Part 2 - TKM0844 - 11E - IM - Ch08

Chapter 8
Risk and Return: Capital Market Theory

To find the expected return from James Fromholtzs investment opportunity, we will use equation 7-3:
n
E (rportfolio ) = (probability i ) * E (return i ),

i =1
where i indexes the various states of nature that are possible. We can picture the states of nature for
Jamess opportunity as:
40%
35%
30%
25%
45%
45%
20%
probability
8-1.
15%
10%
5%
5%
5%
0%
-100%
5%
35%
100%
return
Despite the symmetrical appearance of the graph, the outcomes are not symmetrical: There are
many more outcomes that are positive than negative. Only the 100% return (probability = 5%) is
negative; 95% of the weight of the distribution is positive. We could still have a negative expected
return if the magnitude of the negative return were large enough to overwhelm the other possible
outcomes. However, that wont happen here, since the +100% return, which also has a 5% chance
of occurring, balances our one negative outcome.
A. Applying equation 7-3 to our probability distribution of returns, we have:
E(r) = (0.05) (100%) + (0.45) (35%) + (0.45) (5%) + (0.05) (100%) = 18%.
2011 Pearson Education, Inc. Publishing as Prentice Hall
216
Titman/Keown/Martin
Financial Management, Eleventh Edition
We can see these calculations in the spreadsheet below. Note that the probabilities must sum
to 1(100%).
state of the economy

rapid expansion & recovery
modest growth
continued recession
falls into depression
C = A*B
probability
0.05
0.45
0.45
0.05
1.00
fund return
100%
35%
5%
-100%
E(r) =
prob*return
5.00%
15.75%
2.25%
-5.00%
18.00%
B. The expected return for this investment is positive, as it will be for all investments on an ex ante
basispeople wouldnt invest if they expected to lose money! (This is what distinguishes
investing from gambling.) However, just because the expected return is positive does not mean
that I would necessarily invest. The expected return must be sufficient to compensate me for the
risk that I bear. Knowing that there is a possibility of a negative outcome is not sufficient as a
measure of risk. Therefore, I cant say whether or not Id invest in this opportunityId need
more information. Part of what Id need to know we will find out in Problem 8-2 (but again, that
wont be enough!).
8-2.
To find the standard deviation of the probability distribution given in Problem 8-1, we will use
equation 7-5:
(r E(r ))
i
* probi ,
i =1
where I indexes the various states of nature. For James Fromholtzs opportunity, we have:
(100% 18%)2 * (0.05) + (35% 18%)2 * (0.45) +

(5% 18%)2 * (0.45) + (100% 18%)2 * (0.05)
= 35.19%
We can see the calculations more clearly from the spreadsheet below:
state of the economy

rapid expansion & recovery
modest growth
continued recession
falls into depression
C = A*B
D = (B - 18%)
probability
0.05
0.45
0.45
0.05
fund return
100%
35%
5%
-100%
prob*return
5.00%
15.75%
2.25%
-5.00%
(rtn-E(r))
0.67
0.03
0.02
1.39
1.00
E(r) =
18.00%
E = A*D
2*
(rtn-E(r)) prob
0.0336
0.0130
0.0076
0.0696
variance =
0.1239
standard deviation =
35.19%
(In equation 7-5, the variance is the quantity under the radical sign; the standard deviation is then
the square root of the variance: = 2 .)
Solutions to End of Chapter ProblemsChapter 8
8-3.
217
Mary Guilott is considering creating an equally weighted portfolio of stocks A and B. (Equally
weighted means that each asset has the same weight, equal to 1n , where n is the number of assets.
Since we have two assets here, an equally weighted portfolio puts 50% of the total investment into
each stock.) To find the expected return of this portfolio, we use equation 8-1:
n
E (rportifolio ) (weight i ) E (ri ),

i =1
where i indexes the assets included in the portfolio.

A. Since Mary is considering two assets, whose expected returns are 15% and 10%, we have:
E(rportfolio) = (0.50) (15%) + (0.50) (10%) = 12.5%.
These calculations are detailed in the spreadsheet below:
firm A
firm B
E(r)
15%
10%
B
standard
deviation
12%
6%
C
weight
0.50
0.50
E(rportfolio) =
D = A*C
E(r)*weight
7.50%
5.00%
12.50%
The expected return is exactly between the two assets returns, since the portfolio is equally
weighted. Note that we did not use the correlation coefficient here: The expected return on a
portfolio is not affected by the assets correlation. We will therefore not need to change the
expected return as we explore various correlation values below.
B. To find the portfolios standard deviation, we first find the variance as:
2
portfolio
= (weight A )2 ( A2 ) + (weight B )2 ( B2 )
+2 (weight A ) (weight B ) A B AB ;
then we find the standard deviation as the square root of this variance: portfolio =
2
portfolio
.
(This is what is done in one step in the texts equation 8-3.)

Thus, for Marys portfolio, we have:
2
portfolio
= (0.50)2 (0.12)2 + (0.50)2 (0.06)2 + 2 (0.50) (0.12) (0.06) (0.4)
= 0.0059,
and:
portfolio = .0059 = 0.0771 = 7.71%.
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Titman/Keown/Martin
C.E.
This result will change if we change the correlation coefficient. The lower is , the lower
will be the standard deviation of the portfolio. This is the benefit of diversification. We
can see this in the table and chart below:
portfolio
correlation
coefficient
0.40
0.00
1.00
-1.00
standard
deviation
7.71%
6.71%
9.00%
3.00%
variance
0.0059
0.0045
0.0081
0.0009
10.00%
9.00%
9.00%
8.00%
7.71%
7.00%
portfolio standard deviation
6.71%
6.00%
5.00%
4.00%
3.00%
3.00%
2.00%
1.00%
0.00%
-1.00
-0.80
-0.60
-0.40
-0.20
0.00
0.20
0.40
0.60
0.80
1.00
correlation coefficient
When the correlation coefficient is 1 (that is, when assets A and B are perfectly negatively
correlated), we have reduced the portfolios standard deviation to its lowest possible value for
this weighting scheme: all the way down to 3%. At = 0 (that is, when the assets are independent),
the standard deviationat 6.71%is higher than in the perfect negative correlation case, but
still lower than the original situation. The = + 1 case, perfect positive correlation, is the worstcase scenario. Here, the portfolios standard deviation is simply a weighted average of the
assets standard deviations, so that there is absolutely no benefit from diversification. However,
it is highly unlikely that any two stocks returns will be perfectly positively correlated (lets say
impossible), so in general there will be benefit to diversification.
8-4.
A. To find the expected return and standard deviation of a portfolio with 10% in A and 90% in B
(using the two stocks from Problem 8-3), we proceed as before:
E(rportfolio) = (weight in A) (E(r) of A) + (weight in B) (E(r) of B)
= (0.10) (15%) + (0.90) (10%) = 10.5%.
219
Note that this expected return is lower than the 12.5% we found in Problem 8-3 for the equally
weighted portfolio; this is because we have taken a larger weight here in the lower-yielding
stock, B. More weight in B means lower portfolio expected returns.
For the portfolios variance and standard deviation we have:
2
portfolio
= (weight A )2 ( A2 ) + (weight B )2 ( B2 ) + 2 (weight A ) (weight B ) A B AB ,
= (0.10)2 (0.12)2 + (0.90)2 (0.06)2 + 2 (0.90) (0.10) (0.12) (0.06) (0.40)

