Chapter 8 Risk and Rates of Return

Answers to End-of-Chapter Questions

8-1 a. No, it is not riskless. The portfolio would be free of default risk and liquidity risk, but inflation could erode the portfolios purchasing power. If the actual inflation rate is greater than that expected, interest rates in general will rise to incorporate a larger inflation premium (I ! and" as we saw in #hapter $"the %alue of the portfolio would decline. b. No, you would be sub&ect to rein%estment rate risk. 'ou might expect to (roll o%er) the Treasury bills at a constant (or e%en increasing! rate of interest, but if interest rates fall, your in%estment income will decrease. c. * +.,. go%ernment-backed bond that pro%ided interest with constant purchasing power (that is, an indexed bond! would be close to riskless. The +.,. Treasury currently issues indexed bonds. 8-2 a. The probability distribution for complete certainty is a %ertical line. b. The probability distribution for total uncertainty is the .-axis from - to /. 8-3 a. The expected return on a life insurance policy is calculated &ust as for a common stock. 0ach outcome is multiplied by its probability of occurrence, and then these products are summed. 1or example, suppose a 2-year term policy pays 324,444 at death, and the probability of the policyholders death in that year is 56. Then, there is a 786 probability of 9ero return and a 56 probability of 324,444: 0xpected return ; 4.78(34! / 4.45(324,444! ; 3544. This expected return could be compared to the premium paid. <enerally, the premium will be larger because of sales and administrati%e costs, and insurance company profits, indicating a negati%e expected rate of return on the in%estment in the policy. b. There is a perfect negati%e correlation between the returns on the life insurance policy and the returns on the policyholders human capital. In fact, these e%ents (death and future lifetime earnings capacity! are mutually exclusi%e. The prices of goods and ser%ices must co%er their costs. #osts include labor, materials, and capital. #apital costs to a borrower include a return to the sa%er who supplied the capital, plus a mark-up (called a (spread)! for the financial intermediary that brings the sa%er and the borrower together. The more efficient the financial system, the lower the costs of intermediation, the lower the costs to the borrower, and, hence, the lower the prices of goods and ser%ices to consumers. c. eople are generally risk a%erse. Therefore, they are willing to pay a premium to decrease the uncertainty of their future cash flows. * life insurance policy guarantees an income (the face %alue of the policy! to the policyholders beneficiaries when the policyholders future earnings capacity drops to 9ero.

8-4

'es, if the portfolios beta is equal to 9ero. In practice, howe%er, it may be impossible to find indi%idual stocks that ha%e a nonpositi%e beta. In this case it would also be impossible to ha%e a Answers and Solutions 1

Chapter 8: Risk and Rates of Return

stock portfolio with a 9ero beta. 0%en if such a portfolio could be constructed, in%estors would probably be better off &ust purchasing Treasury bills, or other 9ero beta in%estments. 8,ecurity * is less risky if held in a di%ersified portfolio because of its negati%e correlation with other stocks. In a single-asset portfolio, ,ecurity * would be more risky because * = > and #?* = #?>. No. 1or a stock to ha%e a negati%e beta, its returns would ha%e to logically be expected to go up in the future when other stocks returns were falling. @ust because in one year the stocks return increases when the market declined doesnt mean the stock has a negati%e beta. * stock in a gi%en year may mo%e counter to the o%erall market, e%en though the stocks beta is positi%e. The risk premium on a high-beta stock would increase more than that on a low-beta stock. A
&

8-!

8-"

; Aisk remium for ,tock & ; (rB C rA1!b&.

If risk a%ersion increases, the slope of the ,BD will increase, and so will the market risk premium (rB C rA1!. The product (rB C rA1!b& is the risk premium of the & th stock. If b& is low (say, 4.E!, then the product will be smallF A & will increase by only half the increase in A B. Gowe%er, if b& is large (say, 5.4!, then its risk premium will rise by twice the increase in A B. 8-8 *ccording to the ,ecurity Barket Dine (,BD! equation, an increase in beta will increase a companys expected return by an amount equal to the market risk premium times the change in beta. 1or example, assume that the risk-free rate is H6, and the market risk premium is E6. If the companys beta doubles from 4.8 to 2.H its expected return increases from 246 to 2I6. Therefore, in general, a companys expected return will not double when its beta doubles. a. * decrease in risk a%ersion will decrease the return an in%estor will require on stocks. Thus, prices on stocks will increase because the cost of equity will decline. b. Jith a decline in risk a%ersion, the risk premium will decline as compared to the historical difference between returns on stocks and bonds. c. The implication of using the ,BD equation with historical risk premiums (which would be higher than the (current) risk premium! is that the #* B estimated required return would actually be higher than what would be reflected if the more current risk premium were used.

8-#

Answers and Solutions

Chapter 8: Risk and Rates of Return

$o%utions to End-of-Chapter &rob%e's

8-1

K r

; (4.2!(-E46! / (4.5!(-E6! / (4.I!(2H6! / (4.5!(5E6! / (4.2!(H46! ; 22.I46.

5 ; (-E46 C 22.I46!5(4.2! / (-E6 C 22.I46!5(4.5! / (2H6 C 22.I46!5(4.I! / (5E6 C 22.I46!5(4.5! / (H46 C 22.I46!5(4.2! 5 ; $25.IIF ; 5H.H76. #? ;

5H.H76 ; 5.LI. 22.I46

>eta 4.8 2.I

8-2

In%estment 3LE,444 I4,444 Total 3$E,444

bp ; (3LE,444M3$E,444!(4.8! / (3I4,444M3$E,444!(2.I! ; 2.25. 8-3 rA1 ; H6F rB ; 2L6F b ; 4.$F r ; N r ; rA1 / (rB C rA1!b ; H6 / (2L6 C H6!4.$ ; 24.76. 8-4 rA1 ; E6F A ; H6F rB ; N

rB ; E6 / (H6!2 ; 226. r when b ; 2.5 ; N r ; E6 / H6(2.5! ; 25.56. 8a. r ; 226F rA1 ; $6F A ; I6.

r ; rA1 / (rB C rA1!b 226 ; $6 / I6b I6 ; I6b b ; 2.

Chapter 8: Risk and Rates of Return

Answers and Solutions

b. rA1 ; $6F A

; H6F b ; 2.

r ; rA1 / (rB C rA1!b ; $6 / (H6!2 ; 2L6.

8-!

a.

K r =

i =2

i i

r .

K r' ; 4.2(-LE6! / 4.5(46! / 4.I(546! / 4.5(5E6! / 4.2(IE6! ; 2I6 %ersus 256 for ..

b. ;

(r
i=2

K r! 5

5 5 5 5 . ; (-246 C 256! (4.2! / (56 C 256! (4.5! / (256 C 256! (4.I! / (546 C 256!5(4.5! / (L86 C 256!5(4.2! ; 2I8.86.

. ; 25.546 %ersus 54.LE6 for '. #?. ; .M K r

.

