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Assignment 3 part I

1. How do we define total risk in this chapter and how do we measure it?
2. Whats the source of firm-specific risk? Whats the source of market risk?
3. You receive an investment newsletter advertisement in the mail. The letter claims that you
should invest in a stock that has doubled the return of the S&P 500 Index over the last three
months. It also claims that this stock is a surefire safe bet for the future. Explain how these two
claims are inconsistent with finance theory.
4. What does diversification do to the risk and return characteristics of a portfolio?
5. You are a risk adverse investor with a low-risk portfolio of bonds. How is it possible that adding
some stocks (which are riskier than bonds) to the portfolio can lower the total risk of the
portfolio?
6. FedEx Corp stock ended the previous year at $103.39 per share.
It paid a $0.35 per share dividend last year. It ended last year at $106.69. If you owned 200
shares of FedEx, what was your dollar return and percent return?
7. Rank the following three stocks by their level of total risk, highest to lowest. Rail Haul has an
average return of 12 percent and standard deviation of 25 percent. The average return and
standard deviation of Idol Staff are 15 percent and 35 percent; and of Poker-R-Us are 9 percent
and 20 percent.
8. Rank the following three stocks by their risk-return relationship, best to worst. Rail Haul has an
average return of 12 percent and standard deviation of 25 percent. The average return and
standard deviation of Idol Staff are 15 percent and 35 percent; and of Poker-R-Us are 9 percent
and 20 percent.
9. Determine which one of these three portfolios dominates another. Name the dominated
portfolio and the portfolio that dominates it. Portfolio Blue has an expected return of 12
percent and risk of 18 percent. The expected return and risk of portfolio Yellow are 15 percent
and 17 percent, and for the Purple portfolio are 14 percent and 21 percent.
10. An investor owns $3,000 of Adobe Systems stock, $6,000 of Dow Chemical, and $7,000 of Office
Depot. What are the portfolio weights of each stock?
11. The past five monthly returns for PG&E are -3.17 percent, 3.88 percent, 3.77 percent, 6.47
percent, and 3.58 percent. What is the average monthly return?

12. Consider the characteristics of the following three stocks:


Expected

Standard

Return

Deviation

Pic Image

11%

19%

Tax Help

19

Warm Wear

14

25

The correlation between Pic Image and Tax Help is 0.88. The correlation between Pic Image and
Warm Wear is -0.21. The correlation between Tax Help and Warm Wear is -0.19. If you can pick
only two stocks for your portfolio, which would you pick? Why?
13. At the beginning of the month, you owned $5,500 of General Dynamics, $7,500 of Starbucks,
and $8,000 of Nike. The monthly returns for General Dynamics, Starbucks, and Nike were 7.44
percent, -1.36 percent, and -0.54 percent. What is your portfolio return?
14. The following table shows your stock positions at the beginning of the year, the dividends that
each stock paid during the year, and the stock prices at the end of the year. What is your
portfolio dollar return and percentage return?

Company

Shares

Beginning of

Dividend End of

Year Price

per

Year Price

Share
US Bank

300

$43.50

$2.06

$43.43

PepsiCo

200

59.08

1.16

62.55

JDS Uniphase

500

18.88

Duke Energy

250

27.45

16.66
1.26

33.21

Assignment 3 part II
1. Describe how adding a risk-free security to modern portfolio theory allows investors to do better than the
efficient frontier.
2. Describe how different allocations between the risk-free security and the market portfolio can achieve any
level of market risk desired. Give examples of a portfolio from a person who is very risk averse and a portfolio
for someone who is not so averse to taking risk.
3. Cisco Systems has a beta of 1.25. Does this mean that you should expect Cisco to earn a return 25 percent
higher than the S&P 500 Index return? Explain.
4. Determine what level of market efficiency each event is consistent with:
a. Immediately after an earnings announcement the stock price jumps and then stays at the new
level.
b. The CEO buys 50,000 shares of his company and the stock price does not change.
c. The stock price immediately jumps when a stock split is announced, but then retraces half of
the gain over the next day.
d. An investor analyzes company quarterly and annual balance sheets and income statements
looking for undervalued stocks. The investor earns about the same return as the S&P 500
Index.
5. Compute the expected return given these three economic states, their likelihoods, and the potential returns:
Economic State

Probability

Return

Fast growth

0.3

40%

Slow growth

0.4

10

Recession

0.3

-25

6. If the risk-free rate is 4 percent and the risk premium is 6 percent, what is the required return?
7. The average annual return on the S&P 500 Index from 1986 to 1995 was 15.8 percent. The average annual Tbill yield during the same period was 5.6 percent. What was the market risk premium during these 10 years?
8. Hastings Entertainment has a beta of 0.65. If the market return is expected to be 11 percent and the risk-free
rate is 4 percent, what is Hastings required return?
9. Netflix, Inc. has a beta of 3.61. If the market return is expected to be 13 percent and the risk-free rate is 3
percent, what is Netflix risk premium?
10. You have a portfolio with a beta of 1.35. What will be the new portfolio beta if you keep 85 percent of your
money in the old portfolio and 15 percent in a stock with a beta of 0.78?
11. A manager believes his firm will earn a 14 percent return next year. His firm has a beta of 1.5, the expected
return on the market is 12 percent, and the risk-free rate is 4 percent. Compute the return the firm should
earn given its level of risk and determine whether the manager is saying the firm is undervalued or overvalued.
12. A manager believes his firm will earn a 14 percent return next year. His firm has a beta of 1.2, the expected
return on the market is 11 percent, and the risk-free rate is 5 percent. Compute the return the firm should
earn given its level of risk and determine whether the manager is saying the firm is undervalued or overvalued.
13. You own $7,000 of Human Genome stock that has a beta of 3.5. You also own $8,000 of Frozen Food Express
(beta = 1.6) and $10,000 of Molecular Devices (beta = 0.4). What is the beta of your portfolio?