CHAPTER 8

RISK RETURN AND

PORTFOLIO
MANAGEMENT
 LEARNING OBJECTIVES

At the end of this chapter, you should be able to:

• Understand the relationship between risk and return
• Calculate profits and returns on an investment and convert holding period returns to annual returns.
• Understand how risk is measured and quantified
• Understand the various types of risk that a finance manager and an investor faces
• Understand how a portfolio can be used to diversify risks
• Interpret the trade-off between risk and return.
• Understand the modern portfolio theory and the Capital Asset Pricing model
• Illustrate how the security market line and the capital asset pricing model represent the two-parameter
world of risk and return.
• Understand the Arbitrage Pricing Theory
MEASURING RISK AND RETURN

• Return objectives are normally financial objectives that are not goals in themselves, but they enable
investors to achieve long term goals.
• For a manager of funds, the main job is to be able to invest money to obtain appropriate rate of return.
• The rate of return on an asset may be defined as follows :
Annual Income + (Ending Price - Beginning Price)/ Beginning Price
• It is also well understood that the possible returns on an investment is linked to the risk inherent in the
investment. Modern financial theory has enabled us to look at this relationship in a more systematic
manner. It helps us to make meaningful deductions from the data that is available from the Stock and
Bond Markets.
• When investment are risky, there are different returns it may earn
• Risk (or uncertainty) refers to the variability of expected returns associated with a given
investment.
• Risk, along with the concept of return, is a key consideration in investment and financial
decisions.
2.1 RETURNS

• Dollar Returns
the sum of the cash received and Dividends
the change in value of the asset,
in dollars. Ending
market value

Time 0 1
Percentage Returns
– the sum of the cash received and the
Initial change in value of the asset, divided
investment by the initial investment.
RETURNS: EXAMPLE

Dollar Return:
$27
$327 gain
$300

Time 0 1
Percentage Return:

$327
-$4,500 7.3% =
$4,500
RETURNS
• Return in investment may come in one or two forms
• Capital Gain
• Periodic Income or cash flow or income component
• Return of investment in one year can be presented as follows

Dollar Return = Dividend + Change in Market Value

𝐷𝑖𝑣
𝐷𝑖𝑣 .𝑌𝑖𝑒𝑙𝑑 =
𝑃𝑜

HPR = Profit
Cost 𝑃𝐼 − 𝑃 0
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐺𝑎𝑖𝑛𝑌𝑖𝑒𝑙𝑑 =
HPR =Ending price + Distributions - Beginning price 𝑃0
Beginning price
@
WAYS OF MEASURING RETURNS (CONT’D)

• Ending value - Original Value > 0 (Gain)

• Ending Value – Original Value < 0 (Loss)
Example :
If you buy a stock for $100, and it pays no dividend. A year later, the market
price is $ 105
[ Dividend + Gain]/ Original Value = percentage of return
[0 + (105-100)]/100 = 0.05 ~ 5%
If dividend $ 2
[ 2+ ( 105-100)]/100 = 0.07 ~7%
 RETURNS: EXAMPLE

• Suppose you bought 100 shares of Wal-Mart (WMT) one year ago at $45/share. Over the last year, you
received $0.27/share in dividends (27 cents per share × 100 shares = $27). At the end of the year, the stock
sells for $48/share. How did you do?
• You invested $45 × 100 = $4,500. At the end of the year, you have stock worth $4,800 and cash dividends of
$27. Your dollar gain was $327 = $27 + ($4,800 – $4,500).
• Your percentage gain (returns) for the year is:

$327
7.3% =
$4,500
EXAMPLE

Alex bought 1000 shares in Maybank Berhad at the beginning of the year at RM 11 per share. During the year he
received net dividend of 30 sen. The price of the share at the end of the year was RM12.50. compute the annual
return for the investment.
In this case,
V1= RM 12.50 x 1000 = RM 12, 500
V0= RM 11 x 1000 = RM 11,000
Capital Gain = RM (12,500 – 11,000) = RM 1,500
Income for the year was Y= RM 0.30 x 1000 = 300
AR = X 100 = 16.36
RM11,000
 PROBLEM

