Risk and Rate of Return

Chapter 5 Risk and Rates of Return (Arshad) 5-1

ˆ = (0.1)(-50%) + (0.2)(-5%) + (0.4)(16%) + (0.2)(25%) + (0.1)(60%) k = 11.40%.

2 = (-50% - 11.40%)2(0.1) + (-5% - 11.40%)2(0.2) 11.40%)2(0.4) + (25% - 11.40%)2(0.2) + (60% - 11.40%)2(0.1)

+

2 = 712.44;  = 26.69%. CV =

5-2

26.69% = 2.34. 11.40%

Investment $35,000 40,000 Total $75,000

Beta 0.8 1.4

bp = ($35,000/$75,000)(0.8) + ($40,000/$75,000)(1.4) = 1.12.

5-3

kRF = 5%; RPM = 6%; kM = ? kM = 5% + (6%)1 = 11%. k when b = 1.2 = ? k = 5% + 6%(1.2) = 12.2%.

5-4

kRF = 6%; kM = 13%; b = 0.7; k = ? k = kRF + (kM - kRF)b = 6% + (13% - 6%)0.7 = 10.9%.

5-5

a. k = 11%; kRF = 7%; RPM = 4%. k 11% 4% b

= = = =

kRF + (kM – kRF)b 7% + 4%b 4%b 1.

(16%

-

b. kRF = 7%; RPM = 6%; b = 1. k = kRF + (kM – kRF)b k = 7% + (6%)1 k = 13%.

5-6

ˆ  a. k

n

 Pk i

i

.

i1

ˆY = 0.1(-35%) + 0.2(0%) + 0.4(20%) + 0.2(25%) + 0.1(45%) k = 14% versus 12% for X. b.  =

n

(k

i

ˆ)2 P . k i

i 1

σ 2X = (-10% - 12%)2(0.1) + (2% - 12%)2(0.2) + (12% - 12%)2(0.4) + (20% - 12%)2(0.2) + (38% - 12%)2(0.1) = 148.8%. X = 12.20% versus 20.35% for Y.

ˆ X = 12.20%/12% = 1.02, while CVX = X/ k CVY = 20.35%/14% = 1.45. If Stock Y is less highly correlated with the market than X, then it might have a lower beta than Stock X, and hence be less risky in a portfolio sense. 5-7

a. ki = kRF + (kM - kRF)bi = 9% + (14% - 9%)1.3 = 15.5%. b. 1. kRF increases to 10%: kM increases by 1 percentage point, from 14% to 15%. ki = kRF + (kM - kRF)bi = 10% + (15% - 10%)1.3 = 16.5%. 2. kRF decreases to 8%: kM decreases by 1%, from 14% to 13%. ki = kRF + (kM - kRF)bi = 8% + (13% - 8%)1.3 = 14.5%. c. 1. kM increases to 16%: ki = kRF + (kM - kRF)bi = 9% + (16% - 9%)1.3 = 18.1%.

2. kM decreases to 13%: ki = kRF + (kM - kRF)bi = 9% + (13% - 9%)1.3 = 14.2%.

5-8

$142,500 $7,500 (b) + (1.00) $150,000 $150,000 1.12 = 0.95b + 0.05 1.07 = 0.95b 1.1263 = b.

Old portfolio beta =

New portfolio beta = 0.95(1.1263) + 0.05(1.75) = 1.1575  1.16. Alternative Solutions: 1. Old portfolio beta = 1.12 = (0.05)b1 + (0.05)b2 + ... + (0.05)b20 1.12 = ( bi)(0.05)

b

i

= 1.12/0.05 = 22.4.

New portfolio beta = (22.4 - 1.0 + 1.75)(0.05) = 1.1575  1.16. 2.

b

i

excluding the stock with the beta equal to 1.0 is 22.4 -

1.0 = 21.4, so the beta of the portfolio excluding this stock is b = 21.4/19 = 1.1263. The beta of the new portfolio is: 1.1263(0.95) + 1.75(0.05) = 1.1575  1.16.

5-9

$400,000 $600,000 (1.50) + (-0.50) $4,000,000 $4,000,000 $1,000,000 $2,000,000 + (1.25) + (0.75) $4,000,000 $4,000,000 bp = (0.1)(1.5) + (0.15)(-0.50) + (0.25)(1.25)

Portfolio beta =

+

(0.5)(0.75) = 0.15 - 0.075 + 0.3125 + 0.375 = 0.7625. kp = kRF + (kM - kRF)(bp) = 6% + (14% - 6%)(0.7625) = 12.1%. Alternative solution: First, calculate the return for each stock using the CAPM equation [kRF + (kM - kRF)b], and then calculate the weighted average of these returns. kRF = 6% and (kM - kRF) = 8%.

Stock A B C D Total

Investment $ 400,000 600,000 1,000,000 2,000,000 $4,000,000

Beta 1.50 (0.50) 1.25 0.75

k = kRF + (kM - kRF)b 18% 2 16 12

Weight 0.10 0.15 0.25 0.50 1.00

kp = 18%(0.10) + 2%(0.15) + 16%(0.25) + 12%(0.50) = 12.1%.

5-10

We know that bR = 1.50, bS = 0.75, kM = 13%, kRF = 7%. ki = kRF + (kM - kRF)bi = 7% + (13% - 7%)bi. kR = 7% + 6%(1.50) = 16.0% kS = 7% + 6%(0.75) = 11.5 4.5%

5-11

ˆ = 10%; bX = 0.9; X = 35%. k X ˆ = 12.5%; bY = 1.2; Y = 25%. k Y kRF = 6%; RPM = 5%. a. CVX = 35%/10% = 3.5.

