103 views

Original Title: Chapter5 Solutions

Uploaded by gabrenilla

- RTP Group3 Paper 11 June2012
- Ch06 P14 Build a Model(9)
- Ch06 P14 Build a Model(8)
- Risk and Rates of Return
- TheAnalystNov2010ULIP
- Case Sudy 1 Jimmy and Bill Document 1e
- Problems in Measuring Portfolio Performance - An Application to Contrarian Investment Strategies.pdf
- Spring 2012_MGT201_2
- financial management
- Ch. 19 Capital Asset Pricing
- Chapter 06 IM 10th Ed-MANAJEMEN KEUANGAN
- FM - Leo
- CAPM
- Case Analysis of Nike
- Financial Management Chapter 06 IM 10th Ed
- 5 Portfolio Performance Evaluation
- Beta Max _ FT Alphaville
- Risk and Returns
- Mutual Fund Rev
- 5 Risk and Returns

You are on page 1of 11

line.

from

-∞ to +∞.

its negative correlation with other stocks. In a single-asset

portfolio, Security A would be more risky because σ A > σ B and CVA > CVB.

5-3 a. No, it is not riskless. The portfolio would be free of default risk

and liquidity risk, but inflation could erode the portfolio’s

purchasing power. If the actual inflation rate is greater than that

expected, interest rates in general will rise to incorporate a

larger inflation premium (IP) and--as we shall see in Chapter 7--the

value of the portfolio would decline.

expect to “roll over” the Treasury bills at a constant (or even

increasing) rate of interest, but if interest rates fall, your

investment income will decrease.

purchasing power (that is, an indexed bond) would be close to

riskless. The U.S. Treasury currently issues indexed bonds.

for a common stock. Each outcome is multiplied by its probability

of occurrence, and then these products are summed. For example,

suppose a 1-year term policy pays $10,000 at death, and the

probability of the policyholder’s death in that year is 2 percent.

Then, there is a 98 percent probability of zero return and a 2

percent probability of $10,000:

Generally, the premium will be larger because of sales and

administrative costs, and insurance company profits, indicating a

negative expected rate of return on the investment in the policy.

life insurance policy and the returns on the policyholder’s human

capital. In fact, these events (death and future lifetime earnings

capacity) are mutually exclusive.

pay a premium to decrease the uncertainty of their future cash

flows. A life insurance policy guarantees an income (the face value

of the policy) to the policyholder’s beneficiaries when the policy-

holder’s future earnings capacity drops to zero.

If risk aversion increases, the slope of the SML will increase, and so

will the market risk premium (kM - kRF). The product (kM - kRF)bj is the

risk premium of the jth stock. If b j is low (say, 0.5), then the

product will be small; RPj will increase by only half the increase in

RP M .

However, if bj is large (say, 2.0), then its risk premium will rise by

twice the increase in RPM.

beta will increase a company’s expected return by an amount equal to

the market risk premium times the change in beta. For example, assume

that the risk-free rate is 6 percent, and the market risk premium is 5

percent. If the company’s beta doubles from 0.8 to 1.6 its expected

return increases from 10 percent to 14 percent. Therefore, in general,

a company’s expected return will not double when its beta doubles.

it may be impossible to find individual stocks that have a nonpositive

beta. In this case it would also be impossible to have a stock

portfolio with a zero beta. Even if such a portfolio could be

constructed, investors would probably be better off just purchasing

Treasury bills, or other zero beta investments.

5-8 No. For a stock to have a negative beta, its returns would have to

logically be expected to go up in the future when other stocks’ returns

were falling. Just because in one year the stock’s return increases

when the market declined doesn’t mean the stock has a negative beta. A

stock in a given year may move counter to the overall market, even

though the stock’s beta is positive.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

(0.1)(60%)

= 11.40%.

11.40%)2(0.4)

+ (25% - 11.40%)2(0.2) + (60% - 11.40%)2(0.1)

σ 2

= 712.44; σ = 26.69%.

