Solutions to Chapter 11

Introduction to Risk, Return, and the Opportunity Cost of Capital

1.
a. For the period 1900–2015, average rate of return = 11.4% (see Table 11-1).

b. For the period 1900–2015, average risk premium = 7.6% (see Table 11-1).

c. For the period 1900–2015, standard deviation of returns = 19.9% (see Table 11-4).
Est time: 01–05
Historical performance

2. Investors would not have invested in bonds during the period 1977–1981 if they had
expected to earn negative average returns. Unanticipated events must have led to these
results. For example, inflation and nominal interest rates during this period rose to
levels not seen for decades. These increases, which resulted in large capital losses on
long-term bonds, were almost certainly unanticipated by investors who bought those
bonds in prior years.

The results for this period demonstrate the perils of attempting to measure “normal”
maturity (or risk) premiums from historical data. While experience over long periods may
be a reasonable guide to normal premiums, the realized premium over short periods may
contain little information about expectations of future premiums.
Est time: 06–10
Risk premium

3. If investors become less willing to bear investment risk, they will require a higher risk
premium to compensate them for holding risky assets. Security prices of risky
investments will fall until the expected rates of return on those securities rise to the
now-higher required rates of return.
Est time: 01–05
Risk premium

4. Given that a −20% return is well below the historical average market return, a −20%
return will increase the standard deviation of market returns. A higher risk (standard
deviation) will naturally lead to a higher market risk premium.
Est time: 01–05
Risk premium

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 5. Based on the historical risk premium of the S&P 500 (7.6%) and a risk-free rate of
2.0%, one would predict an expected rate of return of 9.6%. If the stock has the same
systematic risk, it also should provide this expected return. Therefore, the stock price
equals the present value of cash flows for a 1-year horizon.
$2  $50
P0   $47.45
1.096
Est time: 01–05
Risk premium

6. a.

Stock Deviation
Market T-Bill Risk From Squared
Return Return Premium Mean Deviations
2011 0.0098 0.0003 0.0095 -0.1166 0.0136
2012 0.1606 0.0005 0.1601 0.0340 0.0012
2013 0.3306 0.0007 0.3299 0.2038 0.0415
2014 0.1271 0.0005 0.1266 0.0005 0.0000
2015 0.0067 0.0021 0.0046 -0.1215 0.0148
Average Risk Premium 0.1261
Variance 0.0142
Standard Deviation 0.1192

b. The average risk premium was 12.61%.

c. The variance (the average squared deviation from the mean) was 1.42%.
Therefore, standard deviation = .0142  11.92%
Est time: 11–15
Standard deviation and variance

7.
a.
capital gain  dividend ($44  $40)  $2
Rate of return    0.15  15.0%
initial share price $40

b. Dividend yield = dividend/initial share price = $2/$40 = 0.05 = 5%

Capital gains yield = capital gain/initial share price = $4/$40 = 0.10 = 10%

c. Dividend yield = $2/$40 = 0.05 = 5%

Capital gain = $36 – $40 = $4
Capital gains yield = –$4/$40 = –0.10 = –10%

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Est time: 01–05
Dollar and percentage returns

capital gain  dividend ($38  $40)  $2

8. a. (i) Rate of return    0%
initial share price $40
1  nominal rate of return 1 0
Real rate of return  1   1  0.0385  3.85%
1  inflation rate 1  0.04

($40  $40)  $2
(ii) Rate of return   0.05  5%
$40
1  nominal rate of return 1.05
Real rate of return  1   1  0.0096  0.96%
1  inflation rate 1.04

($42  $40)  $2
(iii) Rate of return   0.10  10%
$40
1  nominal rate of return 1.10
b. Real rate of return  1   1  0.0577  5.77%
1  inflation rate 1.04
Est time: 01–05
Nominal and real returns