= 0.0036
2
portfolio = portfolio
= 0.0036 = 0.0598 = 5.98%.
The correlation coefficient we used here was 0.40, which was the same value we used earlier in
Problem 8-3. The portfolio standard deviation is smaller in this case, however, because we have
put more weight in the lower-risk asset, B, the second term in the variance equation above is
2
2
2
2
now (0.90) (0.06) instead of (0.50) (0.06) . However, note that we have done more than
simply overweight the lower-risk asset; the effect here is not the same as what we found for the
expected return. Here, we have actually reduced the portfolio standard deviation below the
standard deviation for the lower-risk asset! This is the effect of diversificationan effect that is
missing in the expected return calculation. Note that this diversification will be even more
pronounced when we use a correlation coefficient of 0.40; we will then be subtracting the
variances third term from the total instead of adding it.
B.D.
The results for the rest of the scenarios outlined in the problem, plus a few others, are
shown in the table below. In the chart, note the following:
Expected return is not a function of the correlation coefficient, so we do not find values for
both = 0.4 and = 0.4.
The variance and standard deviations are smaller when = 0.4 than when = 0.4, except
when the weight in either asset is 0. (In those cases, the portfolio standard deviation equals
the standard deviation of the included asset.)
12%
6%
E(r) =
15%
10%
expected
rho = 0.40
standard
rho = -0.40
standard
weight in A
weight in B
return
variance
deviation
variance
deviation
ASSET B
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
10.00%
10.50%
11.00%
11.50%
12.00%
12.50%
13.00%
13.50%
14.00%
14.50%
0.003600
0.003578
0.003802
0.004270
0.004982
0.005940
0.007142
0.008590
0.010282
0.012218
6.00%
5.98%
6.17%
6.53%
7.06%
7.71%
8.45%
9.27%
10.14%
11.05%
0.003600
0.002542
0.001958
0.001850
0.002218
0.003060
0.004378
0.006170
0.008438
0.011182
6.00%
5.04%
4.43%
4.30%
4.71%
5.53%
6.62%
7.86%
9.19%
10.57%
ASSET A
1.00
0.00
15.00%
0.014400
12.00%
0.014400
12.00%
Titman/Keown/Martin
These values are graphed below:

15.00%
12.00%
14.00%
11.00%
10.00%
13.00%
9.00%
12.00%
8.00%
7.00%
portfolio expected return
220
standard deviation|rho = .4
standard deviation|rho = -.4
expected return
11.00%
6.00%
10.00%
5.00%
4.00%
0.00
0.10
0.20
0.30
0.40
0.50
0.60
0.70
0.80
0.90
9.00%
1.00
weight in firm A
In the graph, note that:

The values on the far left, where the weight in A is 0, are for asset B. It is the lower-risk and
lower-return asset.
The values at the far right are for asset A. It is the higher-risk and higher-yield asset.
As we move to the right, the weight in A increases. This drags the portfolio expected return
up, and the risk up. However, while the increase in E(r) is linear (because the expected
return of a portfolio is a weighted average of the expected returns of the assets in it), the
relationship for standard deviation is not linear. Unless = +1, the standard deviation of a
portfolio is not a weighted average of the standard deviations of the assets in it. The
diversification potential for assets that arent perfectly positively correlated means that the
portfolio can become less risky as we add more of the riskier asset! We can see this quite
clearly using the green curve where the assets are negatively correlated, i.e., rho = 0.4: As
we increase the weight in A, the portfolio standard deviation decreases until we get slightly
above an equal weight in A.
221
16.00%
15.00%
expected portfolio return
14.00%
13.00%
rho = 0.40
12.00%
rho = -0.40
11.00%
10.00%
9.00%
0.00%
B
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
Heres another way to visualize these relationships. Now were plotting portfolio E(r) against
portfolio standard deviation. Investors prefer portfolios that are higher (increased E(r)) and more
to the left (lower ). The curves are created by combining A and B in different proportions.
Note how much better the portfolios behave when we assume that the assets are negatively
correlatedthe opportunities we can create lie much further to the left. Again, this is the effect
of diversification. Lower correlation means there is more diversification potential, and we see
this as the portfolios we create with = 0.40 lie to the left of those we create with = + 0.40.
8-5.
A. We can find the expected return of Penny Franciss portfolio using equation 8-1:
E(rportfolio) = (weight in T-bills) (E(r) of T-bills) + (weight in F) (E(r) of F)
+ (weight in HOG) (E(r) of HOG).
The only question is what the proper weights are. The portfolio weight for an asset is the
proportion of total portfolio dollars allocated to that asset. Thus Penny has $40,000 in T-bills,
out of a total portfolio value of ($40,000 + $30,000 + $30,000) = $100,000, so her weight in
$40,000
T-bills is ( $100,000
) = 4%. The other two assets weights are each 30%. Thus we have:
E(rportfolio) = (0.40) (4.5%) + (0.30) (8.0%) + (0.30) (12.0%) = 7.8%.
Note that this weighted average is between the highest value were averaging, 12.0%, and the
lowest value were averaging, 4.5%.
222
Titman/Keown/Martin
T-bills
Ford (F)
Harley Davidson (HOG)
C = B/(sum of B)
D = A*C
E(r)
4.5%
8.0%
12.0%
$ value
$40,000
$30,000
$30,000
weight
0.40
0.30
0.30
E(r)*weight
1.80%
2.40%
3.60%
$100,000
1.00
7.80%
= E(r) of portfolio
B. If Penny were to change her portfolio composition to 50% F and 50% HOG ($50,000 in each),
then her expected return would rise to 10% (halfway between the expected returns of F and HOG):
T-bills
Ford (F)
Harley Davidson (HOG)
C = B/(sum of B)
D = A*C
E(r)
4.5%
8.0%
12.0%
$ value
$0
$50,000
$50,000
weight
0.00
0.50
0.50
E(r)*weight
0.00%
4.00%
6.00%
$100,000
1.00
10.00%
= E(r) of portfolio
C. Why wouldnt she want to do this? She might not want to increase her portfolios risk. The
increase in expected return that she would generate by reducing her allocation to T-bills comes
at a cost. F and HOG have higher standard deviations than do T-bills.
How do we know about the relative risk, if were not given this information? Stocks are riskier
than bonds, and T-bills are the lowest-risk debt assets in the world. If stocks were not, on
average, much more volatile than debt, then everyone would want to hold stocks exclusively.
Who wouldnt want an asset with higher expected return and lower risk? Unfortunately for
investors, it doesnt work that way. There is a risk-return trade-off, and Penny will confront it
head-on if she moves her money out of her safe T-bills.
8-6.
A. We can find the expected return of Barry Swifters portfolio using equation 8-1:
E(rportfolio) = (weight in T-bills) (E(r) of T-bills) + (weight in S&P) (E(r) of S&P)
+ (weight in EMF)*(E(r) of EMF).
The only question is what the proper weights are. The portfolio weight for an asset is the
proportion of total portfolio dollars allocated to that asset. Thus Barry has $75,000 in T-bills, out
$75,000
) = 10%. We can find
of a total portfolio value of $750,000, so his weight in T-bills is ( $750,000
the other two assets weights the same way: For the S&P 500 fund, its ( $450,000
) = 60%, and for
$750,000
$225,000
) = 30%. Thus for his portfolio we have:
the emerging markets fund, its ( $750,000
E(rportfolio) = (0.10) (4.5%) + (0.60) (8.0%) + (0.30) (12.0%) = 8.85%.
Note that this weighted average is between the highest value were averaging, 12.0%, and the
lowest value were averaging, 4.5%.
We can see the details of these calculations in the spreadsheet below:
T-bills
S&P 500 Index Fund
Emerging Market Fund
C = B/(sum of B)
D = A*C
E(r)
4.5%
8.0%
12.0%
$ value
$75,000
$450,000
$225,000
weight
0.10
0.60
0.30
E(r)*weight
0.45%
4.80%
3.60%
$750,000
1.00
8.85%
= E(r) of portfolio
223
B. If Barry were to reduce the risk of his portfolio by moving all of his emerging markets money
into T-bills, he would lower his expected return, as shown below:
T-bills
S&P 500 Index Fund
Emerging Market Fund
C = B/(sum of B)
D = A*C
E(r)
4.5%
8.0%
12.0%
$ value
$300,000
$450,000
$0
weight
0.40
0.60
0.00
1.00
E(r)*weight
1.80%
4.80%
0.00%
$750,000
6.60%
= E(r) of portfolio
Now his expected return in only 6.6%, a weighted average of the rate on the S&P 500 fund, 8%,
and that on T-bills, 4.5%. (His portfolio return is not exactly between these two asset returns, of
course, because he has more of his money in the S&P 500 fund. Thus his portfolios expected
return is closer to that of the S&P than to that of his T-bills.)
8-7.
To compare the two portfolios that Kelly B. Stiles is considering, we will compute their expected
returns and standard deviations. We will be using the equations from Chapter 7, since the data we
are given are for the portfolios as individual assets. Thus we will use equation 7-3:
n
E (rportfolio ) = (probability i ) * E (return i ),

