CHAPTER TWO

RETURN AND RISK

1. Colfax Glassworks stock currently sells for Rs 36 per share. One year ago the stock sold for Rs 33. The
company recently paid a Rs 3 per share dividend. What was the rate of return for an investor in Colfax
stock during the past year? (Ans: - 18.18%)
2. An investor purchased a share of common stock for Rs 45 one year ago. During the year, the stock paid a
cash dividend of Rs 2.25. The stock is currently selling for Rs 51.25. What is the investor's holding period
return? (Ans: - 18.89%)
3. An investor purchased 100 shares of common stock at Rs 20 per share one year ago. The company declared
and paid a dividend of Rs 2 per share during the year. The investor sold the stock for Rs 21 per share after
the one-year holding period.
a. Calculate the rupee return from this investment.
b. Calculate the HPR for this investment.
c. Partition the HPR into its dividend and capital appreciation components.
(Ans: - a. Rs 300, b. 15%, c. 10%; 5%)
4. Suppose that you have the following data on a performance of your Individual Retirement Account (IRA)
tax-deferred portfolio:
Market value (Rs)
Income distribution (Rs)
January 1, 1990
8000
December 31, 1990
8100
500
December 31, 1991
11000
1000
Calculate:
a. The HPR for 1990.
b. The HPR for 1991.
c. The two-year HPR under the assumption that the Rs 500 distribution would be treated as income that
was not reinvested.
d. The two-year HPR under the assumption that the Rs 500 is reinvested when it was received on
December 31, 1990 at the HPR rate of 1991.
(Ans: - a. 7.5%, b. 48.15%, c. 56.25%, d. 59.26%)
5. Consider the following ex-post HPRs:
Year
Investment A (%)
Investment B (%)
1
10
14
2
15
-10
3
8
30
a. Calculate the arithmetic mean HPR for each investment.
b. Calculate the geometric mean HPR for each investment.
c. Explain why the arithmetic and geometric means are different.
d. Assume that investments A and B have equal risk. Which investment provides the "best" return
performance? (Hint: Assume that Rs 10000 was invested in each alternative and then calculate the
rupee value of the investment at the end of year 3, using geometric means.)
(Ans: - a. 11%; 11.33%, b. 10.96%; 10.08%)
6. Squeaky Bluege has been considering an investment in Oakdale Merchandising. Squeaky has estimated
the following probability distribution of returns for Oakdale stock:
Return (%)
-10
0
10
20
30
Probability
.10
.25
.40
.20
.05
Based on Squeaky's estimates, calculate the expected return and standard deviation of Oakdale stock.
(Ans: - 8.5%; 10.1%)

