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C r
p
C 11.#?.
''. (2.() S"* Answer: e Diff: "
'*. (2.() S"* Answer: a Diff: "
'/. (2.() S"* Answer: $ Diff: "
'0. (2.() S"*+ CAP"+ and portfo#io risk Answer: a Diff: "
,n increase in expected inflation would lead to an increase in r
;F
, the
intercept of the 6.7. If risk aversion were unchanged, then the slope of the
6.7 would remain constant. Therefore, there would be a parallel upward shift
in the 6.7, which would result in an increase in r
.
that is e)ual to the
expected increase in inflation.
*1. (2.() Portfo#io ret!rn+ CAP"+ and $eta Answer: e Diff: "
6tatement e is correct because none of the statements are correct. 6tatement
a is false because if the returns of stocks were perfectly positively
correlated the portfolio&s variance would e)ual the variance of each of the
stocks. 6tatement b is false. , stock can have a negative beta and still
have a positive return because
rs
C
rRF
N 4
rM
2
rRF
5b. 6tatement c is
false. ,ccording to the %,-., stocks with higher betas have higher expected
returns. 8etas are a measure of market risk, while standard deviation is a
measure of stand2alone risk22but not a good measure. The coefficient of
variation is a better measure of stand2alone risk. The portfolio&s beta 4the
measure of market risk5 will be dependent on the beta of each of the randomly
selected stocks in the portfolio. :owever, the portfolio&s beta would
probably approach b
.
C 1, which would indicate higher market risk than a
stock with a beta e)ual to 1.$.
*1. (2.() CAP" and re)!ired ret!rns Answer: d Diff: "
*. (2.() Portfo#io risk and S"* Answer: e Diff: "
*!. (2.() CAP" Answer: c Diff: 0
*#. (2.() S"* Answer: d Diff: 0
*$. (2.) Portfo#io $eta Answer: $ Diff: E
1. C 1Q141.*5 N 40Q15b
b is average beta for other 10 stocks.
1.1'$ C 410Q15b.
@ew 8eta C 1.1'$ N 1Q141.#5 C 1.!$.
*'
. (2.) Portfo#io ret!rn Answer: $ Diff: E
p
r
C 1.041?5 N 1.141?5 C 1./?.
b
-
C 1.041.5 N 1.14.15 C 1./.
**. (2.() Re)!ired ret!rn Answer: a Diff: E
r
s
C '? N 411.$?2'?51. C 1.'?.
*/. (2.() Re)!ired ret!rn Answer: d Diff: E
r
;F
C rR N I- C !? N $? C /?.
r
s
C /? N 4$?5.1 C 1/?.
*0. (2.() CAP" and re)!ired ret!rn Answer: e Diff: E
b
:;
C .1< b
7;
C 1.$. @o changes occur.
r
;F
C 11?. 3ecreases by !? to *?.
r
.
C 1$?. Falls to 11?.
@ow 6.7= r
i
C r
;F
N 4r
.
2 r
;F
5b
i
.
r
:;
C *? N 411? 2 *?5 C *? N #?45 C 1$?
r
7;
C *? N 411? 2 *?51.$ C *? N #?41.$5 C 0
3ifference
'?
/1
. (2.() %eta coefficient Answer: $ Diff: E
In e)uilibrium
r
,
C
r
C 11.!?.
r
,
C r
;F
N 4r
.
2 r
;F
5b
11.!? C $? N 411? 2 $?5b
b C 1.'.
/1
. (2.() %eta coefficient Answer: a Diff: E
1!.*$? C $? N 4*?5b
/.*$? C *?b
b C 1.$.
/
. (2.() "arket risk premi!m Answer: d Diff: E
1.$? C $? N 4;-
.
51.1$
*.$? C 4;-
.
51.1$
;-
.
C '.!1?.
/!
. (2.2) Expected ret!rn Answer: e Diff: "
r
C 1.1142!?5 N 1.114?5 N 1.$4$?5 N 1.$4/?5 N 1.!1411?5 C '.1$?.
Y
r C 1.1$42!?5 N 1.114?5 N 1.!14$?5 N 1.!14/?5 N 1.$411?5 C '.#$?.
E
C 1.1142!? 2 '.1$?5
N 1.114? 2 '.1$?5
N 1.$4$? 2 '.1$?5
N 1.$4/? 2 '.1$?5
N 1.!1411? 2 '.1$?5
C 1$.*!<
E
C !.0*.
%9
E
C !.0*Q'.1$ C 1.'#$.
B
C 1.1$42!? 2 '.#$?5
N 1.114? 2 '.#$?5
N 1.!14$? 2 '.#$?5
N 1.!14/? 2 '.#$?5
N 1.$411? 2 '.#$?5
C 11.0$<
B
C !.!1.
%9
B
C !.!1Q'.#$ C 1.$1!.