i =1
and equation 7-5:
(r E(r ))
i
* probi .
i =1
For example, for portfolio A, we have:

E(r) = (0.20) (2%) + (0.50) (19%) + (0.30) (25%) = 16.6%,
and:
= (2% 16.6%)2 (0.20) + (19% 16.6%)2 (0.50) + (25% 16.6%)2 (0.30)

= 9.66%.
These calculations, and those for portfolio B, are shown in the spreadsheet on the next page.
Titman/Keown/Martin
18.0%
17.0%
9.66%, 16.6%
16.0%
15.0%
expected return
224
14.0%
13.0%
12.0%
11.0%
10.0%
3.16%, 10.2%
9.0%
8.0%
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
standard deviation
Which investment is better? As shown in the graph above, neither is better, since neither
dominates. That is, neither asset is preferred both on expected return (higher) and risk (lower).
Moving from B to A means increasing expected return (good) but also increasing risk (bad). Thus
a reasonable investor could choose either. Which is better for you depends on your risk tolerance.
8-8.
225
We are given beta values from two sources for two types of firms, computer firms and utilities. We
are to use the beta estimates to find the changes in the stock value for a 10% rise and a 10% fall in
the market.
A firms beta magnifies (or mutes) the effect of the markets changes on the stock. That is:
change in stock value = (stock beta) (change in markets value).
We can see this from the CAPM. A firms stocks expected return can be found as:
E(ri) = rrisk-free + i* [E(rmarket) rrisk-free].
Now, if the markets expected return changes, the stocks expected return will, too:
E(ri)new = rrisk-free + i* [E(rmarket)new rrisk-free].
The change in the firms expected return is then:
E(ri)
new
E(ri) = {rrisk-free + i* [E(rmarket)new rrisk-free]} {rrisk-free + i* [E(rmarket) rrisk-free]}

= i* [E(rmarket)
new
E(rmarket)].
Thus we can simply substitute 10% and 10% for the change in market expected return to find the
changes in our stocks expected returns.
(This problem is written using realized stock returns, not expectations. Thats OK. Using the
CAPM as the basis for a model explaining the realized return to a stock leads to the same result:
beta*(% change in market) = % change in stock.)
The results for our stocks are below, for both the Yahoo! Finance betas and the Microsoft Money
Central betas.
company
COMPUTERS
AAPL
DELL
HPQ
UTILITIES
AEP
DUK
CNP
beta from
stock % change if
Yahoo
Finance
2.90
1.81
1.27
0.74
0.40
0.82
market changes by
10%
29.00%
18.10%
12.70%
7.40%
4.00%
8.20%
-10%
-29.00%
-18.10%
-12.70%
-7.40%
-4.00%
-8.20%
beta from
stock % change if
Microsoft
Money Central
2.58
1.37
1.47
0.73
0.56
0.91
market changes by
10%
25.80%
13.70%
14.70%
7.30%
5.60%
9.10%
-10%
-25.80%
-13.70%
-14.70%
-7.30%
-5.60%
-9.10%
Note the following:

The stocks changes are symmetrical: The magnitude of their changes is the same whether the
market rises by 10% or falls by 10%; only the direction of movement is different.
The computer stocks are aggressive: Their betas are greater than 1. Thus their stocks move more
than the market (more than 10% either way). However, the utilities are defensive (betas < 1);
their stocks move in the same direction as the market, but by less than 10% in all cases.
There is no consistent relationship between the relative values for the Microsoft and Yahoo! beta
estimates: Sometimes the Yahoo! values are higher in magnitude (e.g., AAPL); sometimes they
are smaller (e.g., DUK). However, both sources always agree about the defensiveness or
aggressiveness of the stock relative to the market. There is also often agreement within a group
about the most extreme stocks (e.g., both have AAPL as the riskiest of the computer stocks, and
DUK as the least risky of the utilities), but this is not always true.
226
Titman/Keown/Martin
Our results are graphed below. For each stock, we show four bars: two each for the Microsoft beta
estimates (market up and market down) and for the Yahoo! estimates. Note that the variability in
the first three stocksthe computer stocksis much greater than that for the utilities.
30.00%
Yahoo Finance betas
Microsoft Money Central betas
20.00%
% change in stock value
10.00%
0.00%
-10.00%
A
A
P
L
D
E
L
L
H
P
Q
A
E
P
D
U
K
C
N
P
-20.00%
-30.00%
8-9.
We are to use the visual method to estimate B&A Truckings beta, given the relationship depicted
below:
227
The beta estimate will be the slope of the red line in the graphthe line of best fit. Since the slope
of a line can be found with only two points, we will use the two points that actually lie on the line:
(25%, 20%) and the origin. Thus:
(origin)
A
C = (y 1 - y 2)
D = (x 1 - x 2)
E = (C/D)
point 1
point 2
rise
run
slope
x coordinate
0%
-25%
25%
0.80
y coordinate
0%
-20%
20%
The spreadsheet above shows that the slope is 0.80. That is:
slope =
rise [ 0% (20%)]
=
= 0.80.
run [0% (25%)]
(It doesnt matter which points x and y values we put first when finding the rise and run
differences, as long as we are consistent.) The positive value implies that the stocks return moves
in the same direction as the markets, which it does: We can see this from the positive slope of the
red line in the graph. However, since the slopethat is, the betais less than 1, the stock is
defensive, rising and falling by a smaller percentage than the market. Thus B&A Truckings stock
is less risky than the market.
8-10. A. We are given values for both Sugita Corporations and the markets historical returns. These are
shown in the table below in columns B and E, respectively.
A
C = (B - 1.88%)
SUGITA CORPORATION
month
1
2
3
4
5
6
sum =
n=
return
1.8%
-0.5%
2.0%
-2.0%
5.0%
5.0%
11.3%
6
arithmetic average =
1.88%
AVERAGE =
1.88%
variance =
STDEV =
F = (E - 1.25%)
MARKET
2
(rtn-E(r))
0.0000
0.0006
0.0000
0.0015
0.0010
0.0010
0.0040
6
month
1
2
3
4
5
6
sum =
n=
return
1.5%
1.0%
0.0%
-2.0%
4.0%
3.0%
7.5%
6
1.25%
AVERAGE =
1.25%
variance =
0.0008
2.8358%
2.8358%
STDEV =
(rtn-E(r))
0.0000
0.0000
0.0002
0.0011
0.0008
0.0003
0.0023
6
0.0005
2.1389%
2.1389%
To find the averages, we will simply add the returns for each asset, then divide by the number of
returns. For example, for Sugita, we have:
6
average return =
return
i =1
228
Titman/Keown/Martin
where i indexes the 6 monthly returns, and n is the number of returns (so n = 6). Thus:
average return Sugita =
1.8% 0.5% + 2% 2% + 5% + 5%
= 1.88%.
6
This is shown in the table above, as the arithmetic average. Right below that is
AVERAGE = 1.88%, in a gray box. The gray boxes denote Excel functions. Thus, use
= AVERAGE(values) to find the average using Excel.
To find the variance of the return series, we use the following equation:
6
variance =
(return
mean)2
i =1
(n 1)
where using the (n 1) in the denominator is a correction for statistical bias. (We use [n 1]
with sample data, as we have here. We divide by n if we have population data.) Thus for Sugita,
we have:
(1.8% 1.88%)2 + (0.5% 1.88%)2 +
(2% 1.88%)2 + (2% 1.88%)2 +
varianceSugita = 0.0008 =
(5% 1.88%)2 + (5% 1.88%)2

(6 1)
The standard deviation is then the square root of this variance, or 2.84%.
(Note that this is the same result that you get from Excels STDEV function. This is the sample
value. If you want the population value, use STDEVP. For Sugita, this population value is
2.5887%; for the market, it is 1.9526%. However, we will continue to use the sample values.)
If we were to use the CAPM to estimate the expected return for Sugita, we would find:
*
E(rSugita) = rrisk-free + Sugita
[E(rmarket) rrisk-free].
We will estimate the E(rmarket) as the markets average monthly return, 1.25%, times 12, or 15%.
Thus:
E(rSugita) = 4% + (1.18) [15% 4%] = 16.98%.
This is greater than the 15% expected return for the market, since Sugitas beta is aggressive
(greater than 1).
B. The expected monthly return we found for Sugita was 1.88%, or (12) (1.88%) = 22.6% per year.
This is higher than the estimate given from the CAPM. Sugitas beta may now be higher than
1.18. (Betas can change over time. However, aggressive betas tend to get smaller, since betas
tend to move toward 1, the average, over time. Of course, betas can also change if the firm
changes its operations. Perhaps Sugita is operating in a way that exposes it to more market risk
than before.)
229
8-11. A. We are given values for both Zemin Corporations and the markets historical returns. These are
shown in the table below in columns B and E, respectively.
A
C = (B - 2%)
ZEMIN CORPORATION
month
1
2
3
4
5
6
sum =
n=
return
6.0%
3.0%
1.0%
-3.0%
5.0%
0.0%
12.0%
6
2.00%
AVERAGE =
MARKET
2
(rtn-E(r))
0.0016
0.0001
0.0001
0.0025
0.0009
0.0004
0.0056
6
2.00%
variance =
STDEV =
F = (E - 1.17%)
month
1
2
3
4
5
6
sum =
n=
return
4.0%
2.0%
-1.0%
-2.0%
2.0%
2.0%
7.0%
6
1.17%
AVERAGE =
1.17%
variance =
0.0011
3.3466%
3.3466%
STDEV =
(rtn-E(r))
0.0008
0.0001
0.0005
0.0010
0.0001
0.0001
0.0025
6
0.0005
2.2286%
2.2286%
To find the averages, we will simply add the returns for each asset, then divide by the number of
returns. For example, for Zemin, we have:
6
average return =
return
i =1
where i indexes the 6 monthly returns, and n is the number of returns (so n = 6). Thus:
average returnZemin =
6% + 3% + 1% 3% + 5% + 0%
= 2.00%.
6
Thus is shown in the table above, as the arithmetic average. Right below that is
AVERAGE = 2.00%, in a gray box. The gray boxes denote Excel functions. Thus, use
= AVERAGE(values) to find the average using Excel.
To find the variance of the return series, we use the following equation:
6
(return
variance =
mean)2
i =1
(n 1)
where using the (n 1) in the denominator is a correction for statistical bias. (We use [n 1]
with sample data, as we have here. We divide by n if we have population data.) Thus for Zemin,
we have:
(6% 2%)2 + (3% 2%)2 +
(1% 2%)2 + (3% 2%)2 +
varianceZemin = 0.0011 =
(5% 2%)2 + (0% 2%)2