1. Robin wishes to determine the return on 2 stocks that she owned during 2009, Apple Inc. and
Wal-Mart. At the beginning of the year, Apple stock traded for $90.75 per share, and Wal-
Mart was valued at $55.33. During the year, Apple paid no dividends, but Wal-Mart
shareholders received dividends of $1.09 per share. At the end of the year, Apple stock was
worth $210.73, and Wal-Mart sold for $52.84. Calculate the annual rate of return, r, for each
stock.
2. Joe bought some gold coins for $1000 and sold those 4 months later for $1200. Jane on the
other hand bought 100 shares of a stock for $10 and sold those 2 years later for $12 per share
after receiving $0.50 per share as dividends for the year. Calculate the dollar profit and
percent return earned by each investor over their respective holding periods.
CONVERTING HOLDING PERIOD RETURNS TO ANNUAL
RETURNS

• With varying
holding period holding
returns periods,
not
• good for
Necessary comparison.
to state an
investment’s
terms of an performance
annual in
percentage
rate
rate (APR)
of return or an
(EAR)effective
by annual
using the
• following conversion formulas:
•• EAR
Where = n(1is+ HPR)
the
1/n
number – 1of years
or proportion of a year
holding period consists of. that the
EXAMPLE
Given Joe’s HPR of 20% over 4 months and Jane’s HPR of 25% over 2 years, is it correct to conclude
that Jane’s investment performance was better than that of Joe?
Compute each investor’s APR and EAR and then make the comparison.

Joe’s holding period (n) = 4/12 = .333 years

Joe’s APR = HPR/n = 20%/.333 = 60%
Joe’s EAR = (1 + HPR)1/n – 1 =(1.20)1/.33 – 1= 73.76%

Jane’s holding period = 2 years

Jane’s APR = HPR/n = 25%/2 = 12.5%
Jane’s EAR = (1 + HPR)1/n – 1 = (1 .25)1/2 – 1=11.8%

Clearly, on an annual basis, Joe’s investment far outperformed Jane’s investment.

EXTRAPOLATING HOLDING PERIOD RETURNS

• Extrapolating short-term HPRs into APRs and EARs is mathematically correct, but often
unrealistic and infeasible.
• Implies earning the same periodic rate over and over again in 1 year.
• A short holding period with fairly high HPR would lead to huge numbers if return is
extrapolated
EXAMPLE:
UNREALISTIC NATURE OF APR AND EAR
Let’s say you buy a share of stock for $2 and sell it a week later for $2.50. Calculate your HPR,
APR, and EAR. How realistic are the numbers?
N = 1/52 or 0.01923 of 1 year.
Profit = $2.50 - $2.00 = $0.50
HPR = ($0.5/$2.00)X100 = 25%
APR = 25%/0.01923=1300% or
=25%*52 weeks = 1300%
EAR = (1 + HPR)52 – 1
=(1.25)52 – 1X100= 10,947,544.25%
Answer: Highly Improbable!
EXPECTED RETURN

• Probability Distributions
• When an investment is risky, it may earn different returns. Each
possible return has some likelihood of occurring. This information is
summarized with a probability distribution, which assigns a
probability, PR , that each possible return, R , will occur.
• The expected return is the return we would earn on average if we could
repeat the investment many times, drawing the return from the same
distribution each times.
Assume BFI stock currently trades for $100 per share.
In one year, there is a 25% chance the share price will be $140, a 50% chance it will be $110,
and a 25% chance it will be $80.

