Risk Return Solutions

Chapter5RiskandReturn111
Chapter5
RiskandReturn
Instructors Resources
Overview
Thischapterfocusesonthefundamentalsoftheriskandreturnrelationshipofassetsandtheirvaluation.
Forthesingleassetheldinisolation,riskismeasuredwiththeprobabilitydistributionanditsassociated
statistics:themean,thestandarddeviation,andthecoefficientofvariation.Theconceptofdiversification
isexaminedbymeasuringtheriskofaportfolioofassetsthatareperfectlypositivelycorrelated,perfectly
negativelycorrelated,andthosethatareuncorrelated.Next,thechapterlooksatinternational
diversificationanditseffectonrisk.TheCapitalAssetPricingModel(CAPM)isthenpresentedasa
valuationtoolforsecuritiesandasageneralexplanationoftheriskreturntradeoffinvolvedinalltypesof
financialtransactions.
Study Guide
ThefollowingStudyGuideexamplesaresuggestedforclassroompresentation:
Example
Topic
Riskattitudes
Graphicdeterminationofbeta
12
Impactofmarketchangesonreturn
Suggested Answer to Chapter Opening Critical

Thinking Question
Howmightanemployeeworkingincorporatefinancebeaffectedbythemergerofhisorher
companywithanothercorporation?
Sinceoneofthewaystoreapcostsavingsinamergeristoeliminateduplicateoperations,corporate
financeemployeesmustconsiderthepossibilitythattheirpositionmaybeeliminated.Theonlydefense
againstsuchadevastatingcareersetbackistobeproficientinyourjobskillset.Whileexperienceandjob
knowledgemaynotbeenoughtoavoidthecostcuttingaxe,thosequalitieswouldmakeyourjobsearch
easier.Forthosewhoarechosentostaywiththenewlymergedcompany,youcanexpectchange.
Establishedprocedures,thepeoplewithwhomyouworkandevenyourworklocationmayallchange.The
mergermayrequireextraworkonyourpartasthecompanyworkstoassimilatebothpartsintoanew
whole.
112Part2ImportantFinancialConcepts
Answers to Review Questions

1.
Riskisdefinedasthechanceoffinancialloss,asmeasuredbythevariabilityofexpectedreturns
associatedwithagivenasset.Adecisionmakershouldevaluateaninvestmentbymeasuringthe
chanceofloss,orrisk,andcomparingtheexpectedrisktotheexpectedreturn.Someassetsare
consideredriskfree;themostcommonexamplesareU.S.Treasuryissues.
2.
Thereturnonaninvestment(totalgainorloss)isthechangeinvalueplusanycashdistributionsover
adefinedtimeperiod.Itisexpressedasapercentofthebeginningoftheperiodinvestment.The
formulais:
Return
(endingvalue initialvalue) cashdistribution

initialvalue
Realizedreturnrequirestheassettobepurchasedandsoldduringthetimeperiodsthereturnis
measured.Unrealizedreturnisthereturnthatcouldhavebeenrealizediftheassethadbeen
purchasedandsoldduringthetimeperiodthereturnwasmeasured.
3.
(a) Theriskaversefinancialmanagerrequiresanincreaseinreturnforagivenincreaseinrisk.
(b) Theriskindifferentmanagerrequiresnochangeinreturnforanincreaseinrisk.
(c) Theriskseekingmanageracceptsadecreaseinreturnforagivenincreaseinrisk.
Mostfinancialmanagersareriskaverse.
4.
Sensitivityanalysisevaluatesassetriskbyusingmorethanonepossiblesetofreturnstoobtaina
senseofthevariabilityofoutcomes.Therangeisfoundbysubtractingthepessimisticoutcomefrom
theoptimisticoutcome.Thelargertherange,themorevariabilityofriskassociatedwiththeasset.
5.
Thedecisionmakercangetanestimateofprojectriskbyviewingaplotoftheprobability
distribution,whichrelatesprobabilitiestoexpectedreturnsandshowsthedegreeofdispersionof
returns.Themorespreadoutthedistribution,thegreaterthevariabilityorriskassociatedwiththe
returnstream.
6.
Thestandarddeviationofadistributionofassetreturnsisanabsolutemeasureofdispersionofrisk
aboutthemeanorexpectedvalue.Ahigherstandarddeviationindicatesagreaterprojectrisk.Witha
largerstandarddeviation,thedistributionismoredispersedandtheoutcomeshaveahigher
variability,resultinginhigherrisk.
7.
Thecoefficientofvariationisanotherindicatorofassetrisk,measuringrelativedispersion.Itis
calculatedbydividingthestandarddeviationbytheexpectedvalue.Thecoefficientofvariationmay
beabetterbasisthanthestandarddeviationforcomparingriskofassetswithdifferingexpected
returns.
8.
Anefficientportfolioisonethatmaximizesreturnforagivenrisklevelorminimizesriskforagiven
levelofreturn.Returnofaportfolioistheweightedaverageofreturnsontheindividualcomponent
assets:
n
k p wj k j
j1
where:
nnumberofassets,
wjweightofindividualassets,
j expectedreturns.
k
Thestandarddeviationofaportfolioisnottheweightedaverageofcomponentstandarddeviations;
theriskoftheportfolioasmeasuredbythestandarddeviationwillbesmaller.Itiscalculatedby
applyingthestandarddeviationformulatotheportfolioassets:
kp
i 1
9.
(ki k)2
(n 1)
Thecorrelationbetweenassetreturnsisimportantwhenevaluatingtheeffectofanewassetonthe
portfoliosoverallrisk.Returnsondifferentassetsmovinginthesamedirectionarepositively
correlated,whilethosemovinginoppositedirectionsarenegativelycorrelated.Assetswithhigh
positivecorrelationincreasethevariabilityofportfolioreturns;assetswithhighnegativecorrelation
reducethevariabilityofportfolioreturns.Whennegativelycorrelatedassetsarebroughttogether
throughdiversification,thevariabilityoftheexpectedreturnfromtheresultingcombinationcanbe
lessthanthevariabilityorriskoftheindividualassets.Whenoneassethashighreturns,theothers
returnsarelowandviceversa.Therefore,theresultofdiversificationistoreduceriskbyprovidinga
patternofstablereturns.
Diversificationofriskintheassetselectionprocessallowstheinvestortoreduceoverallriskby
combiningnegativelycorrelatedassetssothattheriskoftheportfolioislessthantheriskofthe
individualassetsinit.Evenifassetsarenotnegativelycorrelated,thelowerthepositivecorrelation
betweenthem,thelowertheresultingrisk.
10. Theinclusionofforeignassetsinadomesticcompanysportfolioreducesriskfortworeasons.When
returnsfromforeigncurrencydenominatedassetsaretranslatedintodollars,thecorrelationofreturns
oftheportfoliosassetsisreduced.Also,iftheforeignassetsareincountriesthatarelesssensitiveto
theU.S.businesscycle,theportfoliosresponsetomarketmovementsisreduced.
Whenthedollarappreciatesrelativetoothercurrencies,thedollarvalueofaforeigncurrency
denominatedportfoliodeclinesandresultsinlowerreturnsindollarterms.Ifthisappreciationisdue
tobetterperformanceoftheU.S.economy,foreigncurrencydenominatedportfoliosgenerallyhave
lowerreturnsinlocalcurrencyaswell,furthercontributingtoreducedreturns.
Politicalrisksresultfrompossibleactionsbythehostgovernmentthatareharmfultoforeign
investorsorpossiblepoliticalinstabilitythatcouldendangerforeignassets.Thisformofriskis
particularlyhighindevelopingcountries.Companiesdiversifyinginternationallymayhaveassets
seizedorthereturnofprofitsblocked.
11. Thetotalriskofasecurityisthecombinationofnondiversifiableriskanddiversifiablerisk.
Diversifiableriskreferstotheportionofanassetsriskattributabletofirmspecific,randomevents
(strikes,litigation,lossofkeycontracts,etc.)thatcanbeeliminatedbydiversification.
Nondiversifiableriskisattributabletomarketfactorsaffectingallfirms(war,inflation,political
events,etc.).Somearguethatnondiversifiableriskistheonlyrelevantriskbecausediversifiablerisk
canbeeliminatedbycreatingaportfolioofassetswhicharenotperfectlypositivelycorrelated.
12. Betameasuresnondiversifiablerisk.Itisanindexofthedegreeofmovementofanassetsreturnin
responsetoachangeinthemarketreturn.Thebetacoefficientforanassetcanbefoundbyplotting
theassetshistoricalreturnsrelativetothereturnsforthemarket.Byusingstatisticaltechniques,the
characteristiclineisfittothedatapoints.Theslopeofthislineisbeta.Betacoefficientsfor
activelytradedstocksarepublishedinValueLineInvestmentSurveyandinbrokeragereports.The
betaofaportfolioiscalculatedbyfindingtheweightedaverageofthebetasoftheindividual
componentassets.
13. TheequationfortheCapitalAssetPricingModelis:
kjRF[bj(kmRF)],
where:
kj
RF
bj
km
therequired(orexpected)returnonassetj.
therateofreturnrequiredonariskfreesecurity(aU.S.Treasurybill)
thebetacoefficientorindexofnondiversifiable(relevant)riskforassetj
therequiredreturnonthemarketportfolioofassets(themarketreturn)
Thesecuritymarketline(SML)isagraphicalpresentationoftherelationshipbetweentheamountof
systematicriskassociatedwithanassetandtherequiredreturn.Systematicriskismeasuredbybeta
andisonthehorizontalaxiswhiletherequiredreturnisontheverticalaxis.
14. (a) Ifthereisanincreaseininflationaryexpectations,thesecuritymarketlinewillshowaparallel
shiftupwardinanamountequaltotheexpectedincreaseininflation.Therequiredreturnfora
givenlevelofriskwillalsorise.
(b) TheslopeoftheSML(thebetacoefficient)willbelesssteepifinvestorsbecomelessrisk
averse,andalowerlevelofreturnwillberequiredforeachlevelofrisk.
15. TheCAPMprovidesfinancialmanagerswithalinkbetweenriskandreturn.Becauseitwas
developedtoexplainthebehaviorofsecuritiespricesinefficientmarketsanduseshistoricaldatato
estimaterequiredreturns,itmaynotreflectfuturevariabilityofreturns.Whilestudieshavesupported
theCAPMwhenappliedinactivesecuritiesmarkets,ithasnotbeenfoundtobegenerallyapplicable
torealcorporateassets.However,theCAPMcanbeusedasaconceptualframeworktoevaluatethe
relationshipbetweenriskandreturn.
Suggested Answer to Critical Thinking Question