(6 1)
The standard deviation is then the square root of this variance, or 3.3466%.
230
Titman/Keown/Martin
(Note that this is the same result that you get from Excels STDEV function. This is the
sample value. If you want the population value, use STDEVP. For Zemin, this population
value is 3.0551%; for the market, it is 2.0344%. However, we will continue to use the sample
values.)
If we were to use the CAPM to estimate the expected return for Zemin, we would find:
*
[E(rmarket) rrisk-free].
E(rZemin) = rrisk-free + Zemin
We will estimate the E(rmarket) as the markets average monthly return, 1.17%, times 12, or 14%.
Thus:
E(rZemin) = 4% + (1.54) [14% 4%] = 19.40%.
This is greater than the 14% expected return for the market, since Zemins beta is aggressive
(greater than 1).
B. The expected monthly return we found for Zemin was 2%, or (12) (2%) = 24% per year. This
is higher than the estimate given from the CAPM. Zemins beta may now be higher than 1.54.
(Betas can change over time. However, aggressive betas tend to get smaller, since betas tend to
move toward 1, the average, over time. Of course, betas can also change if the firm changes its
operations. Perhaps Zemin is operating in a way that exposes it to more market risk than before.)
8-12. A. In Problem 8-1, we found that James Fromholtz had an investment opportunity with an expected
return of 18%. He wishes to use this result to find the slope of the Security Market Line (SML).
He also knows that rrisk-free = 2.5% and the beta of the investment is 2.
The equation for the SML is:
E(ri)
rrisk-free + i* [E(rmarket) rrisk-free].
(intercept)
m
(slope)
We can see that this equation is the equation for a line, and so is in the form y = m x + b. We
are looking for the slope of the line, which for the SML is [E(rmarket) rrisk-free].
Substituting the values we have for Jamess investment, we see:
18% = 2.5% + 2 [E(rmarket) rrisk-free],
7.75% = [E(rmarket) rrisk-free].
Thus, the slope of the SML is 7.75%. This is the market risk premium, the number of extra
percentage points that an investor receives, in equilibrium, for each unit of risk he accepts.
B. James is also considering a market index investment with an expected return of 10%. If we were
to use the same 7.75% SML slope that we just found, this would imply that the markets beta
was 0.97 instead of 1:
*
10% = 2.5% + mkt
(7.75%) mkt = 0.97.
231
If we use the market beta of 1, we should have an expected return of [2.5% + (1) (7.75%)] =
10.25%, not 10%. Or to look at this another way, at the current 10% expected return, the implied
slope of the market index investment is 7.5%, not 7.75%:
10% = 2.5% + 1 [E(rmarket) rrisk-free],
7.5% = [E(rmarket) rrisk-free].
C. No matter how we look at this, the market index seems to be shaving a bit from Jamess return.
He would do better with the riskier investment at 18%.
8-13. A. Using the CAPM, we can easily find the expected return for Intel. Assuming that Intels beta is
1.2, the risk-free rate is 3.5%, and the markets expected return is 16%, we have:
*
[E(rmarket) rrisk-free]
E(rIntel) = rrisk-free + Intel
= 3.5% + 1.2 [16% 3.5%] = 18.5%.

This is greater than the markets expected return, since Intels beta is more than 1 (its aggressive).
B. This is Intels expected return (its ex ante return), but it may not be its realized (ex post) return.
Intel is a risky investment. Risk means dispersion: We cannot be certain about what Intels
return will actually be. (If we could be sure, then wed know that its return would be 3.5%:
certainty = no risk = no dispersion = beta of zero = risk-free return.) 18.5% is our best guess or
required return based on its risk profile versus the market, but our realization could be (and
probably will be) different.
8-14. A. Using the CAPM, we can easily find the expected return for Acer. Assuming that Acers beta is
1.5, the risk-free rate is 4.5%, and the markets expected return is 10%, we have:
*
E(rAcer) = rrisk-free + Acer
= 4.5% + 1.5 [10% 4.5%] = 12.75%.

This is greater than the markets expected return, since Acers beta is more than 1 (its
aggressive).
B. This is Acers expected return (its ex ante return), but it may not be its realized (ex post) return.
Acer is a risky investment. Risk means dispersion: We cannot be certain about what Acers
return will actually be. (If we could be sure, then wed know that its return would be 4.5%:
certainty = no risk = no dispersion = beta of zero = risk-free return.) Our best guess is 12.75%
or required return based on its risk profile versus the market, but our realization could be
(and probably will be) different.
8-15. Using the CAPM, we can easily find the expected returns for several projects being evaluated by
Johnson Manufacturing. For example, the beta for project A is 1.50, the markets expected return is
10%, and the risk-free rate is 4%. Thus, for project A, we have:
E(rA) = rrisk-free + A* [E(rmarket) rrisk-free]
= 4% + 1.5 [10% 4%] = 13%.
This opportunitys expected return is greater than the markets, since the opportunitys beta is
greater than 1.
232
Titman/Keown/Martin
Repeating this process for the other three investments, we have:
D = A + B*(C - A)
expected return
risk-free rate
4%
4%
4%
4%
security
A
B
C
D
beta
1.50
0.82
0.60
1.15
for market
10%
10%
10%
10%
for security
13.00%
8.92%
7.60%
10.90%
Note that projects A and D have expected returns (and betas) greater than the market, while B and
C have lower betas and lower expected returns.
Plotting these results, we find the Security Market Line:
14%
A
12%
expected return
10%
B
8%
C
6%
4%
rf
2%
0%
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
beta
8-16. Using the CAPM, we can easily find the expected returns for several projects being evaluated by
Bobbi Manufacturing. For example, the beta for project A is 1.40, the markets expected return is
10%, and the risk-free rate is 3.75%. Thus for project A, we have:
E(rA) = rrisk-free + A* [E(rmarket) rrisk-free]
= 3.75% + 1.4 [10% 3.75%] = 12.50%.
This opportunitys expected return is greater than the markets, since the opportunitys beta is
greater than 1.
233
Repeating this process for the other three investments, we have:
D = A + B*(C - A)
expected return
risk-free rate
3.75%
3.75%
3.75%
3.75%
security
A
B
C
D
beta
1.40
0.75
0.80
1.20
for market
10%
10%
10%
10%
for security
12.50%
8.44%
8.75%
11.25%
Note that projects A and D have expected returns (and betas) greater than the market, while B and
C have lower betas and lower expected returns.
Plotting these results, we find the Security Market Line:
14%
A
12%
expected return
10%
8%
6%
4%
rf
2%
0%
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
beta
8-17. Using the CAPM, we can easily find the expected returns for Breckenridge, Inc. The firm has a beta
of 0.85. The markets expected return is 10.5%, and the risk-free rate is 3.5%. Thus Breckenridges
expected return is:
*
E(rBreckenridge) = rrisk-free + Breckenridge
= 3.5% + 0.85 [10.5% 3.5%] = 9.45%.

The firm has an expected return slightly less than that of the market, since its beta is slightly less
than 1.
234
Titman/Keown/Martin
8-18. Using the CAPM, we can easily find the expected returns for CSB, Inc. The firm has a beta of
0.765. The markets expected return is 10.5%, and the risk-free rate is 3.5%. Thus Breckenridges
expected return is:
*
E(rCSB) = rrisk-free + CSB
= 3.5% + 0.765 [10.5% 3.5%] = 8.855%.