Expected Return  E  R    R
PR  R

E [RBFI] = 25% (0.4) + 50% (0.1) + 25% (-0.20) = 10%

VARIANCE AND STANDARD DEVIATION
• Variance
• The expected squared deviation from the mean
• It is used to compare the relative performance of each asset in a portfolio
• Variance and standard deviation are measures of dispersion
• Helps researchers determine how spread out or clustered together a set of numbers or outcomes is around their mean or
average value.
• The larger the variance, the greater is the variability and hence the riskiness of a set of values

❑
𝑉𝑎𝑟 ( 𝑅 ) 𝜎 =𝑃 [ ( 𝑅 − 𝐸 [ 𝑅 ] ) ] =∑ 𝑃 𝑅 × ( 𝑅 − 𝐸 [ 𝑅 ] )
• Standard Deviation 2 2 2
• The square root of the variance
𝑅

SD( R )  Var ( R)

• The standard deviation (), which is a measure of dispersion of the probability distribution, is commonly used to measure risk. The
smaller the standard deviation, the tighter the probability distribution and, thus, the lower the risk of the investment.
• Both are measures of the risk of a probability distribution
 ER = 10%

• For BFI, the variance and standard deviation are

SD( R)  Var ( R)  0.045  21.2%

• In finance, the standard deviation of a return is also referred to as its volatility. The standard deviation is
easier to interpret because it is in the same units as the returns themselves.
 Stock A
State of Economy Return (ri) Probability (pi)

Recession -6% 0.3

Normal 25 % 0.5
Prosperity 40 % 0.2

Calculate the expected return, variance and the standard variation

1 2 3 4 5 6
Step 1 Step 2 Square Step 3
(Deviation) Deviation
1x2 1-ER (4)2 5x2
Return (ri) Probability (pi) rip (%) (ri-ER) (%) (ri – ER)2 (ri – ER)2 pi
(%)
-6% 0.3 - 1.8 -24.7 610.09 183.03
25 % 0.5 12.5 6.3 39.69 19.84
40 % 0.2 8 21.3 453.69 90.74
ER= 18.7 Var = 293.61
Standard Deviation = √293.61 = 17.14
Stock B
State of Economy Return (ri) Probability (pi)

Recession 10% 0.2

Normal 15% 0.6
Prosperity 20% 0.2
Calculate the expected return, variance and the standard variation

1 2 3 4 5 6
Step 1 Step 2 Step 3
1x2 1-ER (4)2 5x2
Return (ri) Probability (pi) rip (%) (ri-ER) (%) (ri – ER)2 (ri – ER)2 pi
(%)
10% 0.2 2 -5 25 5
15% 0.6 9 0 0 0
20% 0.2 4 5 25 5
ER =15 VAR =10
Standard Deviation = √10 = 3.16%
Analyze the stock riskiness
Stock A Stock B
Expected Return 18.7 % 15 %
Standard Deviation 17.14 % 3.16 %

Higher standard deviation = high risk investment.

Therefore, stock B is less risky from stock A
INVESTMENT RULES
• Investment rule number 1: If faced with 2 investment choices having the same
expected returns, select the one with the lower expected risk.
• Investment rule number 2: If two investment choices have similar risk
profiles, select the one with the higher expected return.
To maximize return and minimize risk, it would be ideal to select an
investment that has a higher expected return and a lower expected risk than the
other alternatives.
Realistically, higher expected returns are accompanied by greater variances
and the choice is not that clear cut. The investor’s tolerance for and attitude
towards risk matters.
In a world fraught with uncertainty and risk, diversification is the key!
ATTITUDE TOWARDS RISK

• Risk averse behaviour is the tendency of a person to reject a bargain

with an uncertain payoff and accept another bargain with a more certain,
but possibly, a lower expected payoff
• Risk loving behaviour of an investor is the willingness to take on
additional risk for an investment that has a relatively low expected return
• Risk neutral people judge risky investments by their expected rates of
return
 PROBLEM 3
Consider the following two risky asset world. There is a 1/3 chance of each state of the economy,
and the only assets are a stock fund and a bond fund.
Calculate the expected return, variance and SD for stock fund and bond fund

Rate of Return
Scenario Probability Stock Fund Bond Fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
 Measuring Stocks’ Co-movement: Covariance and
Correlation
• To find the risk of a portfolio, we need to know

• The risk of the component stocks

• The degree to which they move together
• Covariance
• The expected product of the deviations of two returns from their means
• Measures the directional relationship between two assets
• Covariance between Returns Ri and Rj