for in Practice and Global Focus Box
Internationalmutualfundsdonotincludeanydomesticassetswhereasglobalmutualfundsinclude
bothforeignanddomesticassets.HowmightthisdistinctionaffecttheircorrelationwithU.S.equity
mutualfunds?
Thedifferencebetweenglobalfundsandinternationalfundsisthatglobalfundscaninvestinstocksand
bondsaroundtheworldincludingU.S.securities,whileinternationalfundsinvestinstocksandbonds
aroundtheworld,butnotU.Ssecurities.Therefore,globalfundsaremorelikelytobecorrelatedwithU.S.
equitymutualfundssinceasignificantportionoftheirportfoliosarelikelytobeU.S.equities.Aninvestor
seekingincreasedinternationaldiversificationinaportfolioshouldconsiderinternationalfundsover
globalfundsorincreasetheportionoftheportfoliodevotedtoglobalfundsifseekingdiversification
throughglobalfunds.
Suggested Answer to Critical Thinking Question

for Focus on Ethics Box
Ishittingthenumbersanappropriategoal,giventheChapter1contrastofprofitandshareholder
wealthmaximization?Ifnot,whydoexecutivesemphasizeit?
ThepresentationinChapter1ofourtextbookisclear(andseealsothemoralimperativeintheChapter1
ethicsfocusbox):managersaretomaximizeshareholderwealth,notprofits.Shareholderwealth
encompassescashflowamount,timing,andriskallofwhicharemissedbyanEPSfocus.Further,tothe
extentmanagersfocusonprofit,theyshouldtargetlongruneconomicprofit,notnextquartersEPS.
Really,thereareonlytwojustificationsformanagementattentiononEPS:(1)profitsarealargeand
necessarypartofoperatingcashflows(thinkoftheindirectapproachtothestatementofcashflows,inthe
operatingsection);and(2)investorsmayuseEPSchangestoenablereevaluationofthecompanys
businessstrategyandtrendline.(InChapter7,youwillbepresentedwiththepriceearningsmultiple
approachtostockvaluation.)
Answers to Warm-Up Exercises

E51.
TotalAnnualReturn
Answer:
K1
C1 P1 P0 $0 $12, 000, 000 $10, 000, 000
20%
P0
$10, 000, 000
Logistics,Inc.doubledtheannualrateofreturnpredictedbytheanalyst.Thenegativenet
incomeisirrelevanttotheproblem.
E52.
ExpectedReturn
Answer:
E53.
Analyst
Probability
Return
WeightedValue
0.35
5%
1.75%
0.05
5%
0.25%
0.20
10%
2.0%
0.40
3%
1.2%
Total
1.00
ExpectedReturn
4.70%
ComparingtheRiskofTwoInvestments
Answer: CV10.100.150.6667
CV20.050.120.4167
Basedsolelyonstandarddeviations,investment2haslowerriskthaninvestment1.Basedon
coefficientsofvariation,investment2isstilllessriskythaninvestment1.Sincethetwo
investmentshavedifferentexpectedreturns,usingthecoefficientofvariationtoassessriskis
betterthansimplycomparingstandarddeviationsbecausethecoefficientofvariationconsiders
therelativesizeoftheexpectedreturnsofeachinvestment.
E54.
ComputingtheExpectedReturnofaPortfolio
Answer:
K p (0.45 0.038) (0.40 0.124) (0.15 0.175)
(0.0171) (0.0496) (0.02625)
0.09295 9.295%
Theportfolioisexpectedtohaveareturnofapproximately9.3%.
E55.
CalculatingaPortfolioBeta
Answer:
Beta 0.20 1.15) (0.10 0.85) (0.15 1.60) (0.20 1.35) (0.35 1.85)
0.2300 0.0850 0.2400 0.2700 0.6475 1.3875
Solutions to Problems
P51.
LG1:RateofReturn: kt
(Pt Pt1 Ct )
Pt1
Basic
(a) InvestmentX:Return
($21, 000 $20, 000 $1, 500)