The firm has an expected return less than that of the market, since its beta is less than 1.
8-19. We are told that the market risk premium is 5.3%, and that the expected return on the market is
10.3%. Since the market risk premium is defined as follows:
market risk premium = [E(rmarket) rrisk-free],
we can solve for the risk-free rate as:
5.3% = 10.3% rrisk-free
rrisk-free = 5%.
Now, we can easily find the expected returns for our three assets using the CAPM. For example, for
Tasaco, we have:
*
E(rTasaco) = rrisk-free + Tasaco
= 5% + 0.864 (5.3%) = 9.58%.

We can find LBMs and Exxoss using the same process, as shown below:
A = 10.3% - 5.3%
security
market
Tasaco
LBM
Exxos
risk-free rate
5.0%
5.0%
5.0%
5.0%
beta
1.00
0.864
0.693
0.575
D = A + B*(C)
market
expected return
risk premium
for security
5.3%
10.30%
5.3%
9.58%
5.3%
8.67%
5.3%
8.05%
235
We can graph these expected returns to see the SML:

12%
M
10%
Tasaco
LBM
expected return
8%
Exxos
6%
rf
4%
2%
0%
0.000
0.200
0.400
0.600
0.800
1.000
1.200
beta
8-20. A. We own a portfolio with five stocks. The portfolio proportions, betas, and expected returns for
these five stocks are shown in columns E, B, and F, respectively, in the spreadsheet on the next
page. We are to find the portfolios expected return and beta.
To find the portfolios expected return, we can solve the following:
5
E (rportfolio ) (weight i ) [ E (ri )] ,

i =1
where i indexes our five stocks. Thus we have:

E (rportfolio ) = (0.20) (16%) + (0.30) (14%) +
(0.15) (20%) + (0.25) (12%) +
(0.10) (24%)
= 15.8%
which is between the expected returns of the stock with the highest E(r), 24%, and that with the
lowest, 12%.
B. We could also have found this using the CAPM. However, for that method, we first must find
the portfolios beta. As is expected return, a portfolios beta is simply a weighted average of its
constituents betas:
5
portfolio = (weight i )( i )
i =1
= (0.20) (1) + (0.30) (0.85) +

(0.15) (1.2) + (0.25) (0.60) + (0.10) (1.60)
= 0.945.
Titman/Keown/Martin
Now, we can use the equation for the SML:

*
E(rportfolio) = rrisk-free + portfolio
= 3% + 0.945 [10.5% 3%] = 10.0875%.

This is not the same! It should be. It isnt here, though, because the expected returns we used
above are not consistent with the CAPM, as we will see below. Had we used consistent expected
returns for our stocks (which we will find below), we would have found the following:
E(rportfolio) = (0.20) (10.5%) + (0.30) (9.375%) + (0.15) (12%) +
(0.25) (7.5%) + (0.10) (15%)
= 10.0875%,
as required. Lets see what went wrong here.
The chart below lays it all out. The expected returns that we would expect, given the CAPM, are
in column D. The actual expected returns given in the problem are those in column F. As we see
in column G, the given values are all higher than those we would expect from the CAPM. All
five of these stocks are underpriced!
25%
20%
1
expected return
236
15%
2
4
10%
1
M
4
5%
rf
0%
0.000
0.200
0.400
0.600
0.800
1.000
1.200
1.400
1.600
beta
1.800
237
C. We can also see this from the plot of the CAPM. All of the given values plot above the SML.
D. This means that they are all offering higher expected returns than they should be, given their
systematic risks. Thus, they are all underpriced. Thats why our portfolios expected return was
higher than what was justified, given its beta. We have found five underpriced stocks!
E. Of course, this conclusion is based on our having the right betas. If all of our betas understate
their stocks systematic risks, then we would be underestimating our portfolio risk. If our inputs
are flawed, so will be our conclusion (garbage in/garbage out).
8-21. A.B.
Your fathers retirement portfolio has a beta of 1.80. This means that every percentage
change in the markets return is magnified 1.8 times, moving his portfolio 1.8%. We can
see this from the CAPM. A firms stocks expected return can be found as:
Now, if the markets expected return changes, the stocks expected return will, too:
E(ri)new = rrisk-free + i* [E(rmarket)new rrisk-free].
The change in the firms expected return is then:
E(ri) E(ri) = {rrisk-free + i* [E(rmarket)
new
new
rrisk-free]} {rrisk-free + i* [E(rmarket) rrisk-free]}
= i* [E(rmarket)new E(rmarket)].
Thus, we can simply substitute 7% and 7% for the change in market expected return to
find the changes in your fathers portfolios expected return.
Thus, if the market rises by 7%, your fathers portfolio will rise by (1.80) (7%) = 12.6%.
If the market falls by 7%, your fathers portfolio will fall by (1.80) (7%) = 12.6%.
For example, say that the risk-free rate is 3% and that the initial market return is 20%.
Then your fathers initial portfolio return is:
E(ri) = 3% + 1.80 (20% 3%) = 33.6%.
Now, if the markets return rises by 7%, to 27%, we have:
E(ri) = 3% + 1.80 (27% 3%) = 46.2%,
or a change of (46.2% 33.6%) = 12.6%. On the other hand, if the market falls by 7% to
13%, we have:
E(ri) = 3% + 1.80 (13% 3%) = 21.0%,
or a change of (33.6% 21.0%) = 12.6%.
C. Your fathers portfolio is much riskier than the market. We know that because its beta is much
greater than 1. This translates into magnified swings relative to the market. If your father is very
close to retirement, he should seriously consider lowering the risk of his portfoliohe wouldnt
have enough time to recover from a wild negative swing.
238
Titman/Keown/Martin
8-22. A. The beta of a portfolio is a weighted average of the betas of the securities in the portfolio. That
is, for our portfolio:
4
portfolio = (weighti ) ( i )
i =1
= (0.25) (2.5) + (0.25) (1.0) + (0.25) (0.5) + (0.25) ( 1.50)

= 0.625.
We can see these calculations detailed in the spreadsheet below:
security
market
A
B
C
D
beta
1.00
2.50
1.00
0.50
-1.50
C = A*B
percentage
of portfolio
weight*beta
25%
25%
25%
25%
100%
0.625
0.250
0.125
-0.375
0.625
= portfolio beta
B.C. Thus, this portfolio is defensive: Its beta is less than 1, and it will swing less strongly than
the market. For example, if the markets return were to rise by 25% (25 percentage points,
2500 basis points), your portfolios return would change by (0.625) (25%) = 15.625%; if
the market falls by 25%, your portfolio will fall by 15.625%.
D. Since portfolio beta is a weighted average, we could most easily decrease your portfolios beta
by decreasing the weight of the highest-beta stock, A, and increasing the weight in the lowestbeta stock, D. For example, say we decreased As weight to 10% and increased Ds to 40%:
percentage
security
market
A
B
C
D
beta
1.00
2.50
1.00
0.50
-1.50
of portfolio
weight*beta
10%
25%
25%
40%
100%
0.250
0.250
0.125
-0.600
0.025
= portfolio beta
This reduces the portfolio beta to a tiny 0.025.