26.69%

CV = = 2.34.

11.40%

$35,000 0.8

40,000 1.4

Total $75,000

kM = 5% + (6%)1 = 11%.

k when b = 1.2 = ?

k = 5% + 6%(1.2) = 12.2%.

= 6% + (13% - 6%)0.7

= 10.9%.

11% = 7% + 4%b

4% = 4%b

b = 1.

b. kRF = 7%; RPM = 6%; b = 1.

k = 7% + (6%)1

k = 13%.

5-6 a. k̂ = ∑ Pk

i=1

i i .

= 14% versus 12% for X.

b. σ = ∑ (k

i=1

i

− k̂)2 Pi .

+ (20% - 12%)2(0.2) + (38% - 12%)2(0.1) = 148.8%.

then it might have a lower beta than Stock X, and hence be

less risky in a portfolio sense.

c. 1. kM increases to 16%:

2. kM decreases to 13%:

$142,500 $7,500

5-8 Old portfolio beta = (b) + (1.00)

$150,000 $150,000

1.12 = 0.95b + 0.05

1.07 = 0.95b

1.1263 = b.

Alternative Solutions:

(0.05)b20

∑b i = 1.12/0.05 = 22.4.

1.16.

- 1.0 =

21.4, so the beta of the portfolio excluding this stock is b =

21.4/19 = 1.1263. The beta of the new portfolio is:

$400,000 $600,000

5-9 Portfolio beta = (1.50) + (-0.50)

$4,000,000 $4,000,000

$1,000,000 $2,000,000

+ (1.25) + (0.75)

$4,000,000 $4,000,000

bp = (0.1)(1.5) + (0.15)(-0.50) + (0.25)(1.25) + (0.5)(0.75)

= 0.15 - 0.075 + 0.3125 + 0.375 = 0.7625.

= 6% + (14% - 6%)(0.7625) = 12.1%.

using the CAPM equation [kRF + (kM - kRF)b], and then calculate the

weighted average of these returns.

Stock Investment Beta k = kRF + (kM - kRF)b Weight

A $ 400,000 1.50 18% 0.10

B 600,000 (0.50) 2 0.15

C 1,000,000 1.25 16 0.25

D 2,000,000 0.75 12 0.50

Total $4,000,000 1.00

kR = 7% + 6%(1.50) = 16.0%

kS = 7% + 6%(0.75) = 11.5

4.5%

k̂ Y = 12.5%; bY = 1.2; σ Y = 25%.

kRF = 6%; RPM = 5%.

beta. Therefore, the stock with the higher beta is more

risky. Stock Y has the higher beta so it is more risky than

Stock X.

c. kX = 6% + 5%(0.9)

kX = 10.5%.

kY = 6% + 5%(1.2)

kY = 12%.

d. kX = 10.5%; k̂ X = 10%.

kY = 12%; k̂Y = 12.5%.

since its expected return of 12.5% is greater than its

required return of 12%.

e. bp = ($7,500/$10,000)0.9 + ($2,500/$10,000)1.2

= 0.6750 + 0.30

= 0.9750.

kp = 6% + 5%(0.975)

kp = 10.875%.

f. If RPM increases from 5% to 6%, the stock with the highest beta

will have the largest increase in its required return.

Therefore, Stock Y will have the greatest increase.

Check:

kX = 6% + 6%(0.9)

= 11.4%. Increase 10.5% to 11.4%.

kY = 6% + 6%(1.2)

= 13.2%. Increase 12% to 13.2%.

ks = 6% + (6.5%)1.7 = 17.05%.

9% = kRF + (kM – kRF)bX

9% = 5.5% + (kM – kRF)0.8

(kM – kRF) = 4.375%.

