Homework 3

Numeric Response
1. Suppose a stock had an initial price of $75 per share, paid a dividend of $1.20 per
share during the year, and had an ending share price of $86.
Compute the percentage total return.

2. In Problem 1, what was the dividend yield? The capital gains yield?

3. Using the following returns, calculate the

average returns, the variances, and the standard deviations for X and Y :

4. You've observed the following returns on Mary Ann Data Corporation's stock over the
past five years: 27 percent, 13 percent, 18 percent, -14 percent, and 9 percent.
a. What was the arithmetic average return on Mary Ann's stock over this five-year
period?
b. What was the variance of Mary Ann's returns over this period? The standard
deviation?

5. A stock has had the following year-end prices and dividends:

What are the arithmetic and geometric returns for the stock?

6. What are the portfolio weights for a portfolio that has 135 shares of Stock A that sell for
$47 per share and 105 shares of Stock B that sell for $41 per share?

7. You own a portfolio that has $2,100 invested in Stock A and $3,200 invested in Stock B
. If the expected returns on these stocks are 11 percent and 14 percent, respectively,
what is the expected return on the portfolio?

8. You own a portfolio that is 25 percent invested in Stock X , 40 percent in Stock Y , and
35 percent in Stock Z . The expected returns on these three stocks are 11 percent, 17
percent, and 14 percent, respectively.
What is the expected return on the portfolio?

9. Based on the following information, calculate the expected return and standard
deviation

10. Security F has an expected return of 10 percent and a standard deviation of 43 percent
per year. Security G has an expected return of 15 percent and a standard deviation of
62 percent per year.
a. What is the expected return on a portfolio composed of 30 percent of Security F and
70 percent of Security G ?
b. If the correlation between the returns of Security F and Security G is 0.25, what is
the standard deviation of the portfolio described in part a.?

11. Suppose the expected returns and standard deviations

of Stocks A and B are
= 0 .09,
= 0 .15,
= 0 .36, and
=0 .62.
a. Calculate the expected return and standard deviation of a portfolio that is composed
of 35 percent A and 65 percent B when the correlation between the returns on A and B
is .5.
b. Calculate the standard deviation of a portfolio with the same portfolio weights as in
part (a) when the correlation coefficient between the returns on A and B
is 2.5.
c. How does the correlation between the returns on A and B affect the standard
deviation of the portfolio?

12. You own a stock portfolio invested 10 percent in Stock Q , 35 percent in Stock R , 20
percent in Stock S , and 35 percent in Stock T . The betas for these four stocks are .75,
1.90, 1.38, and 1.16, respectively. What is the portfolio beta?

13. You own a portfolio equally invested in a risk-free asset and two stocks. If one of the
stocks has a beta of 1.65 and the total portfolio is equally as risky as the market, what
must the beta be for the other stock in your portfolio?

14. A stock has a beta of 1.15, the expected return on the market is 11 percent, and the
risk-free rate is 5 percent. What must the expected return on this stock be?

15. A stock has an expected return of 10.2 percent, the risk-free rate is 4 percent, and the
market risk premium is 7 percent. What must the beta of this stock be?
16. A stock has a beta of 1.13 and an expected return of 12.1 percent. A risk-free asset
currently earns 5 percent.
a. What is the expected return on a portfolio that is equally invested in the two assets?

b. If a portfolio of the two assets has a beta of .50, what are the portfolio weights?

c. If a portfolio of the two assets has an expected return of 10 percent, what is its beta?

d. If a portfolio of the two assets has a beta of 2.26, what are the portfolio weights?
How do you interpret the weights for the two assets in this case? Explain.

17. Asset W has an expected return of 12.3 percent and a beta of 1.3. If the risk-free rate is
4 percent, complete the following table for portfolios of Asset W and a risk-free asset.
Illustrate the relationship between portfolio expected return and portfolio beta by
plotting the expected returns against the betas. What is the slope of the line that
results?

18. The market portfolio has an expected return of 12 percent and a standard deviation of
22 percent. The risk-free rate is 5 percent.
a. What is the expected return on a well-diversified portfolio with a standard deviation
of 9 percent?
b. What is the standard deviation of a well-diversified portfolio with an expected return
of 20 percent?