; 25.546M256 ; 2.45, while

#?' ; 54.LE6M2I6 ; 2.IE. If ,tock ' is less highly correlated with the market than ., then it might ha%e a lower beta than ,tock ., and hence be less risky in a portfolio sense.
3I44,444 3H44,444 32,444,444 35,444,444 (2.E4! / (-4.E4! / (2.5E! / 3I,444,444 3I,444,444 3I,444,444 3I,444,444

8-" (4.$E!

ortfolio beta ;

bp ; (4.2!(2.E! / (4.2E!(-4.E4! / (4.5E!(2.5E! / (4.E!(4.$E! ; 4.2E C 4.4$E / 4.L25E / 4.L$E ; 4.$H5E. rp ; rA1 / (rB C rA1!(bp! ; H6 / (2I6 C H6!(4.$H5E! ; 25.26. *lternati%e solution: 1irst, calculate the return for each stock using the #* B equation OrA1 / (rB C rA1!bP, and then calculate the weighted a%erage of these returns. rA1 ; H6 and (rB C rA1! ; 86. ,tock * > # Q Total In%estment 3 I44,444 H44,444 2,444,444 5,444,444 3I,444,444 >eta 2.E4 (4.E4! 2.5E 4.$E r ; rA1 / (rB C rA1!b 286 5 2H 25 Jeight 4.24 4.2E 4.5E 4.E4 2.44

rp ; 286(4.24! / 56(4.2E! / 2H6(4.5E! / 256(4.E4! ; 25.26. 4 Answers and Solutions Chapter 8: Risk and Rates of Return

8-8

In equilibrium: r@ ; 25.E6. r@ ; K r@ ; rA1 / (rB C rA1!b 25.E6 ; I.E6 / (24.E6 C I.E6!b b ; 2.LL.

8-#

Je know that bA ; 2.E4, b, ; 4.$E, rB ; 2L6, rA1 ; $6. ri ; rA1 / (rB C rA1!bi ; $6 / (2L6 C $6!bi. rA ; $6 / H6(2.E4! ; 2H.46 r, ; $6 / H6(4.$E! ; 22.E I.E6

8-1(

*n index fund will ha%e a beta of 2.4. If rB is 25.46 (gi%en in the problem! and the risk-free rate is E6, you can calculate the market risk premium (A B! calculated as rB C rA1 as follows: r ; rA1 / (A B!b 25.46 ; E6 / (A B!2.4 $.46 ; A B. Now, you can use the A >radford: r> ; rA1 / (A B!b ; E6 / ($.46!2.IE ; E6 / 24.2E6 ; 2E.2E6. 1arley: r1 ; rA1 / (A B!b ; E6 / ($.46!4.8E ; E6 / E.7E6 ; 24.7E6. The difference in their required returns is: 2E.2E6 C 24.7E6 ; I.56.
B

, the rA1, and the two stocks betas to calculate their required returns.

8-11

rA1 ; rR / I ; 5.E6 / L.E6 ; H6. rs ; H6 / (H.E6!2.$ ; 2$.4E6.

8-12

+sing ,tock . (or any stock!: 76 ; rA1 / (rB C rA1!b. 76 ; E.E6 / (rB C rA1!4.8 (rB C rA1! ; I.L$E6.

Chapter 8: Risk and Rates of Return

Answers and Solutions

8-13

a. ri ; rA1 / (rB C rA1!bi ; 76 / (2I6 C 76!2.L ; 2E.E6. b. 2. rA1 increases to 246: rB increases by 2 percentage point, from 2I6 to 2E6. ri ; rA1 / (rB C rA1!bi ; 246 / (2E6 C 246!2.L ; 2H.E6. 5. rA1 decreases to 86: rB decreases by 26, from 2I6 to 2L6. ri ; rA1 / (rB C rA1!bi ; 86 / (2L6 C 86!2.L ; 2I.E6. c. 2. rB increases to 2H6: ri ; rA1 / (rB C rA1!bi ; 76 / (2H6 C 76!2.L ; 28.26. 5. rB decreases to 2L6: ri ; rA1 / (rB C rA1!bi ; 76 / (2L6 C 76!2.L ; 2I.56.
32I5,E44 3$,E44 (b! / (2.44! 32E4,444 32E4,444 2.25 ; 4.7Eb / 4.4E 2.4$ ; 4.7Eb 2.25HL ; b.

8-14

Sld portfolio beta ;

New portfolio beta ; 4.7E(2.25HL! / 4.4E(2.$E! ; 2.2E$E 2.2H. *lternati%e solutions: 2. Sld portfolio beta ; 2.25 ; (4.4E!b2 / (4.4E!b5 / ... / (4.4E!b54 b i ! (4.4E! 2.25 ; (
b
i

; 2.25M4.4E ; 55.I.

New portfolio beta ; (55.I C 2.4 / 2.$E!(4.4E! ; 2.2E$E 2.2H. 5.

i excluding the stock with the beta equal to 2.4 is 55.I C 2.4 ; 52.I, so the beta of the portfolio excluding this stock is b ; 52.IM27 ; 2.25HL. The beta of the new portfolio is:

2.25HL(4.7E! / 2.$E(4.4E! ; 2.2E$E 2.2H. 8-1 bGAI ; 2.8F bDAI ; 4.H. No changes occur. rA1 ; H6. Qecreases by 2.E6 to I.E6. rB ; 2L6. 1alls to 24.E6. Now ,BD: ri ; rA1 / (rB C rA1!bi. ! Answers and Solutions Chapter 8: Risk and Rates of Return

rGAI ; I.E6 / (24.E6 C I.E6!2.8 ; I.E6 / H6(2.8! ; rDAI ; I.E6 / (24.E6 C I.E6!4.H ; I.E6 / H6(4.H! ; Qifference 8-1! ,tep 2:

2E.L6 8.26 $.56

Qetermine the market risk premium from the #* B: 4.25 ; 4.4E5E / (rB C rA1!2.5E (rB C rA1! ; 4.4EI.

,tep 5:

#alculate the beta of the new portfolio: (3E44,444M3E,E44,444!(4.$E! / (3E,444,444M3E,E44,444!(2.5E! ; 2.54IE.

,tep L:

#alculate the required return on the new portfolio: E.5E6 / (E.I6!(2.54IE! ; 22.$E6.

8-1"

*fter additional in%estments are made, for the entire fund to ha%e an expected return of 2L6, the portfolio must ha%e a beta of 2.EIEE as shown below: 2L6 ; I.E6 / (E.E6!b b ; 2.EIEE. ,ince the funds beta is a weighted a%erage of the betas of all the indi%idual in%estments, we can calculate the required beta on the additional in%estment as follows: 2.EIEE ;
(3 54,444,444!(2.E! 3E,444,444. / 35E,444,444 35E,444,444

2.EIEE ; 2.5 / 4.5. 4.LIEE ; 4.5. . ; 2.$5$E. 8-18 a. (32 million!(4.E! / (34!(4.E! ; 34.E million. b. 'ou would probably take the sure 34.E million. c. Aisk a%erter. d. 2. (32.2E million!(4.E! / (34!(4.E! ; 3E$E,444, or an expected profit of 3$E,444. 5. 3$E,444M3E44,444 ; 2E6. L. This depends on the indi%iduals degree of risk a%ersion. I. *gain, this depends on the indi%idual. E. The situation would be unchanged if the stocks returns were perfectly positi%ely correlated. Stherwise, the stock portfolio would ha%e the same expected return as the single stock (2E6! but a lower standard de%iation. If the correlation coefficient between each pair of stocks was a negati%e one, the portfolio would be %irtually riskless. ,ince for stocks is generally in the range of /4.LE, in%esting in a portfolio of stocks would definitely be an impro%ement o%er in%esting in the single stock. Chapter 8: Risk and Rates of Return Answers and Solutions "

8-1#

K r. ; 246F b. ; 4.7F . ; LE6.