12.50%
$20, 000
($55, 000 $55, 000 $6,800)

12.36%
$55, 000
(b) InvestmentXshouldbeselectedbecauseithasahigherrateofreturnforthesamelevelof
risk.
InvestmentY:Return
P52.
LG1:ReturnCalculations: kt
(Pt Pt1 Ct )
Pt1
Basic
Investment
P53.
Calculation
kt(%)
($1,100$800$100)$800
25.00
($118,000$120,000$15,000)$120,000
10.83
($48,000$45,000$7,000)$45,000
22.22
($500$600$80)$600
3.33
($12,400$12,500$1,500)$12,500
11.20
LG1:RiskPreferences
Intermediate
(a) TheriskindifferentmanagerwouldacceptInvestmentsXandYbecausethesehavehigher
returnsthanthe12%requiredreturnandtheriskdoesntmatter.
(b) TheriskaversemanagerwouldacceptInvestmentXbecauseitprovidesthehighestreturn
andhasthelowestamountofrisk.InvestmentXoffersanincreaseinreturnfortakingon
moreriskthanwhatthefirmcurrentlyearns.
(c) TheriskseekingmanagerwouldacceptInvestmentsYandZbecauseheorsheiswillingto
takegreaterriskwithoutanincreaseinreturn.
(d) Traditionally,financialmanagersareriskaverseandwouldchooseInvestmentX,sinceit
providestherequiredincreaseinreturnforanincreaseinrisk.
P54.
LG2:RiskAnalysis
Intermediate
(a)
Expansion
Range
24%16%8%
30%10%20%
(b) ProjectAislessrisky,sincetherangeofoutcomesforAissmallerthantherangefor
ProjectB.
(c) Sincethemostlikelyreturnforbothprojectsis20%andtheinitialinvestmentsareequal,the
answerdependsonyourriskpreference.
(d) Theanswerisnolongerclear,sinceitnowinvolvesariskreturntradeoff.ProjectBhasa
slightlyhigherreturnbutmorerisk,whileAhasbothlowerreturnandlowerrisk.
P55.
LG2:RiskandProbability
Intermediate
(a)
Camera
Range
30%20%10%
35%15%20%
(b)
CameraR
CameraS
Possible
Outcomes
Probability
Pri
ExpectedReturn
ki
Weighted
Value(%)(kiPri)
Pessimistic
0.25
20
5.00
Mostlikely
0.50
25
12.50
Optimistic
0.25
30
7.50
1.00
ExpectedReturn
25.00
Pessimistic
0.20
15
3.00
Mostlikely
0.55
25
13.75
Optimistic
0.25
35
8.75
1.00
ExpectedReturn
25.50
(c) CameraSisconsideredmoreriskythanCameraRbecauseithasamuchbroaderrangeof
outcomes.TheriskreturntradeoffispresentbecauseCameraSismoreriskyandalso
providesahigherreturnthanCameraR.
P56.
LG2:BarChartsandRisk
Intermediate
(a)
BarChartLineJ
0.6
Probability
0.5
0.4
0.3
0.2
0.1
0
0.75
1.25
8.5
ExpectedReturn(%)
14.75
16.25
BarChartLineK
0.7
0.6
0.5
Probability
0.4
0.3
0.2
0.1
0
1
2.5
13.5
15
ExpectedReturn(%)
(b)
Probability
Pri
ExpectedReturn
ki
Weighted
Value
(kiPri)
VeryPoor
0.05
0.0075
0.000375
Poor
0.15
0.0125
0.001875
Average
0.60
0.0850
0.051000
Good
0.15
0.1475
0.022125
Excellent
0.05
0.1625
0.008125
1.00
ExpectedReturn
0.083500
VeryPoor
0.05
0.010
0.000500
Poor
0.15
0.025
0.003750
Average
0.60
0.080
0.048000
Good
0.15
0.135
0.020250
Excellent
0.05
0.150
0.007500
1.00
ExpectedReturn
0.080000
Market
Acceptance
LineJ
LineK
(c) LineKappearslessriskyduetoaslightlytighterdistributionthanlineJ,indicatingalower
rangeofoutcomes.
P57.
LG2:CoefficientofVariation: CV
k
k
Basic
7%
0.3500
20%
9.5%
B CVB
0.4318
22%
6%
C CVC
0.3158
19%
5.5%
D CVD
0.3438
16%
(b) AssetChasthelowestcoefficientofvariationandistheleastriskyrelativetotheother
choices.
(a) A CVA
P58.
LG2:StandardDeviationversusCoefficientofVariationasMeasuresofRisk
Basic
(a) ProjectAisleastriskybasedonrangewithavalueof0.04.
(b) ProjectAisleastriskybasedonstandarddeviationwithavalueof0.029.Standarddeviation
isnottheappropriatemeasureofrisksincetheprojectshavedifferentreturns.
0.029
(c) A CVA
0.2417
0.12
0.032
B CVB
0.2560
0.125
0.035
C CVC
0.2692
0.13
0.030
D CVD
0.2344
0.128
InthiscaseprojectDisthebestalternativesinceitprovidestheleastamountofriskforeach
percentofreturnearned.Coefficientofvariationisprobablythebestmeasureinthisinstance
sinceitprovidesastandardizedmethodofmeasuringtherisk/returntradeoffforinvestments
withdifferingreturns.
P59.
LG2:AssessingReturnandRisk
Challenge
(a) Project257
(1) Range:1.00(.10)1.10
n
(2) Expectedreturn: k k i Pri

i=1
ExpectedReturn
RateofReturn
ki
Probability
Pr i
WeightedValue
ki Pr i
.10
0.01
0.001
0.10
0.04
0.004
0.20
0.05
0.010
0.30
0.10
0.030
0.40
0.15
0.060
0.45
0.30
0.135
0.50
0.15
0.075
0.60
0.10
0.060
0.70
0.05
0.035
0.80
0.04
0.032
1.00
0.01
0.010
1.00
3. StandardDeviation:
i=1
0.450
(k k)
i
k k i Pr i
Pri
i=1
ki
ki k
(ki k) 2
Pr i
(ki k) 2Pr i
0.10
0.450
0.550
0.3025
0.01
0.003025
0.10
0.450
0.350
0.1225
0.04
0.004900
0.20
0.450
0.250
0.0625
0.05
0.003125
0.30
0.450
0.150
0.0225
0.10
0.002250
0.40
0.450
0.050
0.0025
0.15
0.000375
0.45
0.450
0.000
0.0000
0.30
0.000000
0.50
0.450
0.050
0.0025
0.15
0.000375
0.60
0.450
0.150
0.0225
0.10
0.002250
0.70
0.450
0.250
0.0625
0.05
0.003125
0.80
0.450
0.350
0.1225
0.04
0.004900
1.00
0.450
0.550
0.3025
0.01
0.003025
0.027350
Project 257 0.027350 0.165378

