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Anjenette A.

Mando
BA 142 Section THX
P8-13
a.

Expected portfolio return


Year
2013
2014
2015
2016
2017
2018

b.

c.

Stock L
14%
14%
16%
17%
17%
19%

Probability
40%
40%
40%
40%
40%
40%

Expected value of portfolio returns


17.6%+16.4%+16%+15.2%+14%+13.6% =

Stock L
14%
14%
16%
17%
17%
19%

Probability
40%
40%
40%
40%
40%
40%

P8-14

a.

Expected
Probability Portfolio
60%
17.60%
60%
16.40%
60%
16.00%
60%
15.20%
60%
14.00%
60%
13.60%

92.80%
6

15.4667%

Standard Deviation of Expected Portfolio Returns

Year
2013
2014
2015
2016
2017
2018

d.
e.

Stock M
20%
18%
16%
14%
12%
10%

0.11413%
(6-1)

Stock M
20%
18%
16%
14%
12%
10%

Expected
Portfolio
Probability Return
60%
17.60%
60%
16.40%
60%
16.00%
60%
15.20%
60%
14.00%
60%
13.60%

Expected
value of
portfolio
returns
15.4667%
15.4667%
15.4667%
15.4667%
15.4667%
15.4667%

0.04551%
0.00871%
0.00284%
0.00071%
0.02151%
0.03484%
0.11413%

1.51%

They are negatively correlated. When the returns of stock L rises, stock M's goes down and vice versa.
By combining two stocks that are more or less negatively correlated, Jamie was able to reduce an overall
risk of his portfolio because the rise of the other stock could negate the decrease in the return of the other
stock.
Portfolio analysis
Alternative 1:
Expected
Returns b.
Year
Asset F
Probability
=
0.05%
2013
16%
100%
16.00%
2014
17%
100%
17.00%
n -1 =
3
2015
18%
100%
18.00%
2016
19%
100%
19.00%
= 0.00016667
Expected portfolio returns =
17.50% b.
= 1.290994%
Alternative 2:
Expected
Year
Asset F
Probability Asset G
Probability Returns
=0
2013
16%
50%
17%
50%
16.50%
b.
2014
17%
50%
16%
50%
16.50%
2015
18%
50%
15%
50%
16.50%
= 0%
2016
19%
50%
14%
50%
16.50%
Expected portfolio returns =
16.50%

Anjenette A. Mando
BA 142 Section THX
Alternative 3:
Year
2013
2014
2015
2016

Asset F
16%
17%
18%
19%

Expected
Probability Asset H
Probability Returns
50%
14%
50%
15.00%
50%
15%
50%
16.00%
50%
16%
50%
17.00%
50%
17%
50%
18.00%
Expected portfolio returns =
16.50%

b.

Total =
n-1=
=
=

0.02250%
0.00250%
0.00250%
0.02250%
0.05000%
3
0.01666667
1.29099%

c.

d.

P8-15
Given:

a.

Alternative 1:
Alternative 2:
Alternative 3:
Summary Statistics
Expected
portfolio
returns
Portfolio
Alternative 1 17.50%
Alternative 2 16.50%
Alternative 3 16.50%

CV = 1.290994%
CV =
0%
CV = 1.29099%

1.290994%
0%
1.290994%

17.50%
16.50%
16.50%

=
=
=

7.37711%
0.00000%
7.82418%

Since the assets have different expected returns, it is


best to use the CV to measure the risk in relation to
CV
its returns. Based on its risk, Alternative 2 seems to
be
the best choice as its asset combination results in
7.37711%
0.00000% a perfectly negative correlation of returns so its
relative risk is equal to 0%.
7.82418%

Correlation, risk and return


Expected
return
Asset

V
8%
5%
W
13%
10%
Perfectly positively correlated
(1) Range of expected return
(2) Range of the risk