K r' ; 25.E6F b' ; 2.5F ' ; 5E6.

rA1 ; H6F A

; E6.

a. #?. ; LE6M246 ; L.E. #?' ; 5E6M25.E6 ; 5.4. b. 1or di%ersified in%estors the rele%ant risk is measured by beta. Therefore, the stock with the higher beta is more risky. ,tock ' has the higher beta so it is more risky than ,tock .. c. r. ; H6 / E6(4.7! ; 24.E6. r' ; H6 / E6(2.5! ; 256. r . ; 246. d. r. ; 24.E6F K r ' ; 25.E6. r' ; 256F K ,tock ' would be most attracti%e to a di%ersified in%estor since its expected return of 25.E6 is greater than its required return of 256. e. bp ; (3$,E44M324,444!4.7 / (35,E44M324,444!2.5 ; 4.H$E4 / 4.L4 ; 4.7$E4. rp ; H6 / E6(4.7$E! ; 24.8$E6. f. If A B increases from E6 to H6, the stock with the highest beta will ha%e the largest increase in its required return. Therefore, ,tock ' will ha%e the greatest increase. #heck: r. ; H6 / H6(4.7! ; 22.I6. r' ; H6 / H6(2.5! ; 2L.56. 8-2( Increase 24.E6 to 22.I6. Increase 256 to 2L.56.

The answers to a, b, c, and d are gi%en below: 5442 5445 544L 544I 544E Bean r* (28.446! LL.44 2E.44 (4.E4! 5$.44 22.L4 r> (2I.E46! 52.84 L4.E4 ($.H4! 5H.L4 22.L4 ortfolio (2H.5E6! 5$.I4 55.$E (I.4E! 5H.HE 22.L4 Chapter 8: Risk and Rates of Return

Answers and Solutions

,td. Qe%. #oef. ?ar.

54.$7 2.8I

54.$8 2.8I

54.2L 2.$8

e. * risk-a%erse in%estor would choose the portfolio o%er either ,tock * or ,tock > alone, since the portfolio offers the same expected return but with less risk. This result occurs because returns on * and > are not perfectly positi%ely correlated (r*> ; 4.88!. K rB ; 4.2($6! / 4.5(76! / 4.I(226! / 4.5(2L6! / 4.2(2E6! ; 226. rA1 ; H6. (gi%en! Therefore, the ,BD equation is: ri ; rA1 / (rB C rA1!bi ; H6 / (226 C H6!bi ; H6 / (E6!bi. b. 1irst, determine the funds beta, b1. The weights are the percentage of funds in%ested in each stock: * ; 32H4M3E44 ; 4.L5. > ; 3254M3E44 ; 4.5I. # ; 384M3E44 ; 4.2H. Q ; 384M3E44 ; 4.2H. 0 ; 3H4M3E44 ; 4.25. b1 ; 4.L5(4.E! / 4.5I(5.4! / 4.2H(I.4! / 4.2H(2.4! / 4.25(L.4! ; 4.2H / 4.I8 / 4.HI / 4.2H / 4.LH ; 2.8. Next, use b1 ; 2.8 in the ,BD determined in art a:
K r1 ; H6 / (226 C H6!2.8 ; H6 / 76 ; 2E6.

8-21

a.

c. rN ; Aequired rate of return on new stock ; H6 / (E6!5.4 ; 2H6. *n expected return of 2E6 on the new stock is below the 2H6 required rate of return on an rN ; 2E6, the new stock should not be in%estment with a risk of b ; 5.4. ,ince r N ; 2H6 = K purchased. The expected rate of return that would make the fund indifferent to purchasing the stock is 2H6.

Chapter 8: Risk and Rates of Return

Answers and Solutions

Co'prehensi)e*$preadsheet &rob%e'
Note to Instructors: +he so%ution to this prob%e' is not pro)ided to students at the back of their te,t. -nstructors can access the Excel fi%e on the te,tbook.s /eb site or the -nstructor.s Resource C0. 8-22 a.
2005 2004 2003 2002 2001 Avg Ret!rns Bartman 24.7% -4.2% 62.8% 2.9% 61.0% 29.4% Reynolds -1.1% 13.2% -10.0% -0.4% 11.7% 2.7%
Bartman 31.5%

Index 32.8% 1.2% 34.9% 14.8% 19.0% 20.6%

Reynolds 9.7% Index 13.8%

b.

"tandard dev#at#on o$ ret!rn

Sn a stand-alone basis, it would appear that >artman is the most risky, Aeynolds the least risky. c.
%oe$$#&#ent o$ 'ar#at#on Bartman 1.07 Reynolds 3.63 Index 0.67

Aeynolds now looks most risky, because its risk (,Q! per unit of return is highest. d. (ear 2005 2004 2003 2002 2001 Index 32.8% 1.2% 34.9% 14.8% 19.0% Bartman 24.7% -4.2% 62.8% 2.9% 61.0%
"to&) Ret!rns 's. Index
80.0% "to&)s* Ret!rns 60.0% 40.0% 20.0% 0.0% 0.0% -20.0% 10.0% 20.0% Index Ret!rns 30.0% 40.0% Bartman Reynolds

Reynolds -1.1% 13.2% -10.0% -0.4% 11.7%

It is clear that >artman mo%es with the market and Aeynolds mo%es counter to the market. ,o, >artman has a positi%e beta and Aeynolds a negati%e one. e. >artmans calculations:

1(

Comprehensive/Spreadsheet Problem

Chapter 8: Risk and Rates of Return

$122AR3 41+&1+ Regression Statistics 2u%tip%e R (.!" 4"22!3 R $5uare (.4 !2!2""# Ad6usted R $5uare (.2" (1"(38 $tandard Error (.2!81211(# 4bser)ations
A;4<A d" Re=ression Residua% +ota%
-ntercept > <ariab%e 1

8art'an9s beta :
1 3 4
Coe""icients Standard Error -(.(22(2"! 4 (.232"((84# 1. 3#3121 8 (.#"(181"11

1. 4
#S (.18(#"11(# (.("1888#2#
P%value (.#3( 2 2" (.21("8#882

SS (.18(#"11(# (.21 !!!"8" (.3#!!3"8#!

t Stat -(.(#4!!(82 1. 8!!22 2"

$ Signi"icance $ 2. 1"3"1(44 (.21("8#882

&ower '() *pper '() &ower '(+,) *pper '(+,) -(."!2 8!3(" (."18 31 -(."!2 8!31 (."18 3 -1. 48241#3# 4.!2!8!!3 -1. 48241#4 4.!2!8"

RE$-01A7 41+&1+ bservation 1 2 3 4 Predicted ! (.4822! 84 -(.((32"#21 (. 1 3( "8 (.2(! (838! (.2"11 3322 Residuals -(.2348(8218 -(.(38 38#!" (.112!(13#8 -(.1""#3!# " (.338!82"44