Covis(positive,
• If the covariance  two
Ri ,R j ) the Ri tend
E[(returns E[to
Rimove j  E[ R j ])]
]) (Rtogether.
• If the covariance is negative, the two returns tend to move in opposite directions
 A B A Deviation B Deviation
Scenario (Pi) (ri) (ri) Ri – ER Ri – ER 4X5=6 1x6
1 2 3 4 5
Recession 1/3 -7% 17% -18% 10% - 0.0180 - 0.006

Normal 1/3 12% 7% 1% 0 0 0

Prosperity 1/3 28% -3% 17% -10% - 0. 0170 - 0.0057

Expected Return (ER) 11% 7% Sum - 0.0017

Variance (Var) 0.0205 0.0067 Covariance - 0.0017

Standard Deviation(SD) 14.3% 8.2%

𝐶𝑜𝑣 (𝑅 𝑖 , 𝑅 𝑗 )=𝑃𝑖[( 𝑅 𝑖 − 𝐸[ 𝑅𝑖 ])(𝑅 𝑗 − 𝐸[ 𝑅 𝑗 ])]

Cov = 1/3 (-0.07 – 0.11)(0.17 – 0.07) + 1/3 (0.12 – 0.11)(0.07 – 0.07) + 1/3 (0.28 – 0.11)(-0.03 – 0.07)
= - 0.0017
• Correlation is scaled covariance and is defined as

Cov ( Ri , R j )
Corr ( Ri , R j ) 
SD ( Ri ) SD ( R j )

• Correlation measures the strength of relationship between the securities

• Correlation ranges from ‑1 to +1, and measures the degree to which the returns share
common risk
CORRELATION
 PORTFOLIO MANAGEMENT
 An investment in a single asset is subject to all the risks associated with that, and only that asset.
 Consider an investment that consists of only the stock issued by one company. If that company's
stock suffers a serious downturn, the investment will sustain the full brunt of the decline.
 However, by splitting the investment between the stocks of two different companies, you reduce
the potential risk to your investments, which is now in a portfolio. Thus diversification is used to
create a portfolio that includes multiple investments in order to reduce risk.
 Modern Portfolio Theory (MPT) quantifies the benefits of diversification.
 THE EXPECTED RETURN OF A PORTFOLIO
• Portfolio weights
• The fraction of the total portfolio held in each investment in the portfolio:

Value of investment i
wi 
Total value of portfolio

• Portfolio weights add up to 100% (that is, w1 + w2 + … + wN = 100%)

• The weight are the fraction of the total funds invested in each asset.

• Example, if we have $50 in one asset (a) and $150 in another (b). Total portfolio = $200
• A = 50/200 = 0.25 while B = 150/200 = 0.75
• Portfolio Return, Rp
• The weighted average of the returns on the investments in the portfolio:

A portfolio consists of assets A and B. Asset A makes up one-third of the

portfolio and has an expected return of 18 percent. Asset B makes up the other
two-thirds of the portfolio and is expected to earn 9 percent. What is the
return on the portfolio?
There are 2 stocks L and U. You put your money half in each. So 50% in L and 50 %
in U. What are the pattern of this portfolio?
Rate of Return is State Occurs
Probability of
State of Stock L Stock U Portfolio (%) Expected Return
State of
Economy on portfolio
Economy (%)

Recession 0.5 - 20% 30% 5 0.5 x 5% = 2.5%

Boom 0.5 70 % 10% 40 0.5 x 40% = 20
%
ER 25% 20% (E(Rp) 22.5 %
VAR 0.2025 0.0100
𝑟 𝑃 =𝑤 𝐵 𝑟 𝐵 +𝑤𝑆 𝑟 𝑆 SD 45% 10%

Your portfolio return, R P , in a recession and

or
boom are; E(RP ) = 0.50 x E(RL ) + 0.50 x E(RU )
R P = 0.50 x - 20% + 0.50 x 30% = 5% = 0.50 x 25% + 0.50 x 20%
R P = 0.50 x 70% + 0.50 x 10% = 40% =22.5%
 EXAMPLE
Rate of Return is State Occurs
Probability of Portfolio
State of Stock A Stock B Stock C Expected Return on
State of Return if
Economy portfolio
Economy state occurs