=
=

between 8% to 13%
between 5% to 10%

Uncorrelated
(1) Range of expected return
(2) Range of the risk

=
=

between 8% to 13%
0% < risk <10%

Perfectly negatively correlated


(1) Range of expected return
(2) Range of the risk

=
=

between 8% to 13%
0% - 10%

Anjenette A. Mando
BA 142 Section THX
Total, nondiversifiable, and diversifiable risk
Number of Portfolio
16.00%
securities
risk
14.00%
1
14.50%
0.06
12.00%
2
13.30%
0.06
10.00%
3
12.20%
0.06
Diversifiable
4
11.20%
0.06
8.00%
5
10.30%
0.06
6.00%
6
9.50%
0.06
4.00%
7
8.80%
0.06
Nondiversifiable
2.00%
8
8.20%
0.06
0.00%
9
7.70%
0.06
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
10
7.30%
0.06
Number of securities
11
7.00%
0.06
12
6.80%
0.06
13
6.70%
0.06 c. Only nondiversifiable risk is relevant because, as shown by the graph,
14
6.65%
0.06 diversifiable risk can be virtually eliminated through holding a portfolio of at
15
6.60%
0.06 least 20 securities that are not positively correlated. David Talbots portfolio,
16
6.56%
0.06 assuming diversifiable risk could no longer be reduced by additions to the
17
6.52%
0.06 portfolio, has 6.47% relevant risk.
18
6.50%
0.06
19
6.48%
0.06
20
6.47%
0.06
Portfolio risk

P8-17

P8-18

Graphic derivation of beta


c. Asset B is more risky since it has a
higher beta of 1.33 which implies that
for every one point that the market
moves, its return will move 1.33 times.
It is higher compared to Asset B's beta
of 0.75.

P8-21
Expected

Asset

Beta

A
B
C
D

0.50
1.60
-0.20
0.90

a and b.

Increase in
Impact on
market return Asset Return

0.10
0.10
0.10
0.10

0.05
0.16
-0.02
0.09

Decrease in
Market
Return

-0.10
-0.10
-0.10
-0.10

Impact on
Asset
Return
-0.05
-0.16
0.02
-0.09

Anjenette A. Mando
BA 142 Section THX
c.
d.
P8-24

Case
A
B
C
D
E
P8-30

Project
A
B
C
D
E

If the market would definitely increase in the near future, I would prefer to invest in Asset B because it
would offer the highest return.
If the market would definitely decrease in the near future, I would prefer to invest in Asset C because in an
economic downturn, Asset C's returns would be increasing.
Capital asset pricing model
Market
Required
Risk-free
return
Beta
Return
rate (rf)
(rm)
5%
8%
1.30
8.90%
8%
13%
0.90
12.50%
9%
12%
-0.20
8.40%
10%
15%
1.00
15.00%
6%
10%
0.60
8.40%
Integrative- Risk, return and CAPM
Market
Risk-free
return
Beta
rate (rf)
(rm)
9%
14%
1.50
9%
14%
0.75
9%
14%
2.00
9%
14%
0.00
9%
14%
-0.50

b.

Required
Return
16.50%
12.75%
19.00%
9.00%
6.50%

Risk
premium
2.50%
-1.25%
5.00%
-5.00%
-7.50%
c.

Required Rate of Return

0.2
0.15
0.1
SML (b)
0.05
0
-0.5

0.75

1.5

Nondiversifiable risk

d.

Project
A
B
C
D
E

Risk-free
rate (rf)
9%
9%
9%
9%
9%

Market
return
(rm)
12%
12%
12%
12%
12%

Beta
1.50
0.75
2.00
0.00
-0.50

Required
Return
13.50%
11.25%
15.00%
9.00%
7.50%

Risk
premium
1.50%
-0.75%
3.00%
-3.00%
-4.50%

Project A is 150% as responsive as the


market.
Project B is 75% as responsive as the
market.
Project C is twice as responsive as the
market.
Project D is unaffected by market
movement.
Project E is only half as responsive as
the market, but moves in the opposite
direction as the market.

Anjenette A. Mando
BA 142 Section THX

e.

The steeper slope of SMLb indicates a higher risk premium than SMLd for these market conditions. When
investor risk aversion declines, investors require lower returns for any given risk level (beta).

Anjenette A. Mando
BA 142 Section THX