Aeynolds calculations:
$122AR3 41+&1+ Regression Statistics 2u%tip%e R (."#"34"##4 R $5uare (.!3 "!3824 Ad6usted R $5uare (. 143 1"! $tandard Error (.(!"!8!"18 4bser)ations
A;4<A d" Re=ression Residua% +ota%
-ntercept > <ariab%e 1

Re?no%ds9 beta :
#S (.(23##( 8# (.((4 814#2
P%value (.(#44 !"2 (.1(!11##"4

-(. !
$ Signi"icance $ .23!4141 # (.1(!11##"4

1 3 4
Coe""icients Standard Error (.141#!2!" (.( 8"44#34 -(. !(4 "2#" (.244#2("23

SS (.(23##( 8# (.(13"444" (.(3""3 (!4

t Stat 2.41! #42"4 -2.2883212 3

&ower '() *pper '() &ower '(+,) *pper '(+,) -(.(44##(1(2 (.328#1 4 -(.(44##(1 (.328#2 -1.33##( ("# (.218##( -1.33##( (8 (.218##

Chapter 8: Risk and Rates of Return

Comprehensive/Spreadsheet Problem

11

RE$-01A7 41+&1+ bservation 1 2 3 4 Predicted ! -(.(41!48 42 (.13 13!44 -(.( 3!"81"4 (.( 8" 3!28 (.(3 21!!!# Residuals (.(3113228# -(.((2828"4" -(.(4!" 8 (" -(.(!2#2(2#4 (.(813" 2 #

Note that these betas are consistent with the scatter diagrams we constructed earlier. AeynoldsT beta suggests that it is less risky than a%erage in a #* B sense, whereas >artman is more risky than a%erage. f.
1ar)et Ret!rn R#s)-$ree rate Re.!#red ret!rn Bartman4 Re.!#red ret!rn Re.!#red ret!rn Reynolds4 Re.!#red ret!rn Re.!#red ret!rn 11.000% 6.040% R#s)-$ree rate 0 1ar)et R#s) +rem#!m @ Beta

6.040% 13.675%

4.960%

1.539

6.040% 3.260%

4.960%

-0.560

This suggests that AeynoldsT stock is like an insurance policy that has a low expected return, but it will pay off in the e%ent of a market decline. *ctually, it is hard to find negati%e-beta stocks, so we would not be inclined to belie%e the AeynoldsT data. =. The beta of a portfolio is simply a weighted a%erage of the betas of the stocks in the portfolio, so this portfolioTs beta would be:
+ort$ol#o ,eta 0.49 0 1ar)et R#s) +rem#!m 4.960%
+ort$ol#o 2e#g3t 25% 15% 40% 20% 100% 1ar)et R#s) +rem#!m 4.96%

Re.!#red ret!rn on /ort$ol#o R#s)-$ree rate Re.!#red ret!rn 6.040% +ort$ol#o re.!#red ret!rn 8.468%

Beta 0.489

h.
Bartman "to&) A "to&) B "to&) % +ort$ol#o Beta Re.!#red ret!rn on /ort$ol#o Re.!#red ret!rn on /ort$ol#o Re.!#red ret!rn on /ort$ol#o -

Beta 1.539 0.769 0.985 1.423 1.179 R#s)-$ree rate 6.04% 11.89% 0

Beta 1.179

12

Comprehensive/Spreadsheet Problem

Chapter 8: Risk and Rates of Return

-nte=rated Case
8-23

2erri%% Ainch -nc. Ris- and Return

Assu'e that ?ou recent%? =raduated with a 'a6or in financeB and ?ou 6ust %anded a 6ob as a financia% p%anner with 2erri%% Ainch -nc.B a %ar=e financia% ser)ices corporation. 3our first assi=n'ent is to in)est C1((B((( for a c%ient. 8ecause the funds are to be in)ested in a business at the end of 1 ?earB ?ou ha)e been instructed to p%an for a 1?ear ho%din= period. AurtherB ?our boss has restricted ?ou to the in)est'ent a%ternati)es in the fo%%owin= tab%eB shown with their probabi%ities and associated outco'es. D0isre=ard for now the ite's at the botto' of the dataE ?ou wi%% fi%% in the b%anks %ater.F
Returns on A%ternati)e -n)est'ents Esti'ated Rate of Return Gi=h Co%%ec1.$. 2arket +ech tions Rubber &ortfo%io -2".(H 2".(H !.(Ha -1".(H -".( 13.( -14.( -3.( 1 .( (.( 3.( 1(.( 3(.( -11.( 41.( 2 .( 4 .( -21.( 2!.( 38.( 1.(H 13.2 13.2 -(.8" #.8H 18.8 1.# (.88 1(. H 1 .2 1.4

$tate of the Econo'? Recession 8e%ow A)=. A)era=e Abo)e A)=. 8oo' r-hat D I r F $td. de). D F

&rob. (.1 (.2 (.4 (.2 (.1

+-8i%%s . H . . . . (.(

2-$tock &ortfo%io (.(H ". 12.( 3.4 (.

Coeff. of <ar. DC<F beta DbF

a

;ote that the esti'ated returns of 1.$. Rubber do not a%wa?s 'o)e in the sa'e direction as the o)era%% econo'?. Aor e,a'p%eB when the econo'? is be%ow a)era=eB consu'ers purchase fewer tires than the? wou%d if the econo'? was stron=er. Gowe)erB if the econo'? is in a f%at-out recessionB a %ar=e nu'ber of consu'ers who were p%annin= to purchase a new car 'a? choose to wait and instead purchase new tires for the car the? current%? own. 1nder these circu'stancesB we wou%d e,pect 1.$. Rubber.s stock price to be hi=her if there is a recession than if the econo'? was 6ust be%ow a)era=e.

2erri%% Ainch.s econo'ic forecastin= staff has de)e%oped probabi%it? esti'ates for the state of the econo'?B and its securit? ana%?sts ha)e de)e%oped a sophisticated
Chapter 8: Risk and Rates of Return Integrated Case 13

