CHAPTER-7 SOLUTIONS and TERMS

Risk, Stand-alone risk, Portfolio

Risk is the chance that some unfavourable event will occur. For instance, the risk of an asset is
essentially the chance that the asset’s cash flows will be unfavourable or less than expected.

The risk of an asset’s cash flows can be considered on a stand-alone basis (each asset by itself)
or in a portfolio context, where the investment is combined with other assets and its risk is
reduced through diversification.

Most rational investors hold portfolios of assets, and they are more concerned with the
riskiness of their portfolios than with the risk of individual assets.

Expected return and Required return

The expected return on an investment is the mean value of its probability distribution of
returns.

The required return on a stock is the minimum expected return that is required to induce an
average investor to purchase the stock.

Standard deviation and Coefficient of variation (CV)

The standard deviation (σ) is a statistical measure of the variability of a set of observations.

The coefficient of variation (CV) is equal to the standard deviation divided by the expected
return; it is a standardized risk measure that allows comparisons between investments having
different expected returns and standard deviations.

Risk aversion, Risk premium for stock i and Market risk premium (RPm)
A risk-averse investor dislikes risk and requires a higher rate of return as an inducement to buy
riskier securities.

A risk premium is the difference between the rate of return on a risk-free asset and the
expected return on Stock i, which has higher risk.

The market risk premium is the difference between the expected return on the market and the
risk-free rate.

Correlation, Correlation coefficient, Market risk, Diversifiable risk and Relevant risk
Correlation is the tendency of two variables to move together. A correlation coefficient (ρ) of
+1.0 means that the two variables move up and down in perfect synchronization, while a
coefficient of –1.0 means the variables always move in opposite directions. A correlation
coefficient of zero suggests that the two variables are not related to one another; that is, they
are independent.
Market risk is that part of a security’s total risk that cannot be eliminated by diversification. It is
measured by the beta coefficient.
An asset’s risk consists of

(1) diversifiable risk, which can be eliminated by diversification. Diversifiable risk is also known
as company specific risk, that part of a security’s total risk associated with random events not
affecting the market as a whole. This risk can be eliminated by proper diversification.
(2) market risk, which cannot be eliminated by diversification.

Capital Asset Pricing Model (CAPM) and Beta (b)

CAPM is a model based upon the proposition that any stock’s required rate of return is equal to
the risk-free rate of return plus a risk premium reflecting only the risk remaining after
diversification.

The beta coefficient is a measure of a stock’s market risk, or the extent to which the returns on
a given stock move with the stock market. A stock’s beta coefficient (b) measures how
much risk a stock contributes to a well-diversified portfolio. The average stock’s beta
would move on average with the market so it would have a beta of 1.0.

A stock with a beta greater than 1 has stock returns that tend to be higher than the market
when the market is up but tend to be below the market when the market is down. The opposite
is true for a stock with a beta less than 1.

The Security Market Line (SML)

The Security Market Line (SML) represents, in a graphical form, the relationship between the
risk of an asset as measured by its beta and the required rates of return for individual securities.
The SML equation is essentially the CAPM, ri = rRF + bi(rM – rRF).

The slope of the SML equation is (rM – rRF), the market risk premium. The slope of the SML
reflects the degree of risk aversion in the economy. The greater the average investor’s aversion
to risk, then the steeper the slope, the higher the risk premium for all stocks, and the higher the
required return.

SOLUTIONS TO END-OF-CHAPTER PROBLEMS

7-2 rRF = 6%; rM = 11%; b = 0.6; rs = ?

rs = rRF + (rM – rRF)b

= 6% + (11% – 6%)0.6
= 9%.

7-3 rRF = 5%; RPM = 7%; rM = ?

rM = 5% + (7%)1 = 12% = rs when b = 1.0.

 rs when b = 1.7 = ?

rs = 5% + 7%(1.7) = 16.9%.
¿
7-4 r = (0.1)(–30%) + (0.2)(–5%) + (0.4)(10%) + (0.2)(16%) + (0.1)(40%)
= 7.2%.

σ2 = (–30% – 7.2%)2(0.1) + (-5% – 7.2%)2(0.2) + (10% – 7.2%)2(0.4)

+ (16% – 7.2%)2(0.2) + (40% – 7.2%)2(0.1)
σ2 = 294.36; σ= 17.16%.

17 . 16 %
CV = 7 .2 % = 2.38.
¿
7-7 r A = (0.1)(–3%) + (0.2)(2%) + (0.4)(7%) + (0.2)(12%) + (0.1)(17%)= 7%.
¿
r B = (0.1)(–10%) + (0.2)(1%) + (0.4)(8%) + (0.20)(16%) + (0.1)(24%) = 8%.

σA = [(0.1)(–3% – 7%)2 + (0.2)(2% – 7%)2 + (0.4)(7% – 7%)2 + (0.2)(12% – 7%)2 + (0.1)

(17% – 7%)2]1/2 = √ 30 % = 5.48%.

σB = [(0.1)(–10% – 8%)2 + (0.2)(1% – 8%)2 + (0.4)(8% – 8%)2] + (0.2)(16% – 8%)2 +

(0.1)(24% – 8%)2]1/2 = √ 80 .6 % = 8.98%.

5. 48 %
CVA = 7 % = 0.78.

8 .98 %
CVB = 8 % = 1.12

7-13 Portfolio beta=

$1,000,000 $1,500,000 $2,500,000 $4,000,000
× 1.75+ ×-0.50+ ×1.0+ ×0.75 = 0.72
$9,000,000 $9,000,000 $9,000,000 $9,000,000

rp = rRF + (rM – rRF)(bp) = 5% + (10% – 5%)(0.72) = 8.6%.

Alternative solution: First compute the return for each stock using the CAPM equation
[rRF + (rM – rRF)b], and then compute the weighted average of these returns.

rRF = 5% and rM – rRF = 5%.

Stock Investment Beta r = rRF + (rM – rRF)b Weight

A $ 1,000,000 1.75 13.75% 0.11
B 1,500,000 (0.50) 2.50 0.17
 C 2,500,000 1.00 10.00 0.28
D 4,000,000 0.75 8.75 0.44
Total $ 9,000,000 1.00

rp = 13.75%(0.11) + 2.5%(0.17) + 10%(0.28) + 8.75%(0.44) = 8.6%.

7-14
a.
Total portfolio = $75 + $125 + $200 = $400

$75/$400 = 0.1875 × 12.5% = 2.34%

$125/$400 = 0.3125 × 6.75% = 2.11%
$200/$400 = 0.50 × 9% = 4.5%
Portfolio expected return = 8.95%

b.
$75/$400 = 0.1875 × 1.9 = 0.356
$125/$400 = 0.3125 × 0.75 = 0.234
$200/$400 = 0.50 × 1.2 = 0.6
Portfolio beta = 1.19

r^ P=3 %+1. 19(5 %)=8. 95 %

Since rp =
r^ P the stocks plot along the SML and are priced correctly.

c. r Off-shore =3 %+2. 3(5 %)=14 .5 %

Since the expected return of 14% < the required return of 14.5%, the investor should not
purchase the stock.

d.
Total portfolio = $75 + $125 + $200 + $100 =
$500

$75/$500 × 12.5% = 1.88%

$125/$500 × 6.75% = 1.69%
$200/$500 × 9% = 3.6%
$100/$500 × 14.5% = 2.9%
Portfolio expected return = 10.1%