(Hint: USE CML line)

19. Consider the following information about stocks I and II:

The market risk premium is 7.5 percent, and the risk-free rate is 4 percent. Which
stock has the most systematic risk? Which one has the most unsystematic risk?
Which stock is riskier? Explain.

Homework 3
Answer Section
NUMERIC RESPONSE
1. ANS:
The return of any asset is the increase in price, plus any dividends or cash flows, all divided by the initial
price. The return of this stock is:
R = [($86 - 75) + 1.20] / $75
R = .1627, or 16.27%
PTS: 1
2. ANS:
The dividend yield is the dividend divided by price at the beginning of the period, so:
Dividend yield = $1.20 / $75
Dividend yield = .0160, or 1.60%
And the capital gains yield is the increase in price divided by the initial price, so:
Capital gains yield = ($86 - 75) / $75
Capital gains yield = .1467, or 14.67%
PTS: 1
3. ANS:
The average return is the sum of the returns, divided by the number of returns. The average return for each stock
was:

.08 .21 .27 .11 .18 .0620,or 6.20%

.12 .27 .32 .18 .24 .0980,or 9.80%

i 1

i 1

We calculate the variance of each stock as:

i 1

N 1

1
.08 .062 2 .21 .062 2 .27 .062 2 .11 .062 2 .18 .062 2 .037170
5 1
1
.12 .098 2 .27 .098 2 .32 .098 2 .18 .098 2 .24 .098 2 .057920

5 1

X2
Y 2

X2

The standard deviation is the square root of the variance, so the standard deviation of each stock is:

X = (.037170)1/2
X = .1928, or 19.28%
Y = (.057920)1/2
Y = .2407, or 24.07%
PTS: 1
4. ANS:
a. To find the average return, we sum all the returns and divide by the number of returns, so:
Arithmetic average return = (.27 +.13 + .18 - .14 + .09)/5
Arithmetic average return = .1060, or 10.60%
b.

Using the equation to calculate variance, we find:

Variance = 1/4[(.27 - .106)2 + (.13 - .106)2 + (.18 - .106)2 + (-.14 - .106)2 +
(.09 - .106)2]
Variance = 0.023430
So, the standard deviation is:
Standard deviation = (0.023430)1/2
Standard deviation = 0.1531, or 15.31%

PTS: 1
5. ANS:
To calculate the arithmetic and geometric average returns, we must first calculate the return for each year. The
return for each year is:
R1 = ($64.83 - 61.18 + 0.72) / $61.18 = .0714, or 7.14%
R2 = ($72.18 - 64.83 + 0.78) / $64.83 = .1254, or 12.54%
R3 = ($63.12 - 72.18 + 0.86) / $72.18 = ?.1136, or ?11.36%
R4 = ($69.27 - 63.12 + 0.95)/ $63.12 = .1125, or 11.25%
R5 = ($76.93 - 69.27 + 1.08) / $69.27 = .1262, or 12.62%
The arithmetic average return was:
RA = (0.0714 + 0.1254 - 0.1136 + 0.1125 + 0.1262)/5
RA = 0.0644, or 6.44%
And the geometric average return was:
RG = [(1 + .0714)(1 + .1254)(1 - .1136)(1 + .1125)(1 + .1262)]1/5 - 1
RG = 0.0601, or 6.01%
PTS: 1
6. ANS:
Total value = 135($47) + 105($41) = $10,650

The portfolio weight for each stock is:

WeightA = 135($47)/$10,650 = .5958
WeightB = 105($41)/$10,650 = .4042
PTS: 1
7. ANS:
Total value = $2,100 + 3,200 = $5,300
So, the expected return of this portfolio is:
E(Rp) = ($2,100/$5,300)(0.11) + ($3,200/$5,300)(0.14) = .1281, or 12.81%
PTS: 1
8. ANS:
E(Rp) = .25(.11) + .40(.17) + .35(.14) = .1445, or 14.45%
PTS: 1
9. ANS:
The expected return of an asset is the sum of the probability of each return occurring times the probability of
that return occurring. So, the expected return of the stock is:
E(RA) = .10(?.105) + .25 (.059) + .45(.130) + .20(.211) = .1050, or 10.50%
To calculate the standard deviation, we first need to calculate the variance. To find the variance, we find
the squared deviations from the expected return. We then multiply each possible squared deviation by its
probability, and then add all of these up. The result is the variance. So, the variance and standard
deviation are:
2 =.10(-.105 - .1050)2 + .25(.059 - .1050)2 + .45(.130 - .1050)2 + .20(.211 - .1050)2 = .00747
= (.00747)1/2 = .0864, or 8.64%
PTS: 1
10. ANS:
a. The expected return of the portfolio is the sum of the weight of each asset times the expected return of
each asset, so:
E(RP) = XFE(RF) + XGE(RG)
E(RP) = .30(.10) + .70(.15)
E(RP) = .1350, or 13.50%
b.