co'puter pro=ra'B which was used to esti'ate the rate of return on each a%ternati)e under each state of the econo'?. Gi=h +ech -nc. is an e%ectronics fir'E Co%%ections -nc. co%%ects past-due debtsE and 1.$. Rubber 'anufactures tires and )arious other rubber and p%astics products. 2erri%% Ainch a%so 'aintains a J'arket portfo%ioK that owns a 'arket-wei=hted fraction of a%% pub%ic%? traded stocksE ?ou can in)est in that portfo%ioB and thus obtain a)era=e stock 'arket resu%ts. Li)en the situation as describedB answer the fo%%owin= 5uestions. A. D1F /h? is the +-bi%%.s return independent of the state of the econo'?M 0o +bi%%s pro'ise a co'p%ete%? risk-free returnM Answer: N$how $8-1 throu=h $8-" here.O +he . H +-bi%% return does not depend on the state of the econo'? because the +reasur? 'ust Dand wi%%F redee' the bi%%s at par re=ard%ess of the state of the econo'?. +he +-bi%%s are risk-free in the defau%t risk sense because the . H return wi%% be rea%iPed in a%% possib%e econo'ic states. Gowe)erB re'e'ber that this return is co'posed of the rea% risk-free rateB sa? 3HB p%us an inf%ation pre'iu'B sa? 2. H. $ince there is uncertaint? about inf%ationB it is un%ike%? that the rea%iPed rea% rate of return wou%d e5ua% the e,pected 3H. Aor e,a'p%eB if inf%ation a)era=ed 3. H o)er the ?earB then the rea%iPed rea% return wou%d on%? be . H Q 3. H : 2HB not the e,pected 3H. +husB in ter's of purchasin= powerB +-bi%%s are not risk%ess. A%soB if ?ou in)ested in a portfo%io of +-bi%%sB and rates then dec%inedB ?our no'ina% inco'e wou%d fa%%E that isB +-bi%%s are e,posed to rein)est'ent rate risk. $oB we conc%ude that there are no tru%? risk-free securities in the 1nited $tates. -f the +reasur? so%d inf%ation-inde,edB ta,e,e'pt bondsB the? wou%d be tru%? risk%essB but a%% actua% securities are e,posed to so'e t?pe of risk. A. D2F /h? are Gi=h +ech.s returns e,pected to 'o)e with the econo'? whereas Co%%ections. are e,pected to 'o)e counter to the econo'?M
14 Integrated Case Chapter 8: Risk and Rates of Return

Answer:

N$how $8-8 here.O Gi=h +ech.s returns 'o)e withB hence are positi)e%? corre%ated withB the econo'?B because the fir'.s sa%esB and hence profitsB wi%% =enera%%? e,perience the sa'e t?pe of ups and downs as the econo'?. -f the econo'? is boo'in=B so wi%% Gi=h +ech. 4n the other handB Co%%ections is considered b? 'an? in)estors to be a hed=e a=ainst both bad ti'es and hi=h inf%ationB so if the stock 'arket crashesB in)estors in this stock shou%d do re%ati)e%? we%%. $tocks such as Co%%ections are thus ne=ati)e%? corre%ated with D'o)e counter toF the econo'?. D;ote: -n actua%it?B it is a%'ost i'possib%e to find stocks that are e,pected to 'o)e counter to the econo'?.F

8.

Ca%cu%ate the e,pected rate of return on each a%ternati)e and fi%% in the b%anks on the row for I r in the tab%e abo)e.

Answer:

N$how $8-# and $8-1( here.O +he e,pected rate of returnB I r B is e,pressed as fo%%ows:
I r =

& r
i =1

i i

Gere &i is the probabi%it? of occurrence of the ith stateB r i is the esti'ated rate of return for that stateB and ; is the nu'ber of states. Gere is the ca%cu%ation for Gi=h +ech:
I r
Gi=h +ech

: (.1D-2".(HF R (.2D-".(HF R (.4D1 .(HF R (.2D3(.(HF R (.1D4 .(HF : 12.4H.

/e use the sa'e for'u%a to ca%cu%ate r.s for the other a%ternati)es:
I r I r I r
+-bi%%s

: . H. : 1.(H. : #.8H. : 1(. H.

Integrated Case 1

Co%%ections 1.$. Rubber

I r

Chapter 8: Risk and Rates of Return

C.

3ou shou%d reco=niPe that basin= a decision so%e%? on e,pected returns is on%? appropriate for risk-neutra% indi)idua%s. 8ecause ?our c%ientB %ike )irtua%%? e)er?oneB is risk a)erseB the riskiness of each a%ternati)e is an i'portant aspect of the decision. 4ne possib%e 'easure of risk is the standard de)iation of returns. D1F Ca%cu%ate this )a%ue for each a%ternati)eB and fi%% in the b%ank on the row for in the tab%e.

Answer:

N$how $8-11 and $8-12 here.O +he standard de)iation is ca%cu%ated as fo%%ows: :

Dr
i =1

I r F 2 &i .

Gi=h +ech : ND-2".( Q 12.4F2D(.1F R D-".( Q 12.4F2D(.2F R D1 .( Q 12.4F2D(.4F R D3(.( Q 12.4F2D(.2F R D4 .( Q 12.4F2D(.1FOS : 4(1.4 : 2(.(H. Gere are the standard de)iations for the other a%ternati)es: +-bi%%s : (.(H. Co%%ections : 13.2H. 1.$. Rubber : 18.8H. 2 : 1 .2H. C. D2F /hat t?pe of risk is 'easured b? the standard de)iationM N$how $8-13 throu=h $8-1 here.O +he standard de)iation is a 'easure of a securit?.s Dor a portfo%io.sF stand-a%one risk. +he %ar=er the standard de)iationB the hi=her the probabi%it? that actua% rea%iPed returns wi%% fa%% far be%ow the e,pected returnB and that %osses rather than profits wi%% be incurred.
1! Integrated Case Chapter 8: Risk and Rates of Return

Answer:

C.

D3F

0raw a =raph that shows rou=h%? the shape of the probabi%it? distributions for Gi=h +echB 1.$. RubberB and +-bi%%s.

Answer:
r o b a b i li t y o f S c c u rre n c e

+ - 8 i%%s

G i= h + e c h

1 .$ . R u b b e r

-H 4

-I E

-L 4

-2 E

2E

L4

IE

H4

A a te o f A e tu rn (6 !

4n the basis of these dataB Gi=h +ech is the 'ost risk? in)est'entB +-bi%%s the %east risk?. 0. $uppose ?ou sudden%? re'e'bered that the coefficient of )ariation DC<F is =enera%%? re=arded as bein= a better 'easure of stand-a%one risk than the standard de)iation when the a%ternati)es bein= considered ha)e wide%? differin= e,pected returns. Ca%cu%ate the 'issin= C<sB and fi%% in the b%anks on the row for C< in the tab%e. 0oes the C< produce the sa'e risk rankin=s as the standard de)iationM Answer: N$how $8-1! throu=h $8-1# here.O +he coefficient of )ariation DC<F is a standardiPed 'easure of dispersion about the e,pected )a%ueE it shows the a'ount of risk per unit of return. C< : * I r. C<+-bi%%s : (.(H* . H : (.(. C<Gi=h +ech : 2(.(H*12.4H : 1.!. C<Co%%ections : 13.2H*1.(H : 13.2.
Chapter 8: Risk and Rates of Return Integrated Case 1"

