Tutorial 4

Chapter 6 The Trade-Off Between Risk and Return

Q6-9. When measuring the volatility of an investments returns, why is it easier to focus on
standard deviation rather than variance?
A6-9. The units of measure in a variance calculation are percent squared which is hard to interpret. For standard deviation, the units of measure are percent, so we can easily compare the
standard deviation to the average return.
P6-1.

You purchase 1,000 shares of Spears Grinders Inc. stock for $45 per share. A year later, the
stock pays a dividend of $1.25 per share and it sells for $49.
a. Calculate your total dollar return.
b. Calculate your total percentage return.
c. Do the answers to parts (a) and (b) depend on whether you sell the stock after one year
or continue to hold it?

A6-1. a. 1,000 ($1.25 + $4) = $5,250

b. ($49 + $1.25 $45)/$45 = 0.1167 or 11.67%.
c. The answer does not depend on whether you sell the stock or hold it.

P6-14. The following data shows the rate of return on stocks and bonds for several recent years.
Calculate the risk premium on equities vs. bonds each year, and then calculate the average
risk premium. Do you think that at the beginning of 2007investors expected the outcomes
we observe in this table?
Year:
2007
2008
2009
2010
Return on stocks (%)
5.6
-37.2
28.5
17.1
Return on bonds (%)
9.9
25.9
14.5
6.4
Risk premium (%)
A6-14. The risk premiums are 4.3, 63.1, +14.0, and +10.7. Overall the average risk premium is
-10.7%. Investors surely did not anticipate these outcomes, particularly not the negative
risk premiums in 2007 and 2008. If investors expected such poor performance from stocks
relative to bonds at the start of the year, then money would have flooded out of the stock
market, causing prices to plummet, and money would have poured into the bond market,
causing prices to rise. Of course bonds can outperform equities after the fact, resulting in
negative risk premiums. If equities always outperformed bonds, then we could hardly say
that equities were riskier than bonds.

P6-19. Here are the nominal returns on stocks, bonds, and bills for the 1920s and 1930s. For each
decade, calculate the standard deviation of returns for each asset class. How do those figures compare with more recent numbers for stocks presented in Table 6.3 and the long-run
figures for all three asset types in Table 6.4?

Nominal Returns (%) on Stocks, Bonds, and Bills

1920s
1930s
Stocks Bonds Bills Stocks Bonds Bills
-17.9
5.8
7.6
-28.3
4.7
2.4
11.6
12.7
7.0
-43.9
-5.3
1.1
30.6
3.5
4.7
-9.8
16.8
1.0
3.0
5.7
5.2
57.6
-0.1
0.3
27.0
6.4
4.1
4.4
10.0
0.2
28.3
5.7
4.1
44.0
5.0
0.2
9.5
7.8
3.3
32.3
7.5
0.2
33.1
8.9
3.1
-34.6
0.2
0.3
38.7
0.1
3.6
28.2
5.5
0.0
-14.5
3.4
4.7
2.9
5.5
0.0
A6-19. The standard deviations are as follows.
1920s: stocks 20.0%, bonds 3.4%, bills 1.5%
1930s: stocks 34.7%, bonds 6.0%, bills 0.7%
In the 1920s, stocks were about as volatile as their recent history and as their long-run average, but in the 30s they were much more volatile than that. Both bonds and bills were
less volatile in the 20s and 30s than they were over the whole 20th century.

P6-23. The table below shows annual returns on Archer Daniels Midland (ADM) and Walmart
The last column of the table shows the annual return that a portfolio invested 50% in ADM
and 50% in Walmart would have earned in 1993. The portfolios return is simply a
weighted average of the returns of ADM and Walmart.

Year
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003

AMD
1.5%
37.4%
-11.2%
31.1%
10.0%
-15.3%
-23.5%
32.9%
1.9%
-12.1%
25.1%

50-50 Portfolio
Walmart
-22.7% -10.6% = (0.5 X 1.5% + 0.5 X -22.7%)
-24.6%
-5.5%
8.0%
50.7%
76.8%
61.2%
9.5%
15.6%
-18.1%
11.1%

a. Plot a graph similar to Figure 6.7 showing the returns on ADM and Walmart each year.
b. Fill in the blanks by calculating the 50-50 portfolios return each year from 1994-2010
and then plot this on the graph you created for part (a). How does the portfolio return
compare to the returns of the individual stocks in the portfolio?
c. Calculate the standard deviation of ADM, Walmart, and the portfolio and comment on
what you find.

A6-23 a. The graph below shows returns each year on the two stocks and on the portfolio. In
general, the return on the portfolio each year falls between the returns on the stocks.
The standard deviation of the portfolio is much less than the standard deviation of either stock in the portfolio.

b. & c.
Year
ADM
Walmart 50-50
1993
1.5%
-22.7%
-10.6%
1994
37.4%
-24.6%
6.4%
1995
-11.2%
-5.5%
-8.3%
1996
31.1%
8.0%
19.6%
1997
10.0%
50.7%
30.4%
1998
-15.3%
76.8%
30.7%
1999
-23.5%
61.2%
18.8%
2000
32.9%
9.5%
21.2%
2001
1.9%
15.6%
8.7%
2002
-12.1%
-18.1%
-15.1%
2003
25.1%
11.1%
18.1%
2004
49.1%
-10.5%
19.3%
2005
12.3%
-8.2%
2.0%
2006
31.0%
3.3%
17.2%
2007
47.2%
0.3%
23.7%
2008
-36.9%
15.0%
-10.9%

2009
2010
Std. dev

10.8%
-1.5%
24.81%

10.9%
1.4%
27.71%

10.9%
0.0%
14.43%