4.
0.165378
0.3675
0.450
Project432
CV
(1) Range:0.500.100.40
n
(2) Expectedreturn: k k i Pr i
i 1
ExpectedReturn
RateofReturn
ki
Probability
Pr i
WeightedValue
ki Pri
0.10
0.05
0.0050
0.15
0.10
0.0150
0.20
0.10
0.0200
0.25
0.15
0.0375
0.30
0.20
0.0600
0.35
0.15
0.0525
0.40
0.10
0.0400
0.45
0.10
0.0450
0.50
0.05
0.0250
k k i Pr i
i 1
1.00
0.300
(k k)
(3) StandardDeviation:
Pri
i 1
ki
ki k
(ki k) 2
Pri
(ki k) 2Pri
0.10
0.300
0.20
0.0400
0.05
0.002000
0.15
0.300
0.15
0.0225
0.10
0.002250
0.20
0.300
0.10
0.0100
0.10
0.001000
0.25
0.300
0.05
0.0025
0.15
0.000375
0.30
0.300
0.00
0.0000
0.20
0.000000
0.35
0.300
0.05
0.0025
0.15
0.000375
0.40
0.300
0.10
0.0100
0.10
0.001000
0.45
0.300
0.15
0.0225
0.10
0.002250
0.50
0.300
0.20
0.0400
0.05
0.002000
0.011250
Project432 0.011250 0.106066

(4) CV
0.106066
0.3536
0.300
(b) BarCharts
Project257
0.35
0.3
0.25
Probability
0.2
0.15
0.1
0.05
0
-10%
10%
20%
30%
40%
45%
50%
60%
70%
80%
100%
RateofReturn
Project432
0.3
0.25
0.2
Probability
0.15
0.1
0.05
0
10%
15%
20%
25%
30%
RateofReturn
35%
40%
45%
50%
(c) SummaryStatistics
Project257
Project432
Range
1.100
0.400
ExpectedReturn( k )
StandardDeviation( k )
0.450
0.300
0.165
0.106
CoefficientofVariation(CV)
0.3675
0.3536
SinceProjects257and432havedifferingexpectedvalues,thecoefficientofvariationshould
bethecriterionbywhichtheriskoftheassetisjudged.SinceProject432hasasmallerCV,it
istheopportunitywithlowerrisk.
P510. LG2:IntegrativeExpectedReturn,StandardDeviation,andCoefficientofVariation
Challenge
n
(a) Expectedreturn: k ki Pri

i 1
ExpectedReturn
AssetF
RateofReturn
ki
Probability
Pri
WeightedValue
kiPri
0.40
0.10
0.04
0.10
0.20
0.02
0.00
0.40
0.00
0.05
0.20
0.01
0.10
0.10
0.01
k k i Pri
i 1
0.04
AssetG
0.35
0.40
0.14
0.10
0.30
0.03
0.20
0.30
0.06
0.11
AssetH
0.40
0.10
0.04
0.20
0.20
0.04
0.10
0.40
0.04
0.00
0.20
0.00
0.20
0.10
0.02
0.10
AssetGprovidesthelargestexpectedreturn.
(b) StandardDeviation: k
(k k)
i
Pri
i 1
(ki k) 2
Pri
0.40 0.04 0.36
0.1296
0.10
0.01296
0.10 0.04 0.06
0.0036
0.20
0.00072
0.00 0.040.04
0.0016
0.40
0.00064
0.05 0.040.09
0.0081
0.20
0.00162
0.10 0.040.14
0.0196
0.10
0.00196
(ki k)
AssetF
0.01790
AssetG
0.35 0.11 .24
0.0576
0.40
0.02304
0.10 0.110.01
0.0001
0.30
0.00003
0.20 0.110.31
0.0961
0.30
0.02883
0.05190
AssetH
0.40 0.10 .30
0.0900
0.10
0.009
0.20 0.10 .10
0.0100
0.20
0.002
0.10 0.10 0.00
0.0000
0.40
0.000
0.00 0.100.10
0.0100
0.20
0.002
0.20 0.100.30
0.0900
0.10
0.009
0.022
0.1338
0.2278
0.1483
Basedonstandarddeviation,AssetGappearstohavethegreatestrisk,butitmustbe
measuredagainstitsexpectedreturnwiththestatisticalmeasurecoefficientofvariation,since
thethreeassetshavedifferingexpectedvalues.Anincorrectconclusionabouttheriskofthe
assetscouldbedrawnusingonlythestandarddeviation.
(c) CoefficientofVariation=
standarddeviation()
expectedvalue
0.1338
3.345
0.04
0.2278
AssetG: CV
2.071
0.11
0.1483
AssetH: CV
1.483
0.10
Asmeasuredbythecoefficientofvariation,AssetFhasthelargestrelativerisk.
AssetF: CV
P511. LG2:NormalProbabilityDistribution
Challenge
(a) Coefficientofvariation:CV k k
Solvingforstandarddeviation: 0.75 k0.189
k 0.750.1890.14175
(b) (1) 68%oftheoutcomeswillliebetween1standarddeviationfromtheexpectedvalue:
1 0.189 0.14175 0.33075
1 0.189 0.14175 0.04725
(2) 95%oftheoutcomeswillliebetween2standarddeviationsfromtheexpectedvalue:
2 0.189 (2 0.14175) 0.4725
2 0.189 (2 0.14175) 0.0945
(3) 99%oftheoutcomeswillliebetween3standarddeviationsfromtheexpectedvalue:
3 0.189 (3 0.14175) 0.61425
3 0.189 (3 0.14175) 0.23625
(c)
ProbabilityDistribution
60
50
40
Probability
30
20
10
0
-0.236
-0.094
0.047
0.189
Return
0.331
0.473
0.614
P512. LG3:PortfolioReturnandStandardDeviation
Challenge
(a) ExpectedPortfolioReturnforEachYear:kp(wLkL)(wMkM)
Expected
PortfolioReturn
AssetL
AssetM
Year
(wLkL)
(wMkM)
kp
2004
(14%0.405.6%)
(20%0.6012.0%)
17.6%
2005
(14%0.405.6%)
(18%0.6010.8%)
16.4%
2006
(16%0.406.4%)
(16%0.609.6%)
16.0%
2007
(17%0.406.8%)
(14%0.608.4%)
15.2%
2008
(17%0.406.8%)
(12%0.607.2%)
14.0%
2009
(19%0.407.6%)
(10%0.606.0%)
13.6%
(b) PortfolioReturn:
w k
j
kp
kp
j1
n
17.6 16.4 16.0 15.2 14.0 13.6
15.467 15.5%
6
(c) StandardDeviation: kp
(ki k)2
i 1 (n 1)
n
(17.6% 15.5%)2 (16.4% 15.5%)2 (16.0% 15.5%)2
(15.2% 15.5%)2 (14.0% 15.5%)2 (13.6% 15.5%)2
kp
6 1
(2.1%)2 (0.9%)2 (0.5%)2
(0.3%)2 (1.5%)2 (1.9%)2
kp
5
kp
(4.41% 0.81% 0.25% 0.09% 2.25% 3.61%)