C<1.$. Rubber : 18.8H*#.8H : 1.#. C<2 : 1 .2H*1(. H : 1.4. /hen we 'easure risk per unit of returnB Co%%ectionsB with its %ow e,pected returnB beco'es the 'ost risk? stock. +he C< is a better 'easure of an asset.s stand-a%one risk than because C< considers both the e,pected )a%ue and the dispersion of a distributionTa securit? with a %ow e,pected return and a %ow standard de)iation cou%d ha)e a hi=her chance of a %oss than one with a hi=h but a hi=h I r. E. $uppose ?ou created a 2-stock portfo%io b? in)estin= C (B((( in Gi=h +ech and C (B((( in Co%%ections. D1F
rp FB the standard de)iation D pFB and the Ca%cu%ate the e,pected return D I

coefficient of )ariation DC<pF for this portfo%io and fi%% in the appropriate b%anks in the tab%e. Answer: N$how $8-2( throu=h $8-23 here.O +o find the e,pected rate of return on the two-stock portfo%ioB we first ca%cu%ate the rate of return on the portfo%io in each state of the econo'?. $ince we ha)e ha%f of our 'one? in each stockB the portfo%io.s return wi%% be a wei=hted a)era=e in each t?pe of econo'?. Aor a recessionB we ha)e: r p : (. D-2"HF R (. D2"HF : (H. /e wou%d do si'i%ar ca%cu%ations for the other states of the econo'?B and =et these resu%ts: $tate &ortfo%io Recession (.(H 8e%ow a)era=e 3.( A)era=e ". Abo)e a)era=e #. 12.( 8oo' ;ow we can 'u%tip%? the probabi%it? ti'es the outco'e in each state to =et the e,pected return on this two-stock portfo%ioB !."H. A%ternati)e%?B we cou%d app%? this for'u%aB
18 Integrated Case Chapter 8: Risk and Rates of Return

r : wi ri : (. D12.4HF R (. D1.(HF : !."HB which finds r as the wei=hted a)era=e of the e,pected returns of the indi)idua% securities in the portfo%io. -t is te'ptin= to find the standard de)iation of the portfo%io as the wei=hted a)era=e of the standard de)iations of the indi)idua% securitiesB as fo%%ows: p wiD iF R w6D 6F : (. D2(HF R (. D13.2HF : 1!.!H. Gowe)erB this is not correctTit is necessar? to use a different for'u%aB the one for that we used ear%ierB app%ied to the two-stock portfo%io.s returns. +he portfo%io.s depends 6oint%? on D1F each securit?.s and D2F the corre%ation between the securities. returns. +he best wa? to approach the prob%e' is to esti'ate the portfo%io.s risk and return in each state of the econo'?B and then to esti'ate p with the for'u%a. Li)en the distribution of returns for the portfo%ioB we can ca%cu%ate the portfo%io.s and C< as shown be%ow: p : ND(.( Q !."F2D(.1F R D3.( Q !."F2D(.2F R D". Q !."F2D(.4F R D#. - !."F2D(.2F R D12.( Q !."F2D(.1FOS : 3.4H. C<p : 3.4H*!."H : (. 1. E. D2F Gow does the riskiness of this 2-stock portfo%io co'pare with the riskiness of the indi)idua% stocks if the? were he%d in iso%ationM Answer: N$how $8-24 throu=h $8-2" here.O 1sin= either or C< as our stand-a%one risk 'easureB the stand-a%one risk of the portfo%io is si=nificant%? %ess than the stand-a%one risk of the indi)idua% stocks. +his is because the two stocks are ne=ati)e%? corre%atedTwhen Gi=h +ech is doin= poor%?B Co%%ections is doin= we%%B and )ice )ersa. Co'binin= the two stocks di)ersifies awa? so'e of the risk inherent in each stock if it were he%d in iso%ationB i.e.B in a 1-stock portfo%io.
Chapter 8: Risk and Rates of Return Integrated Case 1#

4ptiona% Question
0oes the e,pected rate of return on the portfo%io depend on the percenta=e of the portfo%io in)ested in each stockM /hat about the riskiness of the portfo%ioM Answer: 1sin= a spreadsheet 'ode%B it.s eas? to )ar? the co'position of the portfo%io to show the effect on the portfo%io.s e,pected rate of return and standard de)iation: H in Gi=h +ech (H 1( 2( 3( 4( ( !( "( 8( #( 1(( Gi=h +ech &%us Co%%ections I rp p 1.(H 2.1 3.3 4.4 .! !." ".8 #.( 1(.1 11.3 12.4 13.2H #.# !.! 3.2 (.4 3.4 !.8 1(.1 13.4 1!." 2(.(

+he e,pected rate of return on the portfo%io is 'ere%? a %inear co'bination of the two stock.s e,pected rates of return. Gowe)erB portfo%io risk is another 'atter. p be=ins to fa%% as Gi=h +ech and Co%%ections are co'binedE it reaches near Pero at 4(H Gi=h +echE and then it be=ins to rise. Gi=h +ech and Co%%ections can be co'bined to for' a near Pero risk portfo%io because the? are )er? c%ose to bein= perfect%? ne=ati)e%? corre%atedE their corre%ation coefficient is -(.### . D;ote: 1nfortunate%?B we cannot find an? actua% stocks with r : -1.(.F

2(

Integrated Case

Chapter 8: Risk and Rates of Return

A.

$uppose an in)estor starts with a portfo%io consistin= of one rando'%? se%ected stock. /hat wou%d happen D1F to the riskiness and D2F to the e,pected return of the portfo%io as 'ore and 'ore rando'%? se%ected stocks were added to the portfo%ioM /hat is the i'p%ication for in)estorsM 0raw a =raph of the 2 portfo%ios to i%%ustrate ?our answer.

Answer:

N$how $8-28 here.O

Qensity ortfolio of ,tocks with rp ; 24.E6

Sne ,tock

24.E

+he standard de)iation =ets s'a%%er as 'ore stocks are co'bined in the portfo%ioB whi%e rp Dthe portfo%io.s returnF re'ains constant. portfo%ioB risk has been reduced. -n the rea% wor%dB stocks are positi)e%? corre%ated with one anotherTif the econo'? does we%%B so do stocks in =enera%B and )ice )ersa. Corre%ation coefficients between stocks =enera%%? ran=e in the )icinit? of R(.3 . A sin=%e stock se%ected at rando' wou%d on a)era=e ha)e a standard de)iation of about 3 H. As additiona% stocks are added to the portfo%ioB the portfo%io.s standard de)iation decreases because the added stocks are not perfect%? positi)e%? corre%ated. Gowe)erB as 'ore and 'ore stocks are addedB each new stock has %ess of a risk-reducin= i'pactB and e)entua%%? addin= additiona% stocks has )irtua%%? no effect on the portfo%io.s risk as 'easured b? . -n factB stabi%iPes at about 2(H when 4( or 'ore rando'%? se%ected stocks are added. +husB b? co'binin=
Chapter 8: Risk and Rates of Return Integrated Case 21

+husB b?

addin= stocks to ?our portfo%ioB which initia%%? started as a 1-stock

stocks into we%%-di)ersified portfo%iosB in)estors can e%i'inate a%'ost oneha%f the riskiness of ho%din= indi)idua% stocks. D;ote: -t is not co'p%ete%? cost%ess to di)ersif?B so e)en the %ar=est institutiona% in)estors ho%d %ess than a%% stocks. E)en inde, funds =enera%%? ho%d a s'a%%er portfo%io that is hi=h%? corre%ated with an inde, such as the $U& (( rather than ho%din= a%% the stocks in the inde,.F +he i'p%ication is c%ear: -n)estors shou%d ho%d we%%-di)ersified portfo%ios of stocks rather than indi)idua% stocks. D-n factB indi)idua%s can ho%d di)ersified portfo%ios throu=h 'utua% fund in)est'ents.F 8? doin= soB the? can e%i'inate about ha%f of the riskiness inherent in indi)idua% stocks. L. D1F $hou%d portfo%io effects i'pact the wa? in)estors think about the riskiness of indi)idua% stocksM Answer: N$how $8-2# and $8-3( here.O &ortfo%io di)ersification does affect

in)estors. )iews of risk. A stock.s stand-a%one risk as 'easured b? its or C<B 'a? be i'portant to an undi)ersified in)estorB but it is not re%e)ant to a we%%-di)ersified in)estor. A rationa%B risk-a)erse in)estor is 'ore interested in the i'pact that the stock has on the riskiness of his or her portfo%io than on the stock.s stand-a%one risk. $tand-a%one risk is co'posed of di)ersifiab%e riskB which can be e%i'inated b? ho%din= the stock in a we%%-di)ersified portfo%ioB and the risk that re'ains is ca%%ed 'arket risk because it is present e)en when the entire 'arket portfo%io is he%d.