5-14 In equilibrium:

kJ = k̂J = 12.5%.

kJ = kRF + (kM - kRF)b

12.5% = 4.5% + (10.5% - 4.5%)b

b = 1.33.

kLRI = 4.5% + (10.5% - 4.5%)0.6 = 4.5% + 6%(0.6) = 8.1%

Difference 7.2%

(given in the problem) and the risk-free rate is 5 percent, you

can calculate the market risk premium (RPM) calculated as kM - kRF

as follows:

k = kRF + (RPM)b

12.5% = 5% + (RPM)1.0

7.5% = RPM.

Now, you can use the RPM, the kRF, and the two stocks’ betas to

calculate their required returns.

Bradford:

kB = kRF + (RPM)b

= 5% + (7.5%)1.45

= 5% + 10.875%

= 15.875%.

Farley:

kF = kRF + (RPM)b

= 5% + (7.5%)0.85

= 5% + 6.375%

= 11.375%.

15.875% - 11.375% = 4.5%.

5-17 Step 1: Determine the market risk premium from the CAPM:

0.12 = 0.0525 + (kM - kRF)1.25

(kM - kRF) = 0.054.

The beta of the new portfolio is ($500,000/$5,500,000)

(0.75) + ($5,000,000/$5,500,000)(1.25) = 1.2045.

The required return on the new portfolio is:

5.25% + (5.4%)(1.2045) = 11.75%.

5-18 After additional investments are made, for the entire fund to have an

expected return of 13%, the portfolio must have a beta of 1.5455 as

shown below:

b = 1.5455.

the individual investments, we can calculate the required beta on

the additional investment as follows:

($20,000,0

00)(1.5) $5,000,000X

1.5455 = +

$25,000,00

0 $25,000,00

0

1.5455 = 1.2 + 0.2X

0.3455 = 0.2X

X = 1.7275.

c. Risk averter.

d. 1. ($1.15 million)(0.5) + ($0)(0.5) = $575,000, or an expected

profit of $75,000.

2. $75,000/$500,000 = 15%.

were perfectly positively correlated. Otherwise, the stock

portfolio would have the same expected return as the single

stock (15 percent) but a lower standard deviation. If the

correlation coefficient between each pair of stocks was a

negative one, the portfolio would be virtually riskless.

Since r for stocks is generally in the range of +0.6 to

+0.7, investing in a portfolio of stocks would definitely

be an improvement over investing in the single stock.

b. First, determine the fund’s beta, bF. The weights are the

percentage of funds invested in each stock.

A = $160/$500 = 0.32

B = $120/$500 = 0.24

C = $80/$500 = 0.16

D = $80/$500 = 0.16

E = $60/$500 = 0.12

= 0.16 + 0.48 + 0.64 + 0.16 + 0.36 = 1.8.

16 percent required rate of return on an investment with a

risk of b = 2.0. Since kN = 16% > k̂ N = 15%, the new stock

should not be purchased. The expected rate of return that

would make the fund indifferent to purchasing the stock is 16

percent.

5-21 The answers to a, b, c, and d are given below:

kA kB Portfolio

1998 (18.00%) (14.50%) (16.25%)

1999 33.00 21.80 27.40

2000 15.00 30.50 22.75

2001 (0.50) (7.60) (4.05)

2002 27.00 26.30 26.65

Std. Dev. 20.79 20.78 20.13

Coef. Var. 1.84 1.84 1.78

Stock A or Stock B alone, since the portfolio offers the same

expected return but with less risk. This result occurs

because returns on A and B are not perfectly positively

correlated (rAB = 0.88).