7. Consider the following subjective probability distribution for a potential investment:

State of economy
Probability(Pj)
Estimated rate of return (HPRj)
Strong growth
0.10
25%
Moderate growth
0.40
15%
Weak growth
0.40
10%
Recession
0.10
-12%
a. Calculate the expected rate of return.
b. Calculate the variance.
c. Calculate the standard deviation.
d. Calculate the coefficient of variation.
e. Interpret your answers to parts (a) to (d).
(Ans: - a. 11.3%, b. 79.21, c. 8.9%, d. 0.7876)
8. Consider the following ex-post quarterly HPRs provided by a common stock:
Quarter
1
2
3
4
5
6
7
8
Quarterly HPR (%)
-4.3
-1.0 1.5 3.0 6.0 2.0 0.0 -2.5
a. Assuming that each of the ex-post quarterly returns has an equal probability of occurring, calculate the
expected HPR for quarter 9.
b. Using the assumption in part (a), calculate the variance and standard deviation.
c. Assume that the HPRs for quarters 1, 2 and 8 occurred during a recessionary environment and that the
HPR for quarters 4 and 5 occurred during a period of rapid economic growth. The remaining HPRs
occurred during quarters of moderate economic growth. Calculate the probability that quarter 9 will
be (1) a period of rapid economic growth, (2) a recessionary period, and (3) a period of moderate
economic growth.
d. Use the probabilities calculated in part (c) to calculate the expected return, variance, and standard
deviation of the common stock's quarterly HPRs.
e. What are the weaknesses of the forecasting techniques used in parts (a) and (d)?
(Ans: - a.0.5875%, b. 9.2785635; 3.0461%, c. 0.25: 0.375; 0.375, d. 0.58875%)
9. The risk-free rate is 8 percent, and the expected return on the market is 16 percent. The betas for common
stocks of five companies are as follows:
Common stock
1
2
3
4
5
Beta
1.60
0.80
0.70
1.20
1.40
a. Draw the security market line (SML).
b. Locate each common stock on the SML.
c. Based on your answer to part (b), estimate the required return for each stock. Verify your answers by
using equation of SML.
(Ans: - c. 20.8%; 14.4%; 13.6%; 17.6%; 19.2%)
10. Assume the betas of two common stocks are 1=0.9 and 2 =1.3. If the risk free rate of return is 8 percent
and the expected return on the market portfolio is 12 percent:
a. Calculate the required returns for each common stock using the capital asset pricing model.
b. Do the required returns calculated in part (a) include a return to compensate the investor for
unsystematic risk? Explain.
c. If the expected return of stock 1 is 12 percent and expected return of stock 2 is 14 percent, should
the investor buy either stock? Why or why not?
(Ans: - a. 11.6%, b. 13.2%)
11. An investor purchased a share of common stock for Rs 45 one year ago. During the year, the stock paid a
cash dividend of Rs 2.25. The stock is currently selling for Rs 51.25. What is the investor's holding period
return? (Ans: - 18.89%)

12. Consider the following ex-post quarterly holding period returns:

Quarter
Quarterly HPR
Quarter
Quarterly HPR
Quarter
Quarterly HPR
1
15.87%
8
2.73
15
10.57
2
5.38
9
-1.93
16
3.03
3
4.84
10
11.46
17
-1.08
4
6.07
11
11.65
18
16.38
5
-4.44
12
-2.03
19
14.15
6
6.20
13
10.05
20
15.95
7
0.19
14
5.61
Required: a. Mean, b. Variance, c Standard deviation, d. Coefficient of variation.
13. Consider the following subjective probability distribution for a potential investment:
State of economy
Probability
Estimated rate of return on
Estimated rate of
Stock A
return on Stock B
Strong growth
0.1
25%
-10%
Moderate growth
0.4
15
15
Weak growth
0.4
-10
25
Recession
0.1
10
20
a. Which stock has more expected rate of return?
b. Which stock is riskier in terms of standard deviation?
c. Calculate the coefficient of variation. What purpose does coefficient of variation serve?
(TU: BBA: 2005)
14. The annual HPR for Bottlers Nepal and NEPSE index are given below:
Year
1
2
3
4
5
6
7
8
Bottlers Nepal HPR (%) 21.73 4.31 -2.21 -1.69 9.44 -7.93 0.76 -2.99
NEPSE index HPR (%)
9.70 0.17 -0.59 4.59
5.76
0.65
3.90
7.50
a. Calculate the expected return, based on the historical data of common stock of Bottlers Nepal and the
NEPSE index.
b. Calculate the standard deviation of the historical returns of common stock of Bottlers Nepal and the
NEPSE index.
c. What is the estimated beta of common stock of Bottlers Nepal if the covariance of the returns of
common stock of Bottlers Nepal and the NEPSE index is 45.57? (TU: BBA: 2005)
15. Assume that the yield on Treasury bill is 7 percent, the expected return on the market over the next year is
15percent, the beta of the common stock of Salt Trading Corporation is 1.75, and the beta of Bisal Bazar
Ltd. is 0.75. An investor is considering a portfolio of 500 shares each of the common stock of Salt Trading
Corporation and Bisal Bazar Ltd. The current price of a share of Salt Trading Corporation is Rs.380, and
the price of a share of Bisal Bazar is Rs.230.
Calculate:
a. The required rate of return for the common stock of Salt Trading Corporation.
b. The required rate of return for the common stock of Bisal Bazar Ltd.
c. The required rate of return for the portfolio. (TU:BBA: 2005)
16. Mr. Thapa, a financial analyst for Gandaki Noodles Pvt. Ltd., wishes to estimate the rate of return for two
similar risky investments ABC and XYZ. Thapa's reaches indicate that the immediate past returns will act
a reasonable estimate of future returns. A year earlier, investment ABC had a market value of Rs.120000
and investment XYZ of Rs.155000. During the year, investment ABC generated cash flow of Rs.1500 and
investment XYZ generated cash flow of Rs.16800. The current market value of investments ABC and
XYZ are Rs.130000 and Rs185000 respectively.
a. Calculate the expected holding period rate of return on investment ABC and XYZ using most recent
year's data.
b. If the two investments are equally risky, which one should Mr. Thapa recommend? Why?