Therefore, ,sset B has a higher expected return and lower coefficient of
variation and hence it would be preferred.
/#. (2.2) Expected ret!rn Answer: c Diff: "
J
r C 41.541.115 N 41.'541.1$5 N 41.541.15 C 1.1$ C 1$.1?.
>xpected return C 1$.1?.
2
J
C 41.541.11 2 1.1$5
N 1.'41.1$ 2 1.1$5
N 41.541.1 2 1.1$5
C 1.111.
6tandard deviation C 1.111 C 1.1!1' C !.1'?.
/$
. (2.2) Coefficient of variation Answer: $ Diff: "
The expected rate of return will e)ual 1.$4$?5 N 1.$41$?5 N 1.$4$?5 C 1$?.
The variance of the expected return is 1.$4$? 2 1$?5
N 1.$41$? 21$?5
N
1.$4$? 2 1$?5
N 1.4211? 2 1$?5
N 1.#41$? 21$?5
N 1.4#1? 2 1$?5
N 1.1401? 2 1$?5
T
1Q
C 1,!*$
1Q
C !*.1/1?.
%9 C !*.1/1?Q1$? C .#*1.
/*
. (2.2) Coefficient of variation Answer: c Diff: "
>xpected return for stock , is 1.!41?5 N 1.#4/?5 N 1.!4'?5 C /.'?.
>xpected return for stock 8 is 1.!4$?5 N 1.#4#?5 N 1.!4!?5 C #?.
6tandard deviation for stock , is=
S1.!41? 2 /.'?5
N 1.#4/? 2 /.'?5
N 1.!4'? 2 /.'?5
T
1Q
C .!*#0?. 6imilarly,
the standard deviation for stock 8 is 1.**#'?.
%9
,
C .!*#0?Q/.'? C 1./.
%9
8
C 1.**#'?Q#? C 1.10.
//
. (2.) Portfo#io $eta Answer: $ Diff: "
8efore=
1.1$ C 1.0$4b
;
5 N 1.1$41.15
1.0$4b
;
5 C 1.11
b
;
C 1.1$/.
,fter= b
-
C 1.0$4b
;
5 N 1.1$4.15 C 1.11 N 1.11 C 1.1.
/0
. (2./) "arket ret!rn Answer: d Diff: "
b C
;ise
;un
C
B
E
C
2 1'
1$ 2 11
C
#
'
C 1.$.
r
s
C 1$? C 0? N 4r
.
2 0?51.$
'? C 4r
.
2 0?51.$
#? C r
.
2 0?
r
.
C 1!?.
01
. (2.() Re)!ired ret!rn Answer: c Diff: "
6tep 1 6olve for risk2free rate
r
s
C 1$? C r
;F
N 411? 2 r
;F
5.1 C r
;F
N 1? 2 r
;F
r
;F
C $?.
6tep %alculate new market return
r
.
increases by !1?, so r
.
C 1.!411?5 C 1!?.
6tep ! %alculate new re)uired return on stock
r
s
C $? N 41!? 2 $?5 C 1?.
6tep # %alculate percentage change in return on stock
1$?
1$? 2 1?
C #1?.
01. (2.() Re)!ired ret!rn Answer: c Diff: "
8efore= r
s
C 1$? C r
;F
N 4$?51.*< r
;F
C 1$? 2 !.$?< r
;F
C 11.$?.
@ew r
;F
C 11.$? N .1? C 1!.$?.
@ew beta C 1.* 1.$ C 1.1$.
,fter= @ew re)uired rate of return=
r
s
C 1!.$? N 4$?51.1$ C 1/.*$?.
0
. (2.() CAP" and re)!ired ret!rn Answer: d Diff: "
b
p
C
111 , !11 I
111 , 111 I
41./5 N
111 , !11 I
111 , 1$1 I
41.5 N
111 , !11 I
111 , $1 I
41./5
b
p
C 1.1'*.
7ast year= r C 1!?
1!? C *? N ;-
.
41.1'*5
'? C ;-
.
41.1'*5
;-
.
C $.1#0?.
This year=
r C *? N4$.1#0? N ?51.1'*
r C 1$.!!?.
0!
. (Comp: 2.+ 2.() Portfo#io $eta Answer: c Diff: "
,fter additional investments are made, for the entire fund to have an
expected return of 1!.$?,the portfolio must have a beta of 1.$ as shown by
1!.$? C '? N 4'?5b. 6ince the fundGs beta is a weighted average of the betas
of all the individual investments, we can calculate the re)uired beta on the
additional investment as follows=
1.$ C
11 I$1,111,1
1.5 111 4I11,111,
N
11 I$1,111,1
E5 11 4I$1,111,1
1.$ C 1.0' N 1.E
1.0 C 1.E
E C 1.#$.