- RTP Group3 Paper 11 June2012Uploaded bySudha Satish
- Ch06 P14 Build a Model(9)Uploaded byBecky Bergeon Steele
- Ch06 P14 Build a Model(8)Uploaded byKhurram Khan
- Risk and Rates of ReturnUploaded byRizwanahParwin
- TheAnalystNov2010ULIPUploaded byAshik Ramesh
- Case Sudy 1 Jimmy and Bill Document 1eUploaded byTarun Sukhija
- Problems in Measuring Portfolio Performance - An Application to Contrarian Investment Strategies.pdfUploaded byBana Dy
- Spring 2012_MGT201_2Uploaded byinfernal1989
- financial managementUploaded bypankajsingh1991
- Ch. 19 Capital Asset PricingUploaded byJesse Sanders
- Chapter 06 IM 10th Ed-MANAJEMEN KEUANGANUploaded byRizkyAdiPoetra
- FM - LeoUploaded byutsa87
- CAPMUploaded byKumaravel Ds Ashwin
- Case Analysis of NikeUploaded byEndang Kodir
- Financial Management Chapter 06 IM 10th EdUploaded byDr Rushen Singh
- 5 Portfolio Performance EvaluationUploaded bySanjay Punjabi
- Beta Max _ FT AlphavilleUploaded byMarco A Suqor
- Risk and ReturnsUploaded byKadiesha Turlounge
- Mutual Fund RevUploaded byshankar_7185
- 5 Risk and ReturnsUploaded byHarris Narbarte
- 2011-01-24_062805_ktoyerUploaded byMona Vimla
- Definitions for FIRE 312Uploaded byKayla Shelton
- P&GUploaded bysan
- packet1bUploaded byVivian Clement
- Calculation of Beta in Stock MarketsUploaded byneha_baid_1
- capmUploaded byEkta Rawal
- Ch 06 ShowUploaded byMohamed Gamal
- Pravinn Mahajan CA FINAL SFM-NOV2011 Ques PaperUploaded byPravinn_Mahajan
- CHP Study Guide Level 2Uploaded bywhackz
- Risk and Return Theories IIUploaded bySajid Chishti

- Probate Inheritance Tax Form (IHT400 Notes)Uploaded byinternicht
- History of the Term "Moral Hazard" Author(s)- David Rowell and Luke B. ConnellyUploaded byAnonymous 511ThFilp
- Insurable Interest Case DigestUploaded bymb_estanislao
- Annual Report (Full Version) 08-09Uploaded byvikeshjain1981
- The Greensboro Symphony Endowment FundUploaded byGreensboro Symphony
- MF0017Uploaded bygarima bhatngar
- 2013 AD&D Benefits HandbookUploaded byScribd-download
- Term Insurance Ratings Oct1 2011Uploaded byisavecom
- PDF_Answers (1)Ic33.xlsUploaded bySujata Nayar
- Insurance DigestUploaded byJc Alvarez
- ISLU Mortgages Buy to let - Application form.pdfUploaded byges176
- 20. Pineda v. CA (Not Supra, Different Ref. No.)Uploaded byFrancisco Banguis
- project topicsUploaded bynandsa_ju28
- UAW-FCA hourly contract summaryUploaded byClickon Detroit
- ULIPs-Comparative AnalysisUploaded bywithlovejohn
- BIRM_VF_VI_2016-17Uploaded byAshutosh Kumar
- sample-financial-planner-book.pdfUploaded bydebaditya_hit326634
- Flexi Fortune BrochureUploaded bybakhem7hbk200219
- Customer Satisfaction Level of Lic ProductsUploaded byPiyush Soni
- Insurance Underwriting 1Uploaded byAamirx64
- INSURANCE AUXILLIARY SERVICESUploaded bydevashree
- CT5 syllabusUploaded byNvb Subba Reddy Peddapudi
- Insurance Introduction PDF For MBAUploaded byMohit Walter
- Insurance Cases DigestUploaded byAbigail Wright
- Life Insurance Claims & COPRA 1986Uploaded bySamhitha Kandlakunta
- LIC of India Development Officers (Revision of Terms and Conditions of Service) Rules 1986Uploaded byreema
- project report.docxUploaded byVikram Singh Bisht
- InsuranceUploaded byMiguel Platero
- Rate MakingUploaded bySai Teja Nadella
- Manila Bankers CaseUploaded byLhine Kiwalan