22

Integrated Case

Chapter 8: Risk and Rates of Return

L.

D2F

-f ?ou decided to ho%d a 1-stock portfo%ioB and conse5uent%? were e,posed to 'ore risk than di)ersified in)estorsB cou%d ?ou e,pect to be co'pensated for a%% of ?our riskE that isB cou%d ?ou earn a risk pre'iu' on that part of ?our risk that ?ou cou%d ha)e e%i'inated b? di)ersif?in=M

Answer:

N$how $8-31 here.O -f ?ou ho%d a one-stock portfo%ioB ?ou wi%% be e,posed to a hi=h de=ree of riskB but ?ou won.t be co'pensated for it. -f the return were hi=h enou=h to co'pensate ?ou for ?our hi=h riskB it wou%d be a bar=ain for 'ore rationa%B di)ersified in)estors. +he? wou%d start bu?in= itB and these bu? orders wou%d dri)e the price up and the return down. +husB ?ou si'p%? cou%d not find stocks in the 'arket with returns hi=h enou=h to co'pensate ?ou for the stock.s di)ersifiab%e risk.

G.

+he e,pected rates of return and the beta coefficients of the a%ternati)es as supp%ied b? 2erri%% Ainch.s co'puter pro=ra' are as fo%%ows: $ecurit? Gi=h +ech 2arket 1.$. Rubber +-8i%%s Co%%ections D1F Return D I rF 12.4H 1(. #.8 . 1.( Risk D8etaF 1.32 1.(( (.88 (.(( D(.8"F

/hat is a beta coefficientB and how are betas used in risk ana%?sisM

Chapter 8: Risk and Rates of Return

Integrated Case

23

Answer:

N$how $8-32 throu=h $8-38 here.O

Aeturn on ,tock i Gigh Tech (6! (slope ; beta ; 2.L5!
I4

Barket (slope ; beta ; 2.4!

54

T->ills (slope ; beta ; 4!

-54 54 I4

Aeturn on the Barket (6!

-54

D0raw the fra'ework of the =raphB put up the dataB then p%ot the points for the 'arket D4 %ineF and connect the'B and then =et the s%ope as 3* > : 1.(.F $tate that an a)era=e stockB b? definitionB 'o)es with the 'arket. +hen do the sa'e with Gi=h +ech and +-bi%%s. 8eta coefficients 'easure the re%ati)e )o%ati%it? of a =i)en stock )is-V-)is an a)era=e stock. +he a)era=e stock.s beta is 1.(. 2ost stocks ha)e betas in the ran=e of (. to 1. . +heoretica%%?B betas can be ne=ati)eB but in the rea% wor%d the? are =enera%%? positi)e. 8etas are ca%cu%ated as the s%ope of the JcharacteristicK %ineB which is the re=ression %ine showin= the re%ationship between a =i)en stock and the =enera% stock 'arket. As e,p%ained in /eb Appendi, 8AB we cou%d esti'ate the s%opesB and then use the s%opes as the betas. -n practiceB to obtain a %east s5uares re=ression %ine. D2F 0o the e,pected returns appear to be re%ated to each a%ternati)e.s 'arket riskM ?ears of 'onth%? dataB with !( obser)ationsB wou%d =enera%%? be usedB and a co'puter wou%d be used

24

Integrated Case

Chapter 8: Risk and Rates of Return

Answer:

N$how $8-3# here.O +he e,pected returns are re%ated to each a%ternati)e.s 'arket riskTthat isB the hi=her the a%ternati)e.s rate of return the hi=her its beta. A%soB note that +-bi%%s ha)e Pero risk.

D3F

-s it possib%e to choose a'on= the a%ternati)es on the basis of the infor'ation de)e%oped thus farM 1se the data =i)en at the start of the prob%e' to construct a =raph that shows how the +-bi%%.sB Gi=h +ech.sB and the 'arket.s beta coefficients are ca%cu%ated. +hen discuss what betas 'easure and how the? are used in risk ana%?sis.

Answer:

/e do not ?et ha)e enou=h infor'ation to choose a'on= the )arious a%ternati)es. /e need to know the re5uired rates of return on these a%ternati)es and co'pare the' with their e,pected returns.

-.

+he ?ie%d cur)e is current%? f%atB that isB %on=-ter' +reasur? bonds a%so ha)e a . H ?ie%d. Conse5uent%?B 2erri%% Ainch assu'es that the risk-free rate is . H. D1F /rite out the $ecurit? 2arket 7ine D$27F e5uationB use it to ca%cu%ate the re5uired rate of return on each a%ternati)eB and then =raph the re%ationship between the e,pected and re5uired rates of return.

Answer:

N$how $8-4( throu=h $8-42 here.O Gere is the $27 e5uation: ri : rRA R Dr2 Q rRAFbi. 2erri%% Ainch has esti'ated the risk-free rate to be rRA : . H. AurtherB our esti'ate of r2 : I r
2

is 1(. H. +husB the re5uired rates of return for the

a%ternati)es are as fo%%ows:

Chapter 8: Risk and Rates of Return

Integrated Case

Gi=h +ech: 2arket: 1.$. Rubber: +-bi%%s: Co%%ections: -. D2F

. H R D1(. H Q . HF1.32 : 12.1(H. . H R D1(. H Q . HF1.(( : 1(. (H. . H R D1(. H Q . HF(.88 : #.#(H. . H R D1(. H Q . HF( : . (H. . H R D1(. H Q . HF-(.8" : 1.1 H.

Gow do the e,pected rates of return co'pare with the re5uired rates of returnM

Answer:

N$how $8-43 and $8-44 here.O /e ha)e the fo%%owin= re%ationships: E,pected Return DI rF 12.4H 1(. #.8 . 1.( Re5uired Return DrF 12.1H 1(. #.# . 1.2

$ecurit? Gi=h +ech 2arket 1.$. Rubber +-bi%%s Co%%ections

Condition 1nder)a%ued: I r Wr Aair%? )a%ued D'arket e5ui%ibriu'F 4)er)a%ued: r W I r Aair%? )a%ued 4)er)a%ued: r W I r
,BD: r i ; rA1 / (rB rA1 !bi ; E.E6 / E6(bi! Gigh Tech rB

Aequired and 0xpected Aates of Aeturn (6!