Boom 0.4 10% 15% 20% 15% 0.4 x 0.15 = 0.06

Recession 0.6 8% 4% 0 4% 0.6 x 0.04 = 0.024
ER 8.8% 8.4% 8.0% (E(Rp) 0.084 @ 8.4%
VAR
SD
We want to calculate portfolio expected returns in two cases. Assuming the portfolio have equal investment
Rp(Boom) = 1/3(0.1) + 1/3(0.15) + 1/3(0.2) = 15%
Rp(Recession) = 4%
 PROBLEM 4
• Suppose you invest $100,000 and buy 200 shares of Apple at $200 per
share ($40,000) and 1000 shares of Coca-Cola at $60 per share ($60,000).
If Apple’s stock goes up to $240 per share and Coca-Cola stock falls to
$57 per share and neither paid dividends. After the price change,
1. What is the new portfolio weight?
2. What is the new value of the portfolio?

3. What return did the portfolio earn?

SUMMARY FOR PORTFOLIO
THE VOLATILITY OF A PORTFOLIO

• Investors care about return, but also risk

• When we combine stocks in a portfolio, some risk is eliminated through diversification
• Remaining risk depends upon the degree to which the stocks share common risk
• The volatility of a portfolio is the total risk, measured as standard deviation, of the portfolio
• Table below shows returns for three hypothetical stocks, along with their average returns and volatilities
• Note that while the three stocks have the same volatility and average return, the pattern of returns differs
• When the airline stocks performed well, the oil stock did poorly, and when the airlines did poorly, the oil
stock did well
• This example demonstrates two important truths

• By combining stocks into a portfolio, we reduce risk through diversification

• The amount of risk that is eliminated depends upon the degree to which the
stocks move together
• Combining airline stocks reduces volatility only slightly compared to the individual stocks
• Combining airline and oil stocks reduces volatility below that of either stock
 THE VOLATILITY OF A PORTFOLIO
• Computing a Portfolio’s Variance and Standard Deviation
• The formula for the variance of a two-stock portfolio is:

2
𝑉𝑎𝑟 ( 𝑅 𝑃 )=𝑤 𝑆𝐷 ¿ ¿ 1
 A B Portfolio
Scenario (Pi) (ri) (ri) Rp
Recession 1/3 -7% 17% 5%

Normal 1/3 12% 7% 9.5%

Prosperity 1/3 28% -3% 12.%

Expected Return (ER) 11% 7% 9.0%

Variance (Var) 0.0205 0.0067 0.0009

Standard Deviation(SD) 14.3% 8.2% 3%

You invest 50% of your fund in each share.

Correlation = - 0.998
Porfolio Variance
Var(p) = (0.5 x 0.143)2 + (0.5 x 0.082)2 + 2(0.5 x 0.143)(0.5 x 0.082)(-0.998) = 0.0009 (+-3)

SD = √0.0009 = 3%
• Observe the decrease in risk that diversification offers.
• An equally weighted portfolio (50% in A and 50% in B) has less risk than
either A or B held in isolation.
A B P
Expected Return 11 7 9
SD 14.3 8.2 3
COMPUTING THE VOLATILITY OF A TWO-STOCK PORTFOLIO

Problem 5:
Using the data from Table above,
1. What is the volatility (standard deviation) of a portfolio with equal amounts invested in
Apple and Microsoft stock?
2. What is the standard deviation of a portfolio with equal amounts invested in Apple and
Starbucks?
DIVERSIFICATION AND PORTFOLIO RISK

• Diversification can substantially reduce the variability of returns without an equivalent

reduction in expected returns.
• This reduction in risk arises because worse than expected returns from one asset are
offset by better than expected returns from another.
• However, there is a minimum level of risk that cannot be diversified away, and that is
the systematic portion.
 WAYS OF MEASURING RISKS