The variance of a portfolio of two assets can be expressed as:

2

P = X F F + X G G + 2XFXG FGF,G
2

P = .302(.432) + .702(.622) + 2(.30)(.70)(.43)(.62)(.25)

P = .23299
So, the standard deviation is:
P = (.23299)1/2 = .4827, or 48.27%
PTS: 1
11. ANS:
a. The expected return of the portfolio is the sum of the weight of each asset times the expected return of
each asset, so:
E(RP) = XAE(RA) + XBE(RB)
E(RP) = .35(.09) + .65(.15)
E(RP) = .1290, or 12.90%

The variance of a portfolio of two assets can be expressed as:

2

P = X A A + X B B + 2XAXBABA,B
2

P = .352(.362) + .652(.622) + 2(.35)(.65)(.36)(.62)(.50)

2

P = .22906
So, the standard deviation is:
P = (.22906)1/2 = .4786, or 47.86%
b.

P = X A A + X B B + 2XAXBABA,B
2

P = .352(.362) + .652(.622) + 2(.35)(.65)(.36)(.62)(?.50)

2

P = .12751
So, the standard deviation is:
= (.12751)1/2 = .3571, or 35.71%
c.
As Stock A and Stock B become less correlated, or more negatively correlated, the standard
deviation of the portfolio decreases
PTS: 1
12. ANS:
The beta of a portfolio is the sum of the weight of each asset times the beta of each asset. So, the beta of the
portfolio is:
p = .10(.75) + .35(1.90) + .20(1.38) + .35(1.16) = 1.42

PTS: 1
13. ANS:
The beta of a portfolio is the sum of the weight of each asset times the beta of each asset. If the portfolio is as
risky as the market it must have the same beta as the market. Since the beta of the market is one, we
know the beta of our portfolio is one. We also need to remember that the beta of the risk-free asset is
zero. It has to be zero since the asset has no risk. Setting up the equation for the beta of our portfolio, we
get:
p = 1.0 = 1/3(0) + 1/3(1.65) + 1/3(X)
Solving for the beta of Stock X, we get:
X = 1.35
PTS: 1
14. ANS:
CAPM states the relationship between the risk of an asset and its expected return. CAPM is:
E(Ri) = Rf + [E(RM) - Rf] * i
Substituting the values we are given, we find:
E(Ri) = .05 + (.11 - .05)(1.15) = .1190, or 11.90%
PTS: 1
15. ANS:
We are given the values for the CAPM except for the of the stock. We need to substitute these values into
the CAPM, and solve for the of the stock. One important thing we need to realize is that we are given
the market risk premium. The market risk premium is the expected return of the market minus the riskfree rate. We must be careful not to use this value as the expected return of the market. Using the CAPM,
we find:
E(Ri) = .102 = .04 + .07i
i = 0.89
PTS: 1
16. ANS:
a. Again, we have a special case where the portfolio is equally weighted, so we can sum the returns of each
asset and divide by the number of assets. The expected return of the portfolio is:
E(Rp) = (.121 + .05)/2 = .0855, or 8.55%
b.

We need to find the portfolio weights that result in a portfolio with a of 0.50. We know the of
the risk-free asset is zero. We also know the weight of the risk-free asset is one minus the weight of
the stock since the portfolio weights must sum to one, or 100 percent. So:
p = 0.50 = XS(1.13) + (1 - XS)(0)
0.50 = 1.13XS + 0 - 0XS

XS = 0.50/1.13
XS = .4425
And, the weight of the risk-free asset is:
XRf = 1 - .4425 = .5575
c.