5
11.42
2.284 1.51129
5
(d) Theassetsarenegativelycorrelated.
(e) Combiningthesetwonegativelycorrelatedassetsreducesoverallportfoliorisk.
kp
P513. LG3:PortfolioAnalysis
Challenge
(a) Expectedportfolioreturn:
Alternative1:100%AssetF
kp
16% 17% 18% 19%

17.5%
4
Alternative2:50%AssetF50%AssetG
AssetF
(wFkF)
Year
AssetG
(wGkG)
PortfolioReturn
kp
2007
(16%0.508.0%)
(17%0.508.5%)
16.5%
2008
(17%0.508.5%)
(16%0.508.0%)
16.5%
2009
(18%0.509.0%)
(15%0.507.5%)
16.5%
2010
(19%0.509.5%)
(14%0.507.0%)
16.5%
66
16.5%
4
Alternative3:50%AssetF50%AssetH
kp
Year
AssetF
(wFkF)
AssetH
(wHkH)
PortfolioReturn
kp
2007
(16%0.508.0%)
(14%0.507.0%)
15.0%
2008
(17%0.508.5%)
(15%0.507.5%)
16.0%
2009
(18%0.509.0%)
(16%0.508.0%)
17.0%
2010
(19%0.509.5%)
(17%0.508.5%)
18.0%
kp
66
16.5%
4
(b) StandardDeviation: kp
i 1
(ki k)2
(n 1)
(1)
F
[(16.0% 17.5%)2 (17.0% 17.5%)2 (18.0% 17.5%)2 (19.0% 17.5%)2 ]

4 1
[(1.5%)2 (0.5%)2 (0.5%)2 (1.5%)2 ]

3
(2.25% 0.25% 0.25% 2.25%)

3
5
1.667 1.291
3
(2)
FG
[(16.5% 16.5%)2 (16.5% 16.5%)2 (16.5% 16.5%)2 (16.5% 16.5%)2 ]

4 1
FG
[(0)2 (0)2 (0)2 (0)2 ]

3
FG 0
(3)
FH
[(15.0% 16.5%)2 (16.0% 16.5%)2 (17.0% 16.5%)2 (18.0% 16.5%)2 ]

4 1
FH
[(1.5%)2 (0.5%)2 (0.5%)2 (1.5%)2 ]

3
FH
[(2.25 0.25 0.25 2.25)]

3
FH
5
1.667 1.291
3
(c) Coefficientofvariation:CV k k
1.291
0.0738
17.5%
0
CVFG
0
16.5%
1.291
CVFH
0.0782
16.5%
(d) Summary:
CVF
kp:ExpectedValue
ofPortfolio
kp
CVp
Alternative1(F)
17.5%
1.291
0.0738
Alternative2(FG)
16.5%
Alternative3(FH)
16.5%
1.291
0.0
0.0782
Sincetheassetshavedifferentexpectedreturns,thecoefficientofvariationshouldbeusedto
determinethebestportfolio.Alternative3,withpositivelycorrelatedassets,hasthehighest
coefficientofvariationandthereforeistheriskiest.Alternative2isthebestchoice;itis
perfectlynegativelycorrelatedandthereforehasthelowestcoefficientofvariation.
P514. LG4:Correlation,Risk,andReturn
Intermediate
(a) (1) Rangeofexpectedreturn:between8%and13%
(2) Rangeoftherisk:between5%and10%
(b) (1) Rangeofexpectedreturn:between8%and13%
(2) Rangeoftherisk:0risk10%
(c) (1) Rangeofexpectedreturn:between8%and13%
(2) Rangeoftherisk:0risk10%
P515. LG1,4:InternationalInvestmentReturns
Intermediate
(a) Returnpesos
24, 750 20, 500 4, 250
0.20732 20.73%
20, 500
20, 500
(b) Purchaseprice
Salesprice
Priceinpesos
20.50
$2.22584 1, 000shares $2, 225.84