• In relation to investments, the standard deviation is used to measure a

security or a portfolio’s volatility, which means the tendency of the returns to
rise or fall in a period of time. A security that is volatile is also high risk
because its performance may change fast.
• The standard deviation of a security or portfolio measures this risk by
measuring the degree to which the security or portfolio fluctuates in relation to
its average return or the arithmetic mean of the security/portfolio.
RISK: SYSTEMATIC AND UNSYSTEMATIC

• A systematic risk is any risk that affects a large number of assets, each to a greater or lesser
degree. Force from outside of the firm’s control.
• An unsystematic risk is a risk that specifically affects a single asset or small group of assets.
Example, business risk, liquidity risk
• Unsystematic risk can be diversified away.
• Examples of systematic risk include uncertainty about general economic conditions, such as
GNP, interest rates or inflation.
• On the other hand, announcements specific to a single company are examples of unsystematic
risk.
TOTAL RISK

• Total risk = systematic risk (non – controllable) + unsystematic risk (controllable)

• The standard deviation of returns is a measure of total risk.
• For well-diversified portfolios, unsystematic risk is very small.
• Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk.
• Researchers have shown that the best measure of the risk of a security in a large portfolio is the beta (b)of
the security.
• Beta measures the responsiveness of a security to movements in the market portfolio (i.e., systematic risk).

𝐶𝑜𝑣( 𝑅𝑖, 𝑅 𝑀 )
𝛽𝑖= 2
𝜎 (𝑅 𝑀 )
 THE CAPITAL ASSET PRICING MODEL (CAPM)

• The Capital Asset Pricing Model (CAPM) allows us to identify the efficient portfolio of risky assets
without having any knowledge of the expected return of each security.
• Instead, the CAPM uses the optimal choices investors make to identify the efficient portfolio as the
market portfolio, the portfolio of all stocks and securities in the market.
• It describe the relationship between systematic risk and expected return for assets.
• Helps to calculate investment risk and what return on investment an investor should expect
 E[ Ri ]  rf  i  E[ RMkt ]  rf 
    
Risk Premium for Security i

Eri = the expected ( or required return) on the security

Rf = the risk-free security such as T-bill
Rm = the expected return on the market portfolio
B = beta, an index of the non diversifiable risk

The CAPM shows that the expected return of particular asset depends on three things:
• The pure time value of money: As measured by the risk-free rate, R f , this is the reward for
merely waiting for your money, without taking any risk.
• The reward for bearing systematic risk: As measured by the market risk premium, E( R M ) R
f , this component is the reward the market offers for bearing an average amount of systematic
risk in addition to waiting.
• The amount of systematic risk: As measured by Bi , this is the amount of systematic risk
present in a particular asset or portfolio, relative to that in an average asset.
Relationship Between Risk & Return
• Assuming that the risk-free rate (rf) is 8 percent, and the expected return for the market (rm) is 12
percent, then if

Expected return
Beta rj
0 8
𝑅𝑖 =𝑅 𝐹 +β 𝑖 ×(𝑅 𝑀 − 𝑅 𝐹 )
0.5 10
1.0 12
𝑅𝑀
2.0 16

𝑅𝐹

1.0 b
PROBLEM

• Suppose the risk-free return is 3% and you measure the market

risk premium to be 6%. Apple has a beta of 1.2. According to
the CAPM, what is its expected return?
 BETA ON PORTFOLIO
• The beta for overall market is considered to be equal to 1.0.
• Securities with higher beta > 1.0 = risky @ more volatile, while beta with < 1.0, less risky than the
market and also less responsive to changing return in the market.
• If the market is expected to experiencing a 10% increase in its rate of return over the next period,
stock with 1.1 beta are expected to experience an increase in return of approximately 11% (1.1 x 10).
• A portfolio beta is merely the weighted average of the betas of the individual assets included in the
portfolio.
Beta of Portfolio = (W1 x B1) + (W2 x B2)
 EXAMPLE
Asset Proportion of total Beta
investment
1 0.1 1.65
2 0.3 1
3 0.2 1.3
4 0.2 1.1
5 0.2 1.25

Using the formula:

Pb = (0.1 x 1.65) + (0.3 x 1.0) + …….
= 1.2
 DISCUSSION
• Consider the following information about two securities. Which has greater total
risk? Which has greater systematic risk? Greater unsystematic risk? Which asset
will have a higher risk premium?
SD Beta
Security A 40 % 0.5
Security B 20% 1.5

Security A has greater total risk, but it has substantially less systematic
risk. Because total risk is the sum of systematic and unsystematic risk,
Security A must have greater unsystematic risk. Finally, from the
systematic risk principle, Security B will have a higher risk premium
and a greater expected return, despite the fact that it has less total risk.
 EXAMPLE
Beta Suppose you put half of your money in ExxonMobil
The Gap 0.48 and half in Coca-Cola. What would the beta of this
Coke 0.52 combination be?
3m 0.64
ExxonMobile 1.14 Because ExxonMobil has a beta of 1.14 and Coca-Cola
Texas 1.28 has a beta of .52, the portfolio’s
Ebay 2.13 beta, P , would be:
Google 2.60
0.83
Assume the following: the risk-free rate is 8 percent, and the market
portfolio expected return is 12 percent.
Portfolio Beta Rp
A 0.6
B 1.0
c 1.4

1. Calculate for each of the three portfolios the expected return consistent with
the capital asset pricing model.
2. Show graphically the expected portfolio returns in (1)
SOLUTIONS
1. Apple : (0 + 210.73 – 90.75)/90.75 = 132.3%;
Wal Mart : (1.09 + 52.84 – 55.33)/55.33 = -2.5%
2. Joe’s Dollar Profit = Ending value – Original cost
= $1200 - $1000 = $200
Joe’s HPR = Dollar profit/Original cost
= $200/$1000 = 20%
Jane’s Dollar Profit = Ending value +Distributions - Original Cost
= $12*100 + $0.50*100 - $10*100
= $1200 + $50 - $1000
=$250
Jane’s HPR = $250/$1000 = 25%
PROBLEM 3

Stock Fund Bond Fund

Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 0.0324 17% 0.0100
Normal 12% 0.0001 7% 0.0000
Boom 28% 0.0289 -3% 0.0100
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%
PROBLEM 4
1. After the price change, the new portfolio weights are equal to the value of your investment in
each stock divided by the new portfolio value. 1000  $57
200  $240 wCoca Cola   54.29%
wApple   45.71% 105, 000
105, 000

2. The new value of your Apple stock is 200 × $240 = $48,000. The new value of your Coke
stock is 1000 × $57 = $57,000. The new value of your Apple stock is 200 × $240 = $48,000.
The new value of your Coke stock is 1000 × $57 = $57,000.
• The new value of your portfolio is $48,000 +57,000 = $105,000, for a gain of $5000 or a 5% return on your initial
$100,000 investment.
• The return on Apple stock was $40/$200 = 20%, and the return on Coca-Cola stock was -$3/$60 = -5%.

3. The initial portfolio weights were $40,000/$100,000 = 40% for Apple and $60,000/$100,000
RP  wApple RApple  wCoke RCoke  0.40  20%  0.60( 5%)  5%
= 60% for Coca-Cola
 Weight Volatility Correlation with Apple

Apple 0.50 0.41 1

PROBLEM 5 Microsoft 0.50 0.28 0.48
Apple 0.50 0.41 1
Starbucks 0.50 0.32 0.38
• Execute:
For the portfolio of Apple and Starbucks ≈
Evaluate:

• The weights, standard deviations, and correlation of the two stocks are
needed to compute the variance and then the standard deviation of the
portfolio.
• Here, we computed the standard deviation of the portfolio of Apple and
Microsoft to be 29.9% and of Apple and Starbucks to be 30.4%. Note that
the portfolio of Apple and Starbucks is less volatile than either of the
individual stocks. It is also about equally volatile as the portfolio of Apple
and Microsoft. Even though Starbucks is more volatile than Microsoft, its
lower correlation with Apple leads to greater diversification benefits in the
portfolio, which offsets Starbuck’s higher volatility.