Week 2: Risk and Returns

Chapter 7:
Questions and problems: 7.6, 7.7, 7.12, 7.17, 7.19, 7.20, 7.25, 7.27, 7.32, 7.33
7.6

Describe how investing in more than one asset can reduce risk through
diversification.

7.7

Define systematic risk.

7.12

The Security market line: If the expected return on the market is 10 percent
and the risk-free rate is 4 per cent, what is the expected return for a share with
a beta equal to 1.5? What is the market risk premium for the set of
circumstances described?

7.17

Calculating the variance and standard deviation: Ben would like to invest
in gold and is aware that the returns on such an investment can be quite
volatile. Use the following table of states, probabilities, and returns to
determine the expected return and the standard deviation of the return on
Bens gold investment.
Probability
0.1
0.2
0.3
0.2
0.2

Boom
Good
OK
Level
Slump

Return
40.00%
30.00%
15.00%
2.00%
-12.00%

7.19

Portfolios with more than one asset: Jackie is analysing a two-share portfolio
that consists of a Utility share and a Commodity share. She knows that the
return on the Utility has a standard deviation of 40 per cent, and the return on
the Commodity has a standard deviation of 30 per cent. However, she does not
know the exact covariance in the returns of the two shares. Jackie would like
to plot the variance of the portfolio for each of three casescovariance of
0.12, 0, and 0.12in order to understand how the variance of such a
portfolio would react. Do the calculation for each of the extreme cases (0.12
and 0.12), assuming an equal proportion of each share in Jackies portfolio.

7.20

Portfolios with more than one asset: Given the returns and probabilities for the
three possible states listed here, calculate the covariance between the returns of
Share A and Share B. For convenience, assume that the expected returns of Share A
and Share B are 11.75 per cent and 18 per cent, respectively.

Good
OK
Poor

Probability
0.35
0.50
0.15

Return(A)
0.30
0.10
-0.25

Return(B)
0.50
0.10
-0.30

7.25

David is going to purchase two shares to form the initial holdings in his portfolio.
Iron share has an expected return of 15 per cent, while Copper share has an expected
return of 20 per cent. If David plans to invest 30 per cent of his funds in Iron and the
remainder in Copper, then what will be the expected return from his portfolio? What
if David invests 70 per cent of his funds in Iron share?

7.27

In order to fund her retirement, Megan requires a portfolio with an expected return of
12 per cent per year over the next 30 years. She has decided to invest in Shares 1, 2,
and 3, with 25 per cent in Share 1, 50 per cent in Share 2, and 25 per cent in Share 3.
If Shares 1 and 2 have expected returns of 9 per cent and 10 per cent per year,
respectively, then what is the minimum expected annual return for Share 3 that will
enable Megan to achieve her investment requirement?

7.32

The expected return on the market portfolio is 15 per cent, and the return on the riskfree security is 5 per cent. What is the expected return on a portfolio with a beta
equal to 0.5?

7.33

Draw the Security Market Line (SML) for the case where the market risk premium is
5 per cent and the risk-free rate is 7 per cent. Now, suppose an asset has a beta of
-1.0 and an expected return of 4 per cent. Plot it on your graph. Is the security
properly priced? If not, explain what we might expect to happen to the price of this
security in the market. Next, suppose another asset has a beta of 3.0 and an expected
return of 20 per cent. Plot it on the graph. Is this security properly priced? If not,
explain what we might expect to happen to the price of this security in the market.