Pesosperdollar 9.21
Priceinpesos
24.75
$2.51269 1, 000shares $2, 512.69

Pesosperdollar 9.85
(c) Returnpesos
2, 512.69 2, 225.84
286.85
0.12887 12.89%
2, 225.84
2, 225.84
(d) Thetworeturnsdifferduetothechangeintheexchangeratebetweenthepesoandthedollar.
Thepesohaddepreciation(andthusthedollarappreciated)betweenthepurchasedateandthe
saledate,causingadecreaseintotalreturn.Theanswerinpart(c)isthemoreimportantof
thetworeturnsforJoe.Aninvestorinforeignsecuritieswillcarryexchangeraterisk.
P516. LG5:Total,Nondiversifiable,andDiversifiableRisk
Intermediate
(a)and(b)
16
14
12
Portfolio
Risk
(kp)
(%)
10
Diversifiable
8
6
4
Nondiversifiable
2
0
0
10
15
20
25
NumberofSecurities
(c) Onlynondiversifiableriskisrelevantbecause,asshownbythegraph,diversifiableriskcan
bevirtuallyeliminatedthroughholdingaportfolioofatleast20securitieswhicharenot
positivelycorrelated.DavidTalbotsportfolio,assumingdiversifiableriskcouldnolongerbe
reducedbyadditionstotheportfolio,has6.47%relevantrisk.
P517. LG5:GraphicDerivationofBeta
Intermediate
(a)
DerivationofBeta
Asset Return %
32
Asset B
28
b = slope = 1.33
24
20
Asset A
16
12
b = slope = .75
8
4
0
-16
-12
-8
-4
-4 0
12
16
Market
20 Return
-8
-12
(b) Toestimatebeta,theriseoverrunmethodcanbeused: Beta
Rise Y
Run X
Takingthepointsshownonthegraph:
BetaA
Y 12 9 3
0.75
X 8 4 4
Y 26 22 4
1.33
X 13 10 3
Afinancialcalculatorwithstatisticalfunctionscanbeusedtoperformlinearregression
analysis.Thebeta(slope)oflineAis0.79;oflineB,1.379.
(c) Withahigherbetaof1.33,AssetBismorerisky.Itsreturnwillmove1.33timesforeachone
pointthemarketmoves.AssetAsreturnwillmoveatalowerrate,asindicatedbyitsbeta
coefficientof0.75.
BetaB
P518. LG5:InterpretingBeta
Basic
Effectofchangeinmarketreturnonassetwithbetaof1.20:
(a) 1.20(15%)
18.0%increase
(b) 1.20(8%)
9.6%decrease
(c) 1.20(0%)
nochange
(d) Theassetismoreriskythanthemarketportfolio,whichhasabetaof1.Thehigherbeta
makesthereturnmovemorethanthemarket.
P519. LG5:Betas
Basic
(a)and(b)
Asset
Beta
Increasein
MarketReturn
ExpectedImpact
onAssetReturn
Decreasein
MarketReturn
Impacton
AssetReturn
0.50
0.10
0.05
0.10
0.05
1.60
0.10
0.16
0.10
0.16
0.20
0.10
0.02
0.10
0.02
0.90
0.10
0.09
0.10
0.09
(c) AssetBshouldbechosenbecauseitwillhavethehighestincreaseinreturn.
(d) AssetCwouldbetheappropriatechoicebecauseitisadefensiveasset,movinginopposition
tothemarket.Inaneconomicdownturn,AssetCsreturnisincreasing.
P520. LG5:BetasandRiskRankings
Intermediate
(a)
Stock
Beta
1.40
0.80
0.30
Mostrisky
Leastrisky
(b)and(c)
Increasein
ExpectedImpact
Decreasein
Impacton
Asset
Beta
MarketReturn
onAssetReturn
MarketReturn
AssetReturn
0.80
0.12
0.096
0.05
0.04
1.40
0.12
0.168
0.05
0.07
0.30
0.12
0.036
0.05
0.015
(d) Inadecliningmarket,aninvestorwouldchoosethedefensivestock,stockC.Whilethe
marketdeclines,thereturnonCincreases.
(e) Inarisingmarket,aninvestorwouldchoosestockB,theaggressivestock.Asthemarket
risesonepoint,stockBrises1.40points.
n
P521. LG5:PortfolioBetas:bp
w b
j
j1
Intermediate
(a)
Beta
PortfolioA
wA
wAbA
1.30
0.10
0.130
0.30
0.39
0.70
0.30
0.210
0.10
0.07
1.25
0.10
0.125
0.20
0.25
1.10
0.10
0.110
0.20
0.22
0.90
0.40
0.360
0.20
0.18
Asset
bA
0.935
PortfolioB
wB
wBbB
bB
1.11
(b) PortfolioAisslightlylessriskythanthemarket(averagerisk),whilePortfolioBismore
riskythanthemarket.PortfolioBsreturnwillmovemorethanPortfolioAsforagiven
increaseordecreaseinmarketreturn.PortfolioBisthemorerisky.
P522. LG6:CapitalAssetPricingModel(CAPM):kjRF[bj(kmRF)]
Basic
Case
kj
8.9%
5% [1.30(8%5%)]
12.5%
8% [0.90(13%8%)]
8.4%
9% [0.20(12%9%)]
15.0%
10% [1.00(15%10%)]
8.4%
6% [0.60(10%6%)]
RF[bj(kmRF)]
P523. LG5,6:BetaCoefficientsandtheCapitalAssetPricingModel
Intermediate
TosolvethisproblemyoumusttaketheCAPMandsolveforbeta.Theresultingmodelis:
k RF
km RF
10% 5% 5%
Beta
0.4545
16% 5% 11%
15% 5% 10%
Beta
0.9091
16% 5% 11%
18% 5% 13%
Beta
1.1818
16% 5% 11%
20% 5% 15%
Beta
1.3636
16% 5% 11%
IfKatherineiswillingtotakeamaximumofaverageriskthenshewillbeabletohavean
expectedreturnofonly16%.(k5%1.0(16%5%)16%.)
Beta
(a)
(b)
(c)
(d)
(e)
P524. LG6:ManipulatingCAPM:kjRF[bj(kmRF)]
Intermediate
(a) kj 8%[0.90(12%8%)]
kj 11.6%
(b) 15% RF[1.25(14%RF)]
RF 10%
(c) 16% 9%[1.10(km9%)]
km 15.36%
(d) 15% 10%[bj(12.5%10%)
bj
2
P525. LG1,3,5,6:PortfolioReturnandBeta
Challenge
(a) bp(0.20)(0.80)(0.35)(0.95)(0.30)(1.50)(0.15)(1.25)
0.160.33250.450.18751.13
(b) kA
($20, 000 $20, 000) $1, 600 $1, 600
8%
$20, 000
$20, 000
kB
($36, 000 $35, 000) $1, 400 $2, 400
6.86%
$35, 000
$35, 000
kC
($34, 500 $30, 000) 0 $4, 500
15%
$30, 000
$30, 000
kD
($16, 500 $15, 000) $375 $1,875
12.5%
$15, 000
$15, 000
(c) kP
($107, 000 $100, 000) $3,375 $10,375
10.375%
$100, 000
$100, 000
(d) kA4%[0.80(10%4%)]8.8%
kB4%[0.95(10%4%)]9.7%
kC4%[1.50(10%4%)]13.0%
kD4%[1.25(10%4%)]11.5%
(e) Ofthefourinvestments,onlyChadanactualreturnwhichexceededtheCAPMexpected
return(15%versus13%).Theunderperformancecouldbeduetoanyunsystematicfactor
whichwouldhavecausedthefirmnotdoaswellasexpected.Anotherpossibilityisthatthe
firmscharacteristicsmayhavechangedsuchthatthebetaatthetimeofthepurchase
overstatedthetruevalueofbetathatexistedduringthatyear.Athirdexplanationisthatbeta,
asasinglemeasure,maynotcaptureallofthesystematicfactorsthatcausetheexpected
return.Inotherwords,thereiserrorinthebetaestimate.
P526. LG6:SecurityMarketLine,SML
Intermediate
(a),(b),and(d)
SecurityMarketLine
16
B
Km
14
SML
12
MarketRisk
RequiredRateof
Return%
Risk premium
10
Risk-free
Rate
8
6
4
2
0
0
0.2
0.4
0.6
0.8
1.2
1.4
NondiversifiableRisk(Beta)
(c) kjRF[bj(kmRF)]
AssetA
kj0.09[0.80(0.130.09)]
kj0.122
AssetB
kj0.09[1.30(0.130.09)]
kj0.142
(d) AssetAhasasmallerrequiredreturnthanAssetBbecauseitislessrisky,basedonthebeta
of0.80forAssetAversus1.30forAssetB.ThemarketriskpremiumforAssetAis3.2%
(12.2%9%),whichislowerthanAssetBs(14.2%9%5.2%).
P527. LG6:ShiftsintheSecurityMarketLine
Challenge
(a),(b),(c),(d)
SecurityMarketLines
20
SMLd
SMLa
SMLc
Asset A
18
16
14
Required
Return(%)
12
10
8
6
4
Asset A
2
0
0
0.2
0.4
0.6
0.8
1.2
1.4
1.6
1.8
(b) kjRF[bj(kmRF)]
kA8%[1.1(12%8%)]
kA8%4.4%
kA12.4%
(c) kA6%[1.1(10%6%)]
kA6%4.4%
kA10.4%
(d) kA8%[1.1(13%8%)]
kA8%5.5%
kA13.5%
(e) (1) Adecreaseininflationaryexpectationsreducestherequiredreturnasshowninthe
paralleldownwardshiftoftheSML.
(2) Increasedriskaversionresultsinasteeperslope,sinceahigherreturnwouldberequired
foreachlevelofriskasmeasuredbybeta.
P528. LG6:IntegrativeRisk,Return,andCAPM
Challenge
(a)
Project
kj
RF[bj(kmRF)]
kj
9%[1.5(14%9%)]
16.5%
kj
9%[0.75(14%9%)]
12.75%
kj
9%[2.0(14%9%)]
19.0%
kj
9%[0(14%9%)]
9.0%
kj
9%[(0.5)(14%9%)]
6.5%
(b)and(d)
SecurityMarketLine
20
SMLb
18
SMLd
16
14
Required
Rateof
Return(%)
12
10
8
6
4
2
0
-1
-0.5
0.5
1.5
2.5
(c) ProjectAis150%asresponsiveasthemarket.
ProjectBis75%asresponsiveasthemarket.
