Finance: Applications and

Theory Ebook: Applications

and Theory
Content

Chapter9: CHARACTERIZING RISK AND RETURN

Self-Test Problems with Solutions

Computing Returns Consider that you own the following position at the beginning of the year:
200 shares of US Bancorp at $29.89 per share, 300 shares of Micron Technology at $13.31 per
share, and 250 shares of Hilton Hotels at $24.11 per share. During the year, US Bancorp and
Hilton Hotels both paid a dividend of $1.39 and $0.16, respectively. At the end of the year, the
stock prices of US Bancorp, Micron, and Hilton Hotels were $36.19, $13.12, and $34.90,
respectively. What are the dollar and percentage return of the stocks and the return of the
portfolio?
Solution:
You can compute the dollar and percentage returns as:

Now you need the portfolio weights of each stock. The total value of the portfolio at the beginning of
the year was:

So the stock weights are:

Now compute the portfolio return as:

Risk and Re turns The annual returns for GlaxoSmithKline and for Aetna are show in the table.

What is the average return and standard deviation of returns for these two firms? What is the
average return and risk of a portfolio consisting of 75 percent of GlaxoSmithKline and 25 percent
Aetna?

Solution:
Using the average and standard deviation equations for the GlaxoSmithKline returns results in

and Standard deviation of

For the portfolio, to compute the return for the portfolio each year, use the 75 percent and 25
percent weights:

The risk and return of these two stocks and the portfolio are:

This combination of the two stocks forms a portfolio that is only slightly riskier than GlaxoSmithKline
alone, but earns more than twice the return of GlaxoSmithKline.
p. 316

Risk versus Return You have gathered average return and standard deviation data for five
stocks (A-E). How have these stocks performed on a risk-versus-return basis? Compute the
coefficient of variation for each one.

Solution:
Compute the CoVs as:

Since lower values represent a better risk-reward trade-off, the stocks can be ordered from best to
worst as C, D, A, B, and E.

Diversification Opportunities You have also computed the correlation between each of the
five stocks in ST-3. These correlations are reported in the table below. Assess which stocks
should be combined into a portfolio.

Solution:
p. 317

First, note that stocks D and E do not seem to provide much diversification potential with each other
because they have a correlation of nearly 1, at 0.95. They also have similar correlations with the
other stocks. For example, stock D has a correlation with stock C of 0.33 while stock E has a
correlation with stock C of 0.35. Realize that you gain very little in owning both stock D and stock E.
Therefore, select stock D for the portfolio because it has exhibited a better risk-reward relationship
(see ST-3). Also note that all of the other stocks appear to have reasonably low correlations with one

another and therefore would benefit a portfolio. You should look into forming a portfolio of stocks A,
B, C, and D.

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