We can see this effect in the graph below. This graph plots portfolio beta as a function of the
proportion of the portfolio in A. The 25% weights to B and C are kept fixed; the proportion in D
is (50% weight in A). As we increase the weight of the high-beta asset, A, the portfolio beta
rises linearly.
239
1.50
portfolio beta
1.00
0.50
0.00
0%
5%
10%
15%
20%
-0.50
25%
30%
35%
40%
45%
50%
weight in asset A
8-23. A. The beta of a portfolio is a weighted average of the betas of the securities in the portfolio. That
is, for our portfolio:
4
portfolio = (weight i ) * ( i )
i =1
For portfolio 1, we have:
portfolio = (0.10) (2.5) + (0.10) (1.0) + (0.40) (0.5) + (0.40) (1.50) = 0.05.
We repeat these calculations for portfolio 2, as detailed in the spreadsheet below:
C = A*B
PORTFOLIO 1
security
A
B
C
D
beta
2.50
1.00
0.50
-1.50
percentage
of portfolio
10%
10%
40%
40%
100%
weight*beta
0.250
0.100
0.200
-0.600
-0.050
betaportfolio
E = A*D
PORTFOLIO 2
percentage
of portfolio
40%
40%
10%
10%
100%
weight*beta
1.0
0.4
0.05
-0.15
1.3
betaportfolio
240
Titman/Keown/Martin
B. Since portfolio 2s beta is higher than that of portfolio 1, 2 is the riskier portfolio. This is not
surprising, since 2 weights the two higher-beta stocks more heavily. (Portfolio 1s negative beta
also means that its returns will move in the opposite direction of the markets.)
C. If the risk-free rate were 4% and the market risk premium were 5%, we would find the expected
returns for these two portfolios as:
E(r1) = rrisk-free + A* [E(rmarket) rrisk-free]
= rrisk-free + A* [market risk premium]
= 4% 0.05 [5%] = 3.75%.
For portfolio 2 we have a higher expected return, since its beta is higher than that of portfolio 1:
E(r2) = 4% + 1.3 [5%] = 10.5%
8-24. If the risk-free rate is 4% and the expected return on the market is 10%, then the market risk
premium, [E(rmarket) rrisk-free] = 6%.
The SML is a line between the risk-free rate (0 beta, 4% return) and the market expected
return (1, 10%). An asset with a beta of 0.40 is defensive; it will have an expected return
between the risk-free return and the markets expected return. (It will be 4% + 0.40 (6%)
= 6.4% in this case.) An asset whose beta is 1.8 is aggressive; its expected return will
exceed the markets (it is 4% + 1.8 (6%) = 14.8% here). We can see all of these points
on the graph below:
17%
15%
14.80%
13%
11%
expected return
A.B.
9%
market risk
premium =
6%
7%
6.40%
5%
3%
rf
1%
0.00
-1%
0.20
0.40
0.60
0.80
1.00
1.20
1.40
beta
1.60
1.80
2.00
241
C. If the inflation rate falls, leaving the risk-free rate at 2% and the expected return on the market at
8%, the market risk premium remains at 6% (8% 2%), but the SML shifts downparallel to
the old SMLby 200 bp:
17%
15%
13%
12.80%
expected return
11%
9%
7%
market risk
premium =
6%
5%
4.40%
3%
1%
rf
0.00
-1%
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
2.00
beta
D. If investors become more risk averse, leaving the risk-free rate at 4% but increasing the expected
return on the market to 12%, then the slope of the SML will change. The market risk premium
is (12% 4%) = 8%. Note that the high-beta stock now changes by 360 bp instead of only 200
(as in the parallel-shift case); the low-beta stock, on the other hand, now changes by 80 bp,
instead of 200.
19%
18.40%
17%
15%
expected return
13%
11%
market risk
premium =
8%
9%
7%
7.20%
5%
3%
rf
1%
0.00
-1%
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
beta
2.00
242
Titman/Keown/Martin
19%
17%
higher risk aversion

15%
expected return
13%
11%
slope shift
9%
lower inflation premium
initial situation
parallel shift
7%
5%
3%
1%
0.00
-1%
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
2.00
beta
We can summarize our three scenarios using the graph below. The black line shows the initial
situation; the light gray line below it (and parallel to it) is the second scenario, where the inflation
premium lowers all rates by 200 bp; the dark gray line shows the last situation, where the increased
risk aversion causes the slope of the SML to rise.
8-25. A. We own a portfolio with five stocks. The portfolio proportions, betas, and expected returns for
these five stocks are shown in columns E, B, and F, respectively, in the spreadsheet on the next
page. We are to find the portfolio expected return and beta.
To find the portfolio expected return, we can solve the following:
5
E (rportfolio ) = (weight i ) *[ E (ri )],

i =1
where i indexes our five stocks. Thus we have:

E(rportfolio) = (0.10) (12%) + (0.25) (11%) + (0.15) (15%) + (0.30) (9%) + (.20) (14%)
= 11.7%,
which is between the expected returns of the stock with the highest E(r), 15%, and that with the
lowest, 9%.
243
B. We could also have found this using the CAPM. However, for that method we first must find the
portfolios beta. As is the expected return, a portfolios beta is simply a weighted average of its
constituents betas:
5
portfolio = (weight i )( i )
i =1
= (0.10) (1) + (0.25) (0.75) +

(0.15) (1.3) + (0.30) (0.60) + (0.20) (1.20)
= 0.9025.
C. Now, we can use the equation for the SML:

*
E(rportfolio) = rrisk-free + portfolio
= 4% + 0.9025 [10% 4%] = 9.415%.

This is not the same! It should be. It isnt here, though, because the expected returns we used
above are not consistent with the CAPM, as we will see below. Had we used consistent expected
returns for our stocks, we would have found the following:
E(rportfolio) = (0.10) (10%) + (0.25) (8.5%) + (0.15) (11.8%) +
(0.30) (7.6%) + (0.20) (11.2%)
= 9.415%,
as required. Lets see what went happened here.
The chart below lays it all out. The expected returns that we would expect, given the CAPM, are
in column D. The actual expected returns given in the problem are those in column F. As we see
in column G, the given values are all higher than those we would expect from the CAPM. All
five of these stocks are underpriced!
244
Titman/Keown/Martin
17%
15%
5
13%
expected return
11%
1
M
9%
2
4
7%
5%
rf
3%
1%
0.000
-1%
0.200
0.400
0.600
0.800
1.000
1.200
1.400
beta
D. We can also see this from the plot of the CAPM. All of the given values plot above the SML.
This means that they are all offering higher expected returns than they should be, given their
systematic risks. Thus they are all underpriced. Thats why our portfolios expected return was
higher than what was justified, given its beta. We have found five underpriced stocks!
E. Of course, this conclusion is based on our having the right betas. If all of our betas understate
their stocks systematic risks, then we would be underestimating our portfolio risk. If our inputs
are flawed, so will be our conclusion (garbage in/garbage out).
8-26. Anita, Inc. has four investments that it is considering. The beta values for these investments are
given in column A in the table below. Given the T-bill rate of 4.5% (which will be our proxy for the
risk-free rate) and the expected return of the market of 11%, we can use the CAPM to find the
investments expected returns:
For example, for investment H, we have:
E(rH) = 4.5% + 0.75 (11% 4.5%) = 9.375%.
The other assets expected returns are shown in column B below, and then plotted as the SML:
B = 4.5% + A*(11% - 4.5%)
expected
return
security
rf
M
H
T
P
W
beta
0.00
1.00
0.75
1.40
0.95
1.25
for security
4.500%
11.000%
9.375%
13.600%
10.675%
12.625%
= 4.5% + .75*(11% - 4.5%)