0#. (Comp: 2.+ 2.() Portfo#io $eta Answer: e Diff: "
Find the beta of the original portfolio 4b
+ld
5 as 11.*$? C #? N 40? 2 #?5b
+ld
or b
+ld
C 1.!$. To achieve an expected return of 11.$?, the new portfolio
must have a beta 4b
@ew
5 of 11.$? C #? N 40? 2 #?5
@ew b
or
@ew b
C 1.$. To
construct a portfolio with a b
@ew
C 1.$, the added stocks must have an average
beta 4b
,vg
5 such that=
1.$ C 4I$1,111QI*$1,1115b
,vg
N 4I$11,111QI*$1,11151.!$
1.$ C 1.!!!b
,vg
N 1.01
1.' C 1.!!!b
,vg
b
,vg
C 1./.
0$
. (Comp: 2.+ 2.() Portfo#io ret!rn Answer: a Diff: "
The portfolioGs beta is a weighted average of the individual security betas
as follows=
4I$1,111QI*$,11151.$ N 4I$,111QI*$,11151.0 C 1.!. The re)uired rate of
return is then simply= #? N 4'? 2 #?51.! C '.'?.
0'
. (2.() %eta coefficient Answer: a Diff: "
First find the portfolioGs beta=
1$? C '? N 4'?5b
p
0? C '?b
p
b
p
C 1.$.
7et b
c
be the beta of the company for which she works. The portfolioGs beta
is a weighted average of the individual betas of the stocks in the portfolio.
Therefore, 1.$ C 4I$,111QI1,11151. N 4I1$,111QI1,1115b
%.
1.$ C 1.! N 1.*$b
c
1. C 1.*$b
c
b
c
C 1.'.
0*. (2.() CAP" and re)!ired ret!rn Answer: d Diff: "
b
E
C 1.'< b
B
C 1.*< r
;F
C *?< r
.
C 1?.
Inflation increases by 1?, but rR remains constant. r
;F
increases by 1?< r
.
rises to 1#?.
8efore inflation change=
r
E
C *? N $?41.'5 C 1$?.
r
B
C *? N $?41.*5 C 11.$?.
,fter inflation change=
r
E
C /? N 41#? 2 /?51.' C 1*.'?.
r
B
C /? N 41#? 2 /?51.* C 1.?.
r
E
2 r
B
C 1*.'? 2 1.? C $.#?.
0/
. (2.() Expected and re)!ired ret!rns Answer: $ Diff: "
8y calculating the re)uired returns on each of the securities and comparing
re)uired and expected returns, we can identify which security is the best
investment alternative, i.e., the security for which the expected return
exceeds the re)uired return by the largest amount. The expected and re)uired
returns and the differences between them are shown below=
6ecurity >xpected ;eturn ;e)uired ;eturn >xpected2;e)uired
, 0.11? *? N ?41.*5 C 11.#1? 21.!0?
8 *.1'? *? N ?41.15 C *.11? 1.1'?
% $.1#? *? N ?421.'*5 C $.''? 21.'?
3 /.*#? *? N ?41./*5 C /.*#? 1.11?
> 11.$1? *? N ?4.$15 C 1.11? 21.$1?
%learly, security 8 is the best alternative.
00. (Comp: 2.+ 2.() CAP" and $eta coefficient Answer: d Diff: "
-ortfolio beta is found from the %,-.=
1*? C *? N 41#? 2 *?5b
p
b
p
C 1.#/'.
The portfolio beta is a weighted average of the betas of the stocks within
the portfolio.
1.#/' C 4Q1$541./5 N 4$Q1$541.15 N 4!Q1$541.#5 N 4$Q1$5b
3
1.#/' C 1.11'* N 1.!''* N 1./11 N 4$Q1$5b
3
1.'*$ C $Q1$b
3
b
3
C .1'.
111. (Comp: 2.+ 2.() Portfo#io re)!ired ret!rn Answer: a Diff: 0
6tep 1 Find the beta of the original portfolio by taking a weighted average
of the individual stocksG betas. (e calculate a beta of 1.!.
1
]
1
,
_
,
_
,
_
,
_
+ + + 41./5
I1,'11,111
I$11,111
41.#5
I1,'11,111
I$11,111
415
I1,'11,111
I!11,111
41.'5
I1,'11,111
I!11,111
6tep Find the market risk premium using the original portfolio.
r
s
C 1.1$ C 1.1' N 4r
.
2 r
;F
51.!. If you substitute for all the
values you know, you calculate a market risk premium of 1.1$.
6tep ! %alculate the new portfolio&s beta.
The )uestion asks for the new portfolioGs re)uired rate of return.