We need to find the portfolio weights that result in a portfolio with an expected return of 10 percent.
We also know the weight of the risk-free asset is one minus the weight of the stock since the
portfolio weights must sum to one, or 100 percent. So:
E(Rp) = .10 = .121XS + .05(1 - XS)
.10 = .121XS + .05 - .05XS
XS = .7042
So, the of the portfolio will be:
p = .7042(1.13) + (1 - .7042)(0) = 0.796

d.

Solving for the of the portfolio as we did in part b, we find:

p = 2.26 = XS(1.13) + (1 - XS)(0)
XS = 2.26/1.13 = 2
XRf = 1 - 2 = -11
The portfolio is invested 200% in the stock and -100% in the risk-free asset. This represents
borrowing at the risk-free rate to buy more of the stock.

PTS: 1
17. ANS:
First, we need to find the of the portfolio. The of the risk-free asset is zero, and the weight of the risk-free
asset is one minus the weight of the stock, so the of the portfolio is:

= XW(1.3) + (1 - XW)(0) = 1.3XW

So, to find the of the portfolio for any weight of the stock, we simply multiply the weight of the stock
times its .
Even though we are solving for the and expected return of a portfolio of one stock and the risk-free
asset for different portfolio weights, we are really solving for the SML. Any combination of this stock
and the risk-free asset will fall on the SML. For that matter, a portfolio of any stock and the risk-free
asset, or any portfolio of stocks, will fall on the SML. We know the slope of the SML line is the market
risk premium, so using the CAPM and the information concerning this stock, the market risk premium is:
E(RW) = .123 = .04 + MRP(1.30)
MRP = .083/1.3 = .0638, or 6.38%

So, now we know the CAPM equation for any stock is:
E(Rp) = .04 + .0638p
The slope of the SML is equal to the market risk premium, which is 0.0638. Using these equations to fill
in the table, we get the following results:
XW

E(Rp)

0%
25
50
75
100
125
150

.0400
.0608
.0815
.1023
.1230
.1438
.1645

0
0.325
0.650
0.975
1.300
1.625
1.950

PTS: 1
18. ANS:
Because a well-diversified portfolio has no unsystematic risk, this portfolio should lie on the Capital Market
Line (CML). The slope of the CML equals:
SlopeCML = [E(RM) - Rf] / M
SlopeCML = (0.12 - 0.05) / 0.22
SlopeCML = 0.31818
a.

The expected return on the portfolio equals:

E(RP) = Rf + SlopeCML(P)
E(RP) = .05 + .31818(.09)
E(RP) = .0786, or 7.86%

b.

The expected return on the portfolio equals:

E(RP) = Rf + SlopeCML(P)
.20 = .05 + .31818(P)
P = .4714, or 47.14%

PTS: 1
19. ANS:
The amount of systematic risk is measured by the of an asset. Since we know the market risk premium and
the risk-free rate, if we know the expected return of the asset we can use the CAPM to solve for the of
the asset. The expected return of Stock I is:
E(RI) = .15(.11) + .55(.18) + .30(.08) = .1395, or 13.95%

Using the CAPM to find the of Stock I, we find:

.1395 = .04 + .075I
I = 1.33
The total risk of the asset is measured by its standard deviation, so we need to calculate the standard
deviation of Stock I. Beginning with the calculation of the stock I variance, we find:
I2 = .15(.11 - .1395)2 + .55(.18 - .1395)2 + .30(.08 - .1395)2
I2 = .00209
I = (.00209)1/2 = .0458, or 4.58%

Using the same procedure for Stock II, we find the expected return to be:
E(RII) = .15(-.25) + .55(.11) + .30(.31) = .1160
Using the CAPM to find the of Stock II, we find:
.1160 = .04 + .075II
II = 1.01
And the standard deviation of Stock II is:
II2 = .15(-.25 - .1160)2 + .55(.11 - .1160)2 + .30(.31 - .1160)2
II2 = .03140
II = (.03140)1/2 = .1772, or 17.72%
Although Stock II has more total risk than I, it has much less systematic risk, since its beta is much
smaller than I. Thus, I has more systematic risk, and II has more unsystematic and more total risk. Since
unsystematic risk can be diversified away, I is actually the riskier stock despite the lack of volatility in
its returns. Stock I will have a higher risk premium and a greater expected return.
PTS: 1