1  nominal rate of return

9. Real rate of return  1
1  inflation rate
1.95
Costaguana: Real return   1  0.0833  8.33%
1.80
1.12
Ruritania: Real return   1  0.0980  9.80%
1.02
Ruritania provides the higher real rate of return despite the lower nominal rate of return.
Notice that the approximate relationship between real and nominal rates of return is valid
only for low rates:
Real rate of return  nominal rate of return – inflation rate
This approximation incorrectly suggests that the Costaguanan real rate was higher than the
Ruritanian real rate.
Est time: 01–05
Nominal and real returns

10. We use the following relationship:

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 1  nominal rate of return
Real rate of return  1
1  inflation rate
Nominal Rate of Real Rate of
Asset Class Inflation Rate
Return Return
Treasury bills 3.80% 3.00% 0.78%
Treasury bonds 5.30% 3.00% 2.23%
Common stocks 11.40% 3.00% 8.16%
Est time: 01–05
Nominal and real returns

11.

Average Price of Index Total Market Value Index

Year
Stocks in Market (using DJIA method) of Stocks (using S&P method)

2010 74.81 100 20,166.20 100

2011 98.71 131.95 25,121.48 124.57
2012 105.36 140.84 26,111.82 129.48
2013 84.202 112.55 21,276.14 105.50
2014 102.372 136.84 24,359.74 120.79
Est time: 06–10
Stock market prices and reporting

12. In 2016, the Dow was nearly 114% above the 2009 level. Therefore, in 2016, a 40-
point movement was far less significant in percentage terms than it was in 2009. We
would expect to see more 40-point days in 2016 even if market risk as measured by
percentage returns is no higher than it was in 2009.
Est time: 01–05
Stock market prices and reporting

13.
a. Interest rates tend to fall at the outset of a recession and rise during boom periods.
Because bond prices move inversely with interest rates, bonds provide higher returns
during recessions when interest rates fall.

b. rstock = [0.2  (.05)] + (0.6  .15) + (0.2  .25) = .13 or 13.0%

rbonds = (0.2  .14) + (0.6  .08) + (0.2  .04) = .084 or 8.4%
Variance (stocks) = [0.2  (.05  .13)2] + [0.6  (.15  .13)2] + [0.2  (.25 – .13)2]
= .0096

Standard deviation = .0096  .098 or 9.80%

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 Variance (bonds) = [0.2  (.14  .084)2] + [0.6  (.08  .084)2] + [0.2  (.04 
.084)2] = .001024

Standard deviation = .001024  3.20%

c. Stocks have both higher expected return and higher volatility. More risk-averse
investors will choose bonds, while those who are less risk-averse might choose
stocks.
Est time: 06–10
Standard deviation and variance

$8  ($240  $80)
14. a. Boom:  210%
$80
$4  ($90  $80)
Normal:  17.5%
$80
$0  ($0  $80)
Recession:  100%
$80
210  17.5  (100)
r  42.5%
3
1 1 1
Variance =  (2.10  .425) 2   (.175  .425) 2   (1.00  .425) 2  1.6327
3 3 3

Standard deviation = 1.6327 = 127.78%

b. The bankruptcy lawyer does well when the rest of the economy is floundering, but does
poorly when the rest of the economy is flourishing and the number of bankruptcies is
down. Therefore, the Leaning Tower of Pita is a risk-reducing investment. When the
economy does well and the lawyer’s bankruptcy business suffers, the stock return is
excellent, thereby stabilizing total income.
Est time: 01–05
Standard deviation and variance

15. Escapist Films:

$0  ($18  $25)
Boom:  28%
$25
$1  ($26  $25)
Normal:  8%
$25

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 $3  ($34  $25)
Recession:  48%
$25
( 28)  8  48
r  9.33%
3
1 1 1
Variance =  (.28  .0933) 2   (.08  .0933) 2   (.48  .0933) 2  .096356
3 3 3

Standard deviation = .096356 = 31.04%

Portfolio rate of return:

Boom: (28 + 210)/2 = 91%
Normal: (8 + 18)/2 = 13%
Recession: (48 –100)/2 = –26%
Expected return = 26%
1 1 1
Variance =  (.91  .26) 2   (.13  .26) 2   (.26  .26) 2  .236585
3 3 3
Standard deviation = .236585 = 48.64%

Est time: 11–15

Standard deviation and variance

16. The return and risk profile results for Mesozoic Funds and the Market are calculated in
the tables below.

Mesozoic Deviation Squared Market Deviation Squared

Fund From Deviation Portfolio From Deviation
Return Mean From Mean Return Mean From Mean
2011 -1.20 -16.34 267.00 2011 -1.70 -13.60 184.96
2012 24.80 9.66 93.32 2012 16.10 4.20 17.64
2013 40.70 25.56 653.31 2013 33.10 21.20 449.44
2014 11.10 -4.04 16.32 2014 12.70 0.80 0.64
2015 0.30 -14.84 220.23 2015 -0.70 -12.60 158.76
Ave Return 15.14 1,250.17 Ave Return 11.90 811.44
Variance 250.03 Variance 162.29
Stnd. Dev. 15.81 Stnd. Dev. 12.74
Comparing the risk-return profile of Diana Sauros with the market portfolio reveals that her
fund performed slightly better than the market:

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 𝑅𝑒𝑡𝑢𝑟𝑛 15.14
𝑀𝑒𝑠𝑜𝑧𝑜𝑖𝑧 → = = 0.9576
𝜎 15.81
𝑅𝑒𝑡𝑢𝑟𝑛 11.90
𝑀𝑎𝑟𝑘𝑒𝑡 → = = 0.9341
𝜎 12.74

17. a. Recession: (.05  0.6) + (.14  0.4) = .026 or 2.6%

Normal economy: (.15  0.6) + (.08  0.4) = .122 or 12.2%
Boom: (.25  0.6) + (.04  0.4) = .166 or 16.6%

b. Expected return = (0.2  .026) + (0.6  .122) + (0.2  .166) = .1116 or 11.16%
Variance = [0.2  (.026 – .1116)2] + [0.6  (.122 – .1116)2] + [0.2  (.166 – .1116)2]
= .002125

Standard deviation = .002125 = 4.61%

c. The investment opportunities have these characteristics:

Mean Return Standard Deviation
Stocks 13.00% 9.80%
Bonds 8.40% 3.20%
Portfolio 11.16% 4.61%
The best choice depends on the degree of your aversion to risk. Nevertheless, we
suspect most people would choose the portfolio over stocks since the portfolio has
almost the same return with much lower volatility. This is the advantage of
diversification.
Est time: 06–10
Standard deviation and variance

18. a. The calculation of risk is in the following tables. Digital Cheese carries more risk
with a standard deviation of 6.9 versus 4.8 for Executive Fruit:

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 Digital Deviation Squared Executive Deviation Squared
Cheese From Deviation Fruit From Deviation
Return Mean From Mean Return Mean From Mean
January 15.00 13.38 178.89 January 7.00 3.63 13.14
February -3.00 -4.63 21.39 February 1.00 -2.38 5.64
March 5.00 3.38 11.39 March 4.00 0.63 0.39
April 7.00 5.38 28.89 April 13.00 9.63 92.64
May -4.00 -5.63 31.64 May 2.00 -1.38 1.89
June 3.00 1.38 1.89 June 5.00 1.63 2.64
July -2.00 -3.63 13.14 July -3.00 -6.38 40.64
August -8.00 -9.63 92.64 August -2.00 -5.38 28.89
Ave Return 1.63 379.88 Ave Return 3.38 185.88
Variance 47.48 Variance 23.23
Stnd. Dev. 6.89 Stnd. Dev. 4.82

b. The portfolio returns and variance are calculated as follows:

Digital Executive 50/50 Deviation Squared

Cheese Fruit Portfilio From Deviation
Return Return Return Mean From Mean
January 15.00 7.00 11.00 8.50 72.25
February -3.00 1.00 -1.00 -3.50 12.25
March 5.00 4.00 4.50 2.00 4.00
April 7.00 13.00 10.00 7.50 56.25
May -4.00 2.00 -1.00 -3.50 12.25
June 3.00 5.00 4.00 1.50 2.25
July -2.00 -3.00 -2.50 -5.00 25.00
August -8.00 -2.00 -5.00 -7.50 56.25
Ave Return 2.50 240.50
Variance 30.06
Stnd. Dev. 5.48

c. The portfolio standard deviation is 5.5, which is less than the average of 5.9.

19. Risk reduction is most pronounced when the stock returns vary against each other.
When one firm does poorly, the other will tend to do well, thereby stabilizing the return
of the overall portfolio.
Est time: 01–05
Diversification concepts and measures

20. a. General Steel should be exposed to higher market risks than General Food Supplies,
since the industrial market is more cyclical than staple markets.

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 b. General Cinemas should be exposed to higher market risks than Club Med, since the
movies are consumed with disposable income, while healthcare is a defensive sector.

21. The expected rate of return on the stock is 4%. The standard deviation is 22%.
(−18 + 26)
𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = = 4%
2
(−18 − 4)2 + (26 − 4)2
𝑠𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝑑𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛 = √ = 22%
2

22. Sassafras is not a risky investment for a diversified investor. Its return is better when
the economy enters a recession. Therefore, the company risk offsets the risk of the rest
of the portfolio. Sassafras is a portfolio stabilizer despite the fact that there is a 90%
chance of loss.
Compare Sassafras to purchasing an insurance policy. Most of the time, you lose money
on your insurance policy. But the policy pays off big if you suffer losses elsewhere—for
example, if your house burns down. For this reason, we view insurance as a risk-reducing
hedge, not as speculation. Similarly, Sassafras may be viewed as analogous to an
insurance policy on the rest of your portfolio since it tends to yield higher returns when
the rest of the economy fares poorly.
In contrast, the Leaning Tower of Pita has returns that are positively correlated with the
rest of the economy. It does best in a boom and goes out of business in a recession. For
this reason, Leaning Tower would be a risky investment for a diversified investor since it
increases exposure to the macroeconomic or market risk to which the investor is already
exposed.
Est time: 06–10
Systematic and unsystematic risk

23. a. Using Excel’s AVERAGE and STDEV functions gives monthly data of:

XOM CVX WMT

Average 0.40% 0.30% 0.94%
Standard
deviation 4.98% 10.10% 4.81%

b. Using Excel’s CORREL function gives:

XOM CVX WMT

XOM 1
BP 0.617642 1
WMT 0.288041 0.370487 1

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 Not surprisingly, two firms from the same industry, ExxonMobil and Chevron,
have the highest correlation, at 0.62.

b. Using Excel, the standard deviation for an equally weighted portfolio of Walmart
and ExxonMobil is 3.93. Using the values from part (a), the average standard
deviation for the two stocks is 4.89% = (4.98% + 4.81%)/2.

c. Using Excel, the standard deviation for an equally weighted portfolio of Chevron
and ExxonMobil is 6.87%. Using the values from part (a), the average standard
deviation for the two stocks is 7.54% = (4.98% + 10.10%)/2. Pairing Walmart with
ExxonMobil provides greater benefits from diversification because the correlation in
their returns is the lowest (0.22804).
Est time: 11–15
Diversification concepts and measures

24. a. True. Diversified portfolios are less risky as compared to securities with equal
returns.

b. True.

c. False.

d. False. Diversification still works with non-perfect correlations.

e. False. Diversified portfolios depend on the market risk of the individual stocks.

f. True.

g. True.

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