55 28 2I 24 H 5 -5 -H -5.4 -2.4 4.4

+.,. Aubber

r A1

#ollections
>eta

2.4

5.4

D;ote: +he p%ot %ooks so'ewhat unusua% in that the >-a,is e,tends to the %eft of Pero. /e ha)e a ne=ati)e-beta stockB hence a re5uired return that is %ess than the risk-free rate.F +he +-bi%%s and 'arket portfo%io p%ot on the $27B Gi=h +ech p%ots abo)e itB and Co%%ections and 1.$. Rubber p%ot be%ow
2! Integrated Case Chapter 8: Risk and Rates of Return

it. +husB the +-bi%%s and the 'arket portfo%io pro'ise a fair returnB Gi=h +ech is a =ood dea% because its e,pected return is abo)e its re5uired returnB and Co%%ections and 1.$. Rubber ha)e e,pected returns be%ow their re5uired returns. -. D3F 0oes the fact that Co%%ections has an e,pected return that is %ess than the +-bi%% rate 'ake an? senseM Answer: Co%%ections is an interestin= stock. -ts ne=ati)e beta indicates ne=ati)e 'arket riskTinc%udin= it in a portfo%io of Jnor'a%K stocks wi%% %ower the portfo%io.s risk. +hereforeB its re5uired rate of return is be%ow the risk-free rate. 8asica%%?B this 'eans that Co%%ections is a )a%uab%e securit? to rationa%B we%%-di)ersified in)estors. +o see wh?B consider this 5uestion: /ou%d an? rationa% in)estor e)er 'ake an in)est'ent that has a ne=ati)e e,pected returnM +he answer is J?esKT6ust think of the purchase of a %ife or fire insurance po%ic?. +he fire insurance po%ic? has a ne=ati)e e,pected return because of co''issions and insurance co'pan? profitsB but businesses bu? fire insurance because the? pa? off at a ti'e when nor'a% operations are in bad shape. 7ife insurance is si'i%arTit has a hi=h return when work inco'e ceases. A ne=ati)e-beta stock is conceptua%%? si'i%ar to an insurance po%ic?. -. D4F /hat wou%d be the 'arket risk and the re5uired return of a (- ( portfo%io of Gi=h +ech and Co%%ectionsM 4f Gi=h +ech and 1.$. RubberM Answer: N$how $8-4 and $8-4! here.O ;ote that the beta of a portfo%io is si'p%? the wei=hted a)era=e of the betas of the stocks in the portfo%io. +husB the beta of a portfo%io with (H Gi=h +ech and (H Co%%ections is:
bp =

w b
i=1 i

Chapter 8: Risk and Rates of Return

Integrated Case

2"

bp : (. DbGi=h +echF R (. DbCo%%ectionsF : (. D1.32F R (. DQ(.8"F : (.22 B rp : rRA R Dr2 Q rRAFbp : . H R D1(. H Q . HFD(.22 F : . H R HD(.22 F : !.!3H !.!H. Aor a portfo%io consistin= of (H Gi=h +ech p%us (H 1.$. RubberB the re5uired return wou%d be: bp : (. D1.32F R (. D(.88F : 1.1(. rp : . H R HD1.1(F : 11.((H. X. D1F $uppose in)estors raised their inf%ation e,pectations b? 3 percenta=e points o)er current esti'ates as ref%ected in the . H risk-free rate. /hat effect wou%d hi=her inf%ation ha)e on the $27 and on the returns re5uired on hi=h- and %ow-risk securitiesM Answer: N$how $8-4" here.O
Aequired and 0xpected Aates of Aeturn (6! I4 LE L4
Increased Inflation

Increased Aisk *%ersion

5E 54 2E 24 E 4.44 4.E4 2.44 2.E4 5.44 >eta

Sriginal ,ituation

Gere we ha)e p%otted the $27 for betas ran=in= fro' ( to 2.(. +he basecase $27 is based on rRA : . H and r2 : 1(. H. -f inf%ation e,pectations increase b? 3 percenta=e pointsB with no chan=e in risk a)ersionB then the entire $27 is shifted upward Dpara%%e% to the base case $27F b? 3 percenta=e points. ;owB rRA : 8. HB r2 : 13. HB and a%% securities. re5uired

28

Integrated Case

Chapter 8: Risk and Rates of Return

returns rise b? 3 percenta=e points. ;ote that the 'arket risk pre'iu'B r 2 Q rRAB re'ains at X. D2F percenta=e points.

$uppose instead that in)estors. risk a)ersion increased enou=h to cause the 'arket risk pre'iu' to increase b? 3 percenta=e points. D-nf%ation re'ains constant.F /hat effect wou%d this ha)e on the $27 and on returns of hi=h- and %ow-risk securitiesM

Answer:

N$how $8-48 throu=h $8- ( here.O re'ains at

/hen in)estors. risk a)ersion rRA

increasesB the $27 is rotated upward about the 3-intercept Dr RAF.

. HB but now r2 increases to 13. HB so the 'arket risk

pre'iu' increases to 8H. +he re5uired rate of return wi%% rise sharp%? on hi=h-risk Dhi=h-betaF stocksB but not 'uch on %ow-beta securities.

4ptiona% Question
Ainancia% 'ana=ers are 'ore concerned with in)est'ent decisions re%atin= to rea% assets such as p%ant and e5uip'ent than with in)est'ents in financia% assets such as securities. Gow does the ana%?sis that we ha)e =one throu=h re%ate to rea%-asset in)est'ent decisionsB especia%%? corporate capita% bud=etin= decisionsM Answer: +here is a =reat dea% of si'i%arit? between ?our financia% asset decisions and a fir'.s capita% bud=etin= decisions. Gere is the %inka=e: 1. A co'pan? 'a? be thou=ht of as a portfo%io of assets. -f the co'pan? di)ersifies its assetsB and especia%%? if it in)ests in so'e pro6ects that tend to do we%% when others are doin= bad%?B it can %ower the )ariabi%it? of its returns. 2. Co'panies obtain their in)est'ent funds fro' in)estorsB who bu? the fir'.s stocks and bonds. /hen in)estors bu? these securitiesB the? re5uire a risk pre'iu' that is based on the co'pan?.s risk as the? Din)estorsF see it. AurtherB since in)estors in =enera% ho%d we%%-

Chapter 8: Risk and Rates of Return

Integrated Case

2#

di)ersified portfo%ios of stocks and bondsB the risk that is re%e)ant to the' is the securit?.s 'arket riskB not its stand-a%one risk. +husB in)estors )iew the fir'.s risk fro' a 'arket-risk perspecti)e. 3. +hereforeB when a 'ana=er 'akes a decision to bui%d a new p%antB the riskiness of the in)est'ent in the p%ant that is re%e)ant to the fir'.s in)estors Dits ownersF is its 'arket riskB not its stand-a%one risk. Accordin=%?B 'ana=ers need to know how ph?sica%-asset in)est'ent decisions affect their fir'.s beta coefficient. A particu%ar asset 'a? %ook 5uite risk? when )iewed in iso%ationB but if its returns are ne=ati)e%? corre%ated with returns on 'ost other stocksB the asset 'a? rea%%? ha)e %ow risk. /e wi%% discuss a%% this in 'ore detai% in our capita% bud=etin= discussion.

3(

Integrated Case

Chapter 8: Risk and Rates of Return