(e have all of the necessary information except the new portfolioGs
beta. @ow, 6tock 1 has 1 weight 4we sold it5 and 6tock # has a
weight of
,
_
I1,'11,111
I/11,111
1.$. The portfolioGs new beta is=
+
,
_
415
I1,'11,111
I!11,111
+
,
_
41.#5
I1,'11,111
I$11,111
,
_
41./5
I1,'11,111
I/11,111
1.$$.
6tep # Find the portfolio&s re)uired return.
Thus, r
s
C 1.1' N 41.1$51.$$ C 1!.'$? 1!.'!?.
111. (2.2) Coefficient of variation Answer: $ Diff: E
Lsing your financial calculator you find the mean to be 11./ and the
population standard deviation to be 1$.*1$. The coefficient of variation is
Aust the standard deviation divided by the mean, or 1$.*1$Q11./ C 1.#$$1
1.#'.
11
. (2.) Portfo#io standard deviation Answer: a Diff: "
Fill in the columns for "EB" and "product," and then use the formula to
calculate the standard deviation. (e did each 4r 2
r
5
- calculation with a
calculator, stored the value, did the next calculation and added it to the
first one, and so forth. (hen all three calculations had been done, we
recalled the stored memory value, took its s)uare root, and had
EB
C /.1?.
-robability -ortfolio EB -roduct
1.1 2$.1? 21.$?
1./ 1*.$ 1#.1
1.1 !1.1 !.1
^
r
C 1'.$?
EB
C 44r 2
r
5
-5
U
C /.1*? /.1?.
11!. (2.() CAP" and re)!ired ret!rn Answer: e Diff: "
r
,
C '? N 411? 2 '?5b
,
.
%alculate b
,
as follows using a financial calculator=
' Input / N
2/ Input ! N
2/ Input 2 N
1/ Input 1 N
1
y ,m
swap b
,
C 1.#$!#.
r
,
C '? N $?41.#$!#5 C /.''0? /.*?.
11#. (2.() CAP" and re)!ired ret!rn Answer: a Diff: "
(ith your financial calculator input the following=
2 Input / N
1 Input ! N
2/ Input 1/ N
1 Input 2* N
1
y,m
swap b
%
C 21.*'.
r
%
C /? N 41#? 2 /?5421.*'5 C /? 2 #.$/? C !.#?.
11$. (Comp: 2./+ 2.() Expected and re)!ired ret!rns Answer: c Diff: "
Lse the calculator&s regression function to find beta
A
. It is 21.''11.
Find r
;F
. @ote that ;-
.
C r
.
2 r
;F
, so
#? C 1? 2 r
;F
r
;F
C /?.
Find r
K
C /? 2 #?41.''5 C $.!'?.
C /.11? 2 $.!'? C .'#?.
11'
. (Comp: 2.+ 2./+ 2.() Portfo#io ret!rn Answer: c Diff: "
%alculate
E b
and
B b
for the stocks using the regression function of a
calculator.
b
E
C 1.*!$/< b
B
C 1.!!#0.
r
E
C *? N $?41.*!$/5 C 11.'*0?.
r
B
C *? N $?41.!!#05 C 1!.'*#$?.
r
p
C 1#Q1411.'*0?5 N 'Q141!.'*#$?5 C 11.$/?.
11*. (Comp: 2.+ 2./+ 2.() Re)!ired ret!rn on stock Diff: 0
rB
21
.2
.2
3
/
r
.
-3 -/ / 3 .2 .2 21 2/
a. The least s)uares procedure yields the following e)uation for predicting
the rate of return on 6tock B= r
B
C a N br
.
C .$ N 1.$r
.
. Therefore, the
beta for 6tock B is 1.$1. The regression line is plotted in the graph.
b. r
B
C r
;F
N 4r
.
2 r
;F
5b
B
C '? N 4#?51.$ C /?.
c. The stock is now riskier. (ith greater risk and the same expected earnings
and dividends, the price of the stock would fall. Thus, capital losses
would be incurred, and they would offset if not overwhelm the dividend
return, with the net result being a low or even negative reali"ed rate of
return during 111. The re)uired rate of return would rise. (ith the same
expected dividends and dividend growth rate, but a lower market price, the
expected rate of return on the now lower priced stock would rise to e)ual
the now higher re)uired rate of return.
d. ,dding the point 2$, 1 for 111 to the data set produces this regression
e)uation=
r
B
C .*$ N 1.!r
.
. beta C 1.!.
Thus, the historical beta declines when the 110 data is added.
e. r
B
C '? N 4#?51.! C *.?.
f. This is down from /? in 110. 6ince we know that investors regard 6tock B
as being riskier, the true re)uired rate of return must be higher than /?,
not lower. This demonstrates one of the problems with using the %,-.. In
this case, rising risk caused a decline in the price of the stock, which
caused a low rate of return, which in turn caused the calculated beta to
decline. In this example, historical betas do not reflect risk well at
all.