta coefficient. Therefore, the asset is more risky as evidenced by a higher beta (1.20) compared that of the market. P8-23: Portfolio betas a. Calculate the betas.
Asset 1 2 3 4 5 Total Market beta A beta B beta Asset beta 1.30 0.70 1.25 1.10 0.90 Portfolio weights Portfolio A Portfolio B 10% 30% 30% 10% 10% 20% 10% 20% 40% 20% 100% 100% 1 0.935 1.11

b. Portfolio A (.935) is less risky than the market (1.00) as evidenced by a lower calculated beta. On the other hand, Portfolio B is more risky than the market as evidenced by a 1.11 calculated beta. Between the two portfolios, Asset B is more risky as shown by a higher beta of 1.11 compared to that of Asset A with 0.905. P8-24: Capital asset pricing model (CAPM) a. CAPM equation: rj = RF + [bj * (rm RF)]
Case A B C D E RF (%) 5 8 9 10 6 rm (%) 8 13 12 15 10 b 1.30 0.90 -0.20 1.00 0.60 rj (%) 8.90 12.50 8.40 15.00 8.40

P8-26: Manipulating CAPM *CAPM equation: rj = RF + [bj * (rm RF)] a. RF (%) 8 b. RF (%) 10 c. RF (%) 9 d. RF (%) 10 rm (%) 12.5000 b 2.00 rj (%) 15 rm (%) 12 rm (%) 14 rm (%) 15.3636 b 0.90 b 1.25 b 1.10 rj (%) 11.6 rj (%) 15 rj (%) 16

P8-28: Security Market Line a. Draw the security market line.

18 16 14 12 10 8 6 4 2 0 0 0.5 1 1.5 2 2.5 Nondiversifiable risk, b

b. The market risk premium is 4% (=13%-9%). c. Asset RF (%) rm (%) A B 9 9 13 13

Required return (%)

b 0.80 1.3

rj (%) 12.2 14.2

d. The risk premium for asset A (12.2) is less than the market risk premium (13) because the beta of asset A is less than 1. On the other hand, the risk premium for asset B (14.2) is greater than the market risk premium because the beta of Asset B is greater than 1. P8-29: Shifts in the security market line a.
20

16 Required return Required return Required return 8

12

4 0 0.5 1 1.5 2 2.5

b.

Asset A

RF (%) 8 RF (%) 6

rm (%) 12 rm (%) 10

b 1.10 b 1.10

rj (%) 12.4 rj (%) 10.4

c. Asset A

d.

Asset A

RF (%) 8

rm (%) 13

b 1.10

rj (%) 13.5

e. A decreased inflationary expectation will result to a decline in the required returns of risky assets by the same percentage. Graphically, this is shown by the parallel shift of the SML to the left. On the other hand, an increased risk aversion of investors will result to higher required returns for each level of risk. The required returns are expected to increase by the factor of beta. P8-30: Integrative-Risks, return and CAPM a.
Item Risk-free Market portfolio Project A Project B Project C Project D Project E

Beta, b 0 1 1.5 0.75 2 0 -0.5

Rate of return(%) 9 14 16.5 12.75 19 9 6.5

b.
19 Required return (%) 16 13 10 7 4 -1 0 1 Nondiversifiable risk 2 Rate of return(%) (C) Rate of return (%)

c. Project B which has the highest beta (2) is considered as the most risky project among the five alternatives. Projects A and C have higher required returns than the market portfolio because their beta is greater than 1. On the other hand, projects (B &D) with beta less than 1, the required returns are less than the market portfolio. It is also important to note that project E with negative beta (-0.5) has the lowest required return because it moves in opposite direction to market. d.
Rate of return (%) Project A 13.5 Project B 11.25 Project C 15 Project D 9 Project E 7.5

e. Generally, a decline in investor risk aversion will result to a decrease in required returns of risky assets by the factor of beta. For example, from r=16.5%, Project A has now 13.5% making it less risky. However, a project with negative beta (Project E) will move in opposite direction to market; thus a decrease in risk aversion will result to an increase in required return making Project E (b= -0.5) more risky.