ProjectCistwiceasresponsiveasthemarket.
ProjectDisunaffectedbymarketmovement.
ProjectEisonlyhalfasresponsiveasthemarket,butmovesintheoppositedirectionasthe
market.
(d) SeegraphfornewSML.
kA9%[1.5(12%9%)]
13.50%
kB9%[0.75(12%9%)]
11.25%
kC9%[2.0(12%9%)]
15.00%
kD9%[0(12%9%)]
9.00%
kE9%[0.5(12%9%)]
7.50%
(e) ThesteeperslopeofSMLbindicatesahigherriskpremiumthanSMLdforthesemarket
conditions.Wheninvestorriskaversiondeclines,investorsrequirelowerreturnsforany
givenrisklevel(beta).
P529. EthicsProblem
Intermediate
Onewayistoaskhowthecandidatewouldhandleahypotheticalsituation.Onemaygaininsight
intothemoral/ethicalframeworkwithinwhichdecisionsaremade.Anotherapproachistousea
pencilandpaperhonestytestthesearesurprisinglyaccurate,despitetheobviousnotionthatthe
jobcandidatemayattempttogametheexambygivingtherightversustheindividuallyaccurate
responses.Beforeevenadministeringthesituationalinterviewquestionorthetest,askthe
candidatetolistthepreferredattributesofthetypeofcompanyheorsheaspirestoworkfor,and
seeifcharacterandethicstermsemergeinthedescription.Somecompaniesdocredithistory
checks,aftergainingthecandidatesapprovaltodoso.Usingallfourofthesetechniquesallows
onetotriangulatetowardavalidanddefensibleappraisalofacandidateshonestyandintegrity.
Case
Analyzing Risk and Return on Chargers Products Investments
Thiscaserequiresstudentstoreviewandapplytheconceptoftheriskreturntradeoffbyanalyzingtwo
possibleassetinvestmentsusingstandarddeviation,coefficientofvariation,andCAPM.
(a) Expectedrateofreturn: kt
(Pt Pt1 Ct )
Pt1
AssetX:
Year
Cash
Flow(Ct)
Ending
Value(Pt)
Beginning
Value(Pt1)
Gain/
Loss
AnnualRate
ofReturn
1997
$1,000
$22,000
$20,000
$2,000
15.00%
1998
1,500
21,000
22,000
1,000
2.27
1999
1,400
24,000
21,000
3,000
20.95
2000
1,700
22,000
24,000
2,000
1.25
2001
1,900
23,000
22,000
1,000
13.18
2002
1,600
26,000
23,000
3,000
20.00
2003
1,700
25,000
26,000
1,000
2.69
2004
2,000
24,000
25,000
1,000
4.00
2005
2,100
27,000
24,000
3,000
21.25
2006
2,200
30,000
27,000
3,000
19.26
AverageexpectedreturnforAssetX11.74%
AssetY:
Beginning
Value(Pt1)
Year
Cash
Flow(Ct)
Ending
Value(Pt)
Gain/
Loss
AnnualRate
ofReturn
1997
$1,500
$20,000
$20,000
$0
1998
1,600
20,000
20,000
8.00
1999
1,700
21,000
20,000
1,000
13.50
2000
1,800
21,000
21,000
8.57
2001
1,900
22,000
21,000
1,000
13.81
2002
2,000
23,000
22,000
1,000
13.64
2003
2,100
23,000
23,000
9.13
2004
2,200
24,000
23,000
1,000
13.91
2005
2,300
25,000
24,000
1,000
13.75
2006
2,400
25,000
25,000
9.60
7.50%
AverageexpectedreturnforAssetY11.14%
(b) k
(k k)
i
(n 1)
i 1
AssetX:
Year
Return
ki
Average
Return,k
(ki k)
(ki k) 2
1997
15.00%
11.74%
3.26%
10.63%
1998
2.27
11.74
9.47
89.68
1999
20.95
11.74
9.21
84.82
2000
1.25
11.74
12.99
168.74
2001
13.18
11.74
1.44
2.07
2002
20.00
11.74
8.26
68.23
2003
2.69
11.74
9.05
81.90
2004
4.00
11.74
7.74
59.91
2005
21.25
11.74
9.51
90.44
2006
19.26
11.74
7.52
56.55
712.97
x
CV
712.97
79.22 8.90%
10 1
8.90
0.76
11.74%
AssetY:
Year
Return
ki
Average
Return,k
(k i k)
(k i k)2
1997
7.50%
11.14%
3.64%
13.25%
1998
8.00
11.14
3.14
9.86
1999
13.50
11.14
2.36
5.57
2000
8.57
11.14
2.57
6.60
2001
13.81
11.14
2.67
7.13
2002
13.64
11.14
2.50
6.25
2003
9.13
11.14
2.01
4.04
2004
13.91
11.14
2.77
7.67
2005
13.75
11.14
2.61
6.81
2006
9.60
11.14
1.54
2.37
69.55
69.55
7.73 2.78%
10 1
2.78
CV
0.25
11.14%
Y
(c) SummaryStatistics:
AssetX
AssetY
11.74%
11.14%
StandardDeviation
8.90%
2.78%
CoefficientofVariation
0.76
0.25
ExpectedReturn
Comparingtheexpectedreturnscalculatedinpart(a),AssetXprovidesareturnof11.74percent,
onlyslightlyabovethereturnof11.14percentexpectedfromAssetY.Thehigherstandard
deviationandcoefficientofvariationofInvestmentXindicatesgreaterrisk.Withjustthis
information,itisdifficulttodeterminewhetherthe0.60percentdifferenceinreturnisadequate
compensationforthedifferenceinrisk.Basedonthisinformation,however,AssetYappearsto
bethebetterchoice.
(d) Usingthecapitalassetpricingmodel,therequiredreturnoneachassetisasfollows:
CapitalAssetPricingModel:kjRF[bj(kmRF)]
Asset
RF[bj(kmRF)]
kj
7%[1.6(10%7%)]
11.8%
7%[1.1(10%7%)]
10.3%
Fromthecalculationsinpart(a),theexpectedreturnforAssetXis11.74%,comparedtoits
requiredreturnof11.8%.Ontheotherhand,AssetYhasanexpectedreturnof11.14%anda
requiredreturnofonly10.8%.ThismakesAssetYthebetterchoice.
(e) Inpart(c),weconcludedthatitwouldbedifficulttomakeachoicebetweenXandYbecausethe
additionalreturnonXmayormaynotprovidetheneededcompensationfortheextrarisk.In
part(d),bycalculatingarequiredrateofreturn,itwaseasytorejectXandselectY.Therequired
returnonAssetXis11.8%,butitsexpectedreturn(11.74%)islower;thereforeAssetXis
unattractive.ForAssetYthereverseistrue,anditisagoodinvestmentvehicle.
Clearly,ChargerProductsisbetteroffusingthestandarddeviationandcoefficientofvariation,
ratherthanastrictlysubjectiveapproach,toassessinvestmentrisk.BetaandCAPM,however,
providealinkbetweenriskandreturn.Theyquantifyriskandconvertitintoarequiredreturn
thatcanbecomparedtotheexpectedreturntodrawadefinitiveconclusionaboutinvestment
acceptability.Contrastingtheconclusionsintheresponsestoquestions(c)and(d)aboveshould
clearlydemonstratewhyJuniorisbetteroffusingbetatoassessrisk.
(f) (1) Increaseinriskfreerateto8%andmarketreturnto11%:
Asset
RF[bj(kmRF)]
8%[1.6(11%8%)]
12.8%
8%[1.1(11%8%)]
11.3%
kj
(2) Decreaseinmarketreturnto9%:
Asset
RF[bj(kmRF)]
kj
7%[1.6(9%7%)]
10.2%
7%[1.1(9%7%)]
9.2%
Insituation(1),therequiredreturnrisesforbothassets,andneitherhasanexpectedreturn
abovethefirmsrequiredreturn.
Withsituation(2),thedropinmarketratecausestherequiredreturntodecreasesothatthe
expectedreturnsofbothassetsareabovetherequiredreturn.However,AssetYprovidesa
largerreturncomparedtoitsrequiredreturn(11.149.201.94),anditdoessowithless
riskthanAssetX.
Group Exercises
Thisexerciseusescurrentinformationfromseveralwebsitesregardingtherecentperformanceofeach
groupsshadowfirm.Thisinformationisthencomparedtoarelevantindex.Thetimeperiodsfor
comparisonare1and5years.Calculatedannualreturnsandbasicgraphicalanalysisbegintheprocessof
comparison.Correlationbetweenthefirmandthemarketisinvestigatedfurtherthroughtheuseofthe
firmsbeta,andtheriskfreerateasrepresentedbythe3monthTreasuryrate.Lastly,thegroupisaskedto
graphthefirmsSMLusingthedatatheycalculated.
Accurateandtimelyinformationisthefirstmessageofthisassignment.Studentsareencouragedtolookat
severalsitesandalsotosearchforothers.Theinformationcontentofthedifferentsitescanthenbe
compared.Thisinformationisthenusedtogetstudentstoseehowbasicstockmarketanalysisisdone.As
always,partsofthisexercisecanbemodifiedordroppedattheadoptersdiscretion.Onesuggestionisto
addothercorporationstothecomparison(s).Also,someofthemorecomplexcalculationscouldbe
eliminated.
Answers to Web Exercises