= 4.5% + 1.4*(11% - 4.5%)
= 4.5% + .95*(11% - 4.5%)
= 4.5% + 1.25*(11% - 4.5%)
245
17%
15%
T
13%
W
M
expected return
11%
9%
7%
5%
rf
3%
1%
0.00
-1%
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
beta
8-27. A. Grace Corporation has four investments that it is considering. The beta values for these investments
are given in column A in the table below. Given the T-bill rate of 2.5% (which will be our
proxy for the risk-free rate) and the expected return of the market of 9%, we can use the CAPM
to find the investments expected returns:
For example, for investment K, we have:
E(rK) = 2.5% + 1.12 (9% 2.5%) = 9.78%.
The other assets expected returns are shown in column B below, and then plotted as the SML:
B = 2.5% + A*(9% - 2.5%)
expected
return
security
rf
M
K
G
B
U
beta
0.00
1.00
1.12
1.30
0.75
1.02
for security
2.500%
9.000%
9.780%
10.950%
7.375%
9.130%
= 2.5% + 1.12*(9% - 2.5%)

= 2.5% + 1.30*(9% - 2.5%)
= 2.5% + 0.75*(9% - 2.5%)
= 2.5% + 1.02*(9% - 2.5%)
Titman/Keown/Martin
B. If the risk-free rate were to rise to 4.5% while the market risk premium (that is, [E(rmarket) rrisk-free])
were to fall to 5% (from 6.5% above), our expected returns would change as follows:
security
rf
M
K
G
B
U
B = 4.5% + A*(5%)
beta
0.00
1.00
1.12
1.30
0.75
1.02
expected
return
for security
4.500%
9.500%
10.100%
11.000%
8.250%
9.600%
= 4.5% + 1.12*(5%)
= 4.5% + 1.30*(5%)
= 4.5% + 0.75*(5%)
= 4.5% + 1.02*(5%)
C. The two scenarios are graphed below. The flatter, higher gray line is the second scenario, with
the higher risk-free rate and lower market risk premium. The black line represents the first scenario,
with the lower risk-free rate and higher market risk premium. This black line is more likely to
represent a recessionary period, when rates are lower overall, given lower expected inflation and
less economic activity. The gray line is more likely to represent the expansionary periodmore
economic activity mean more demand for funds for investment, pushing rates up; optimism
means that investors risk aversion may lessen, meaning a lower market risk premium.
17%
15%
13%
11%
G
M
expected return
246
9%
K
U
7%
5%
3%
rf
1%
0.00
-1%
0.20
0.40
0.60
0.80
1.00
beta
1.20
1.40

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Chapter 8

Risk and Return: Capital Market Theory

E (rportfolio ) = (probability i ) * E (return i ),

2011 Pearson Education, Inc. Publishing as Prentice Hall

Financial Management, Eleventh Edition

state of the economy

(100% 18%)2 * (0.05) + (35% 18%)2 * (0.45) +

state of the economy

2011 Pearson Education, Inc. Publishing as Prentice Hall

Solutions to End of Chapter ProblemsChapter 8

E (rportifolio ) (weight i ) E (ri ),

where i indexes the assets included in the portfolio.

(This is what is done in one step in the texts equation 8-3.)

portfolio = .0059 = 0.0771 = 7.71%.

2011 Pearson Education, Inc. Publishing as Prentice Hall

Financial Management, Eleventh Edition

portfolio standard deviation

2011 Pearson Education, Inc. Publishing as Prentice Hall

Solutions to End of Chapter ProblemsChapter 8

= (0.10)2 (0.12)2 + (0.90)2 (0.06)2 + 2 (0.90) (0.10) (0.12) (0.06) (0.40)

2011 Pearson Education, Inc. Publishing as Prentice Hall

Financial Management, Eleventh Edition

These values are graphed below:

portfolio expected return

portfolio standard deviation

In the graph, note that:

2011 Pearson Education, Inc. Publishing as Prentice Hall

Solutions to End of Chapter ProblemsChapter 8

expected portfolio return

portfolio standard deviation

2011 Pearson Education, Inc. Publishing as Prentice Hall

Financial Management, Eleventh Edition

2011 Pearson Education, Inc. Publishing as Prentice Hall

Solutions to End of Chapter ProblemsChapter 8

E (rportfolio ) = (probability i ) * E (return i ),

and equation 7-5:

For example, for portfolio A, we have:

= (2% 16.6%)2 (0.20) + (19% 16.6%)2 (0.50) + (25% 16.6%)2 (0.30)

2011 Pearson Education, Inc. Publishing as Prentice Hall

Financial Management, Eleventh Edition

2011 Pearson Education, Inc. Publishing as Prentice Hall

Solutions to End of Chapter ProblemsChapter 8

E(ri) = {rrisk-free + i* [E(rmarket)new rrisk-free]} {rrisk-free + i* [E(rmarket) rrisk-free]}

Note the following:

2011 Pearson Education, Inc. Publishing as Prentice Hall

Financial Management, Eleventh Edition

% change in stock value

2011 Pearson Education, Inc. Publishing as Prentice Hall

Solutions to End of Chapter ProblemsChapter 8

2011 Pearson Education, Inc. Publishing as Prentice Hall

Financial Management, Eleventh Edition

(5% 1.88%)2 + (5% 1.88%)2

2011 Pearson Education, Inc. Publishing as Prentice Hall

Solutions to End of Chapter ProblemsChapter 8

(5% 2%)2 + (0% 2%)2

2011 Pearson Education, Inc. Publishing as Prentice Hall

Financial Management, Eleventh Edition

rrisk-free + i* [E(rmarket) rrisk-free].

2011 Pearson Education, Inc. Publishing as Prentice Hall

Solutions to End of Chapter ProblemsChapter 8

= 3.5% + 1.2 [16% 3.5%] = 18.5%.

= 4.5% + 1.5 [10% 4.5%] = 12.75%.

2011 Pearson Education, Inc. Publishing as Prentice Hall