17. Assume that the risk free rate is 6%, the expected return on the market over the next year is 14 percent, the
beta of the common stock of Compaq Computer is 1.55, and the beta of Bell Computer is 0.75. An
investor is considering a portfolio of 100 shares each of the common stock of Compaq Computer and Bell
Computer. The current price of a share of Bell Computer is Rs.23 and the current price of Compaq
Computer is Rs.38.
Calculate:
a. The required rate of return for the common stock of Compaq Computer.
b. The required rate of return for the common stock of Bell Computer.
c. The required rate of return for the portfolio. (Ans: - a. 18.4%, b. 12%, c. 16%)
18. The following are the annual holding period returns for Terai Bank Ltd. and return on market index:
Year
HPR on common stock of Terai Bank Ltd.
HPR on Market index
1
7.5%
17.1%
2
22.8
14.0
3
0.0
5.8
4
-9.9
-7.0
5
0.6
5.6
a. Based on historical rate of return data, calculate the expected return on common stock of Terai Bank
Ltd. and on market index.
b. Calculate the standard deviation of the returns of common stock of Terai Bank Ltd. and on market
index.
c. Calculate the covariance and correlation coefficient of the returns of Terai Bank Ltd. and market
index.
d. What is the estimated beta for common stock of Terai Bank Ltd.?
e. Is investing in the stock of Terai Bank Ltd. more risky than investing of market portfolio?
(Ans: - a. 4.2%; 7.1%, b. 10.83%; 8.37% c. 74.202; 0.8186, d. 1.059, e. Yes)
19. Consider the following subjective probability distribution of returns on Stock A and Stock B for a potential
investment:
State of economy
Probability
Estimated rate of return on
Estimated rate of
Stock A
return on Stock B
Strong growth
0.1
25%
-10%
Moderate growth
0.4
15
15
Weak growth
0.4
-10
25
Recession
0.1
10
20
a. Which stock would you select on the basis of expected rate of return?
b. Calculate standard deviation of the return of Stock A and Stock B. what purpose does standard
deviation serve for an investor?
c. Calculate the coefficients of variation. What purpose does coefficient of variation serve?
d. Suppose that Stock A has a beta of 1.5 and Stock B has a beta of 1.3. Interpret the values of beta to an
investor and explain how this additional information influences an investors decisions.
(TU: BBA: 2006)
20. Consider the probabilities and rate of returns on Stock A and Stock B under different economic conditions:
Economic conditions
Probability Stock A
Stock B
Bad
0.30
15 %
5%
Average
0.40
10 %
10 %
Good
0.30
5%
15 %
a. Calculate the expected rate of return for each stock.
b. Calculate the variances and standard deviations of the stocks.
c. Calculate the coefficients of variation.
d. What is the covariance between the returns of Stock A and Stock B? What purpose does covariance
serve?
e. Calculate the beta for Stock A and Stock B assuming that the covariance between Stock A and the market
is 220, the covariance between Stock B and the market is 420 and the variance of the market is 169.