Thisassignmentdriveshomethetopicofinflation.Sinceinflationandfutureexpectationsofinflation
driveinterestrates,thisassignmenttiesinnicelywiththepreviousassignment.Thestudentisdirectedto
theCPIattheBLSWebsite.Thedeliverableisgraphsoninflationthatcanbeusedtocomparethe
patternofinflationtothepreviouslyacquiredgraphsofinterestrates.Asecondpartoftheassignment
coversexchangerates.Thestudentisaskedtoretrieveinformationontheexchangeratesofseveral
currenciesattheWebsiteofhis/herchoosing.

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Chapter5RiskandReturn111

Suggested Answer to Chapter Opening Critical

Answers to Review Questions

(endingvalue initialvalue) cashdistribution

Suggested Answer to Critical Thinking Question

Suggested Answer to Critical Thinking Question

Answers to Warm-Up Exercises

C1 P1 P0 $0 $12, 000, 000 $10, 000, 000

($21, 000 $20, 000 $1, 500)

($55, 000 $55, 000 $6,800)

(2) Expectedreturn: k k i Pri

Project 257 0.027350 0.165378

Project432 0.011250 0.106066

(a) Expectedreturn: k ki Pri

0.40 0.04 0.36

0.10 0.04 0.06

0.35 0.11 .24

0.40 0.10 .30

0.20 0.10 .10

0.10 0.10 0.00

(17.6% 15.5%)2 (16.4% 15.5%)2 (16.0% 15.5%)2

(15.2% 15.5%)2 (14.0% 15.5%)2 (13.6% 15.5%)2

(0.3%)2 (1.5%)2 (1.9%)2

(4.41% 0.81% 0.25% 0.09% 2.25% 3.61%)

16% 17% 18% 19%

[(16.0% 17.5%)2 (17.0% 17.5%)2 (18.0% 17.5%)2 (19.0% 17.5%)2 ]

[(1.5%)2 (0.5%)2 (0.5%)2 (1.5%)2 ]

(2.25% 0.25% 0.25% 2.25%)

[(16.5% 16.5%)2 (16.5% 16.5%)2 (16.5% 16.5%)2 (16.5% 16.5%)2 ]

[(0)2 (0)2 (0)2 (0)2 ]

[(15.0% 16.5%)2 (16.0% 16.5%)2 (17.0% 16.5%)2 (18.0% 16.5%)2 ]

[(1.5%)2 (0.5%)2 (0.5%)2 (1.5%)2 ]

[(2.25 0.25 0.25 2.25)]

24, 750 20, 500 4, 250

$2.22584 1, 000shares $2, 225.84

$2.51269 1, 000shares $2, 512.69

(b) Toestimatebeta,theriseoverrunmethodcanbeused: Beta

($20, 000 $20, 000) $1, 600 $1, 600

($36, 000 $35, 000) $1, 400 $2, 400

($34, 500 $30, 000) 0 $4, 500

($16, 500 $15, 000) $375 $1,875

($107, 000 $100, 000) $3,375 $10,375

Answers to Web Exercises

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