f. Now you have a number of measures of risk (Variance, Standard deviation, coefficient of variation and
beta) for Stock A and Stock B. Evaluate Stock A and Stock B in terms of these risk measures and
explain the significance of each measure for investment decision making. (TU: BBA: 2007)
21. You have forecasted the following rate of return on the stocks of Himal Bank Ltd. and Terai Bank Ltd. under
various economic conditions:
Economic conditions
Probability
Possible HPR
Himal Bank Ltd.
Terai Bank Ltd.
Above growth
0.05
40 %
50 %
Growth
0.15
25 %
20 %
Average
0.60
10 %
10 %
Recession
0.15
5%
8%
Below Recession
0.05
-2 %
2%
a.Which stock is desirable in terms of expected return?
b. Calculate standard deviation of the return of each stock.
c. Calculate the coefficients of variation. What additional information do you get by computing coefficients
of variation?
d. What is the covariance between returns of these two stocks?
e. If the variance of the NEPSE return is 169, covariance between the return of the NEPSE and Himal is 120
and covariance between the return of the NEPSE and Terai is 244, which stock has more systematic
risk? (TU: BBA: 2008)
22. Consider the following subjective probability distribution of Stock A and Stock B for a potential investment:
State of economy
Probability
RA
RB
Strong growth
0.10
25 %
15 %
Moderate growth
0.40
15 %
17 %
Weak growth
0.40
10 %
10 %
Recession
0.10
-12 %
5%
a. Compute the expected return of each stock. Which stock is appropriate for investment?
b. Compute the standard deviation and variance of each stocks return. By this measure, which is the
preferable stock?
c. Compute the coefficient of variation of each stock. Which stock is more risky?
d. If you invest 40 percent in Stick A and remaining in Stock B, what return would you expect from this
type of combined investment? (TU: BBA: 2009)
23. Mr. Shrestha is trying to decide which of the following common stocks to purchase. What would you
recommend? Use graph to explain.
Name of Issuer
Expected return, E( r )
Standard deviation ( )
Able Corporation (A)
7.0 %
3.7 %
Baker Incorporation (B)
7.7 %
4.9 %
Charles & Company Ltd. (C)
15.0 %
15.0 %
Diamond Corporation (D)
3.0 %
3.7 %
Energy Design, Inc. (E)
7.7 %
12.0 %
(TU: BBA: 2009)
24. You collected the following data on the Stocks of Nabil Bank Ltd.
Price of the stock on January 1, 2007 = Rs. 3450
Cash dividends in January = Rs. 0
Price of the stock on February 1, 2007 = Rs. 3500
Cash dividends in February = Rs. 80
Price of the stock on March 1, 2007 = Rs. 3450
Cash dividends in March = Rs. 0
Price of the stock on April 1, 2007 = Rs. 3475
a. Calculate the return for the months of January, February, and March.
b. Based on the monthly returns calculated in (a), calculate arithmetic mean rate of return and geometric
mean rate of return.

c. If you purchase 10 stocks of Nabil on 1 st January 2007 and sell them on 1 st April 2007, what is the
holding period return? (TU: BBA: 2007)
25. Consider the following data related to IBM stocks.
Year (t)
End-of-year Price (Pt )
Calendar-year Dividend
2000
$74.60
$2.88
2001
$64.30
$3.44
2002
$67.70
$3.44
2003
$56.70
$3.44
2004
$96.25
$3.44
2005
$122.00
$3.71
a. Calculate the arithmetic mean of the total return for IBM, 2001-2005.
b. Calculate the standard deviation of the return.
c. Calculate the coefficient of variation of the return.
d. Assume that the beta of IBM stocks is 1.1. What does it mean?
e. If the market return is 10 percent and the risk-free rate is 6 percent, what would be the required rate of
return for IBM stock? (TU: BBA: 2010)