CVY = 25%/12.5% = 2.0.

b. For diversified investors the relevant risk is measured by beta. Therefore, the stock with the higher beta is more risky. Stock Y has the higher beta so it is more risky than Stock X. c. kX = 6% + 5%(0.9) kX = 10.5%. kY = 6% + 5%(1.2) kY = 12%.

ˆX = 10%. d. kX = 10.5%; k ˆ kY = 12%; k Y = 12.5%. Stock Y would be most attractive to a diversified investor since its expected return of 12.5% is greater than its required return of 12%. e. bp = ($7,500/$10,000)0.9 + ($2,500/$10,000)1.2 = 0.6750 + 0.30 = 0.9750. kp = 6% + 5%(0.975) kp = 10.875%. f. If RPM increases from 5% to 6%, the stock with the highest beta will have the largest increase in its required return. Therefore, Stock Y will have the greatest increase. Check: kX = 6% + 6%(0.9) = 11.4%. Increase 10.5% to 11.4%. kY = 6% + 6%(1.2)

= 13.2%.

5-12

Increase 12% to 13.2%.

kRF = k* + IP = 2.5% + 3.5% = 6%. ks = 6% + (6.5%)1.7 = 17.05%.

5-13

Using Stock X (or any stock): 9% = kRF + (kM – kRF)bX 9% = 5.5% + (kM – kRF)0.8 (kM – kRF) = 4.375%.

5-14

In equilibrium: ˆ = 12.5%. kJ = k J kJ = kRF + (kM - kRF)b 12.5% = 4.5% + (10.5% - 4.5%)b b = 1.33.

5-15

bHRI = 1.8;

bLRI = 0.6.

No changes occur.

kRF = 6%.

Decreases by 1.5% to 4.5%.

kM = 13%.

Falls to 10.5%.

Now SML:

ki = kRF + (kM - kRF)bi.

kHRI = 4.5% + (10.5% - 4.5%)1.8 = 4.5% + 6%(1.8) = 15.3% kLRI = 4.5% + (10.5% - 4.5%)0.6 = 4.5% + 6%(0.6) = 8.1% Difference 7.2%

5-16

An index fund will have a beta of 1.0. If kM is 12.5 percent (given in the problem) and the risk-free rate is 5 percent, you can calculate the market risk premium (RPM) calculated as kM - kRF as follows: k = kRF + (RPM)b 12.5% = 5% + (RPM)1.0 7.5% = RPM. Now, you can use the RPM, the kRF, and the two stocks’ betas to calculate their required returns.

Bradford: kB = kRF + (RPM)b = 5% + (7.5%)1.45 = 5% + 10.875% = 15.875%. Farley: kF = kRF + (RPM)b = 5% + (7.5%)0.85 = 5% + 6.375% = 11.375%. The difference in their required returns is: 15.875% - 11.375% = 4.5%.

5-17

5-18

Step 1:

Determine the market risk premium from the CAPM: 0.12 = 0.0525 + (kM - kRF)1.25 (kM - kRF) = 0.054.

Step 2:

Calculate the beta of the new portfolio: The beta of the new portfolio is ($500,000/$5,500,000)(0.75) + ($5,000,000/$5,500,000)(1.25) = 1.2045.

Step 3:

Calculate the required return on the new portfolio: The required return on the new portfolio is: 5.25% + (5.4%)(1.2045) = 11.75%.

After additional investments are made, for the entire fund to have an expected return of 13%, the portfolio must have a beta of 1.5455 as shown below: 13% = 4.5% + (5.5%)b b = 1.5455. Since the fund’s beta is a weighted average of the betas of all the individual investments, we can calculate the required beta on the additional investment as follows:

($20,000,000)(1.5) $5,000,000X + $25,000,000 $25,000,000 1.5455 = 1.2 + 0.2X 0.3455 = 0.2X X = 1.7275. 1.5455 =

5-19

a. ($1 million)(0.5) + ($0)(0.5) = $0.5 million. b. You would probably take the sure $0.5 million. c. Risk averter. d. 1. ($1.15 million)(0.5) + ($0)(0.5) = $575,000, or an expected profit of $75,000. 2. $75,000/$500,000 = 15%.

3. This depends on the individual’s degree of risk aversion. 4. Again, this depends on the individual. 5. The situation would be unchanged if the stocks’ returns were perfectly positively correlated. Otherwise, the stock portfolio would have the same expected return as the single stock (15 percent) but a lower standard deviation. If the correlation coefficient between each pair of stocks was a negative one, the portfolio would be virtually riskless. Since r for stocks is generally in the range of +0.6 to +0.7, investing in a portfolio of stocks would definitely be an improvement over investing in the single stock.

5-20

ˆ M = 0.1(7%) + 0.2(9%) + 0.4(11%) + 0.2(13%) + 0.1(15%) = 11%. a. k kRF = 6%.

(given)

Therefore, the SML equation is ki = kRF + (kM - kRF)bi = 6% + (11% - 6%)bi = 6% + (5%)bi. b. First, determine the fund’s beta, bF. percentage of funds invested in each stock. A B C D E

The

weights

are

the

= $160/$500 = 0.32 = $120/$500 = 0.24 = $80/$500 = 0.16 = $80/$500 = 0.16 = $60/$500 = 0.12

bF = 0.32(0.5) + 0.24(2.0) + 0.16(4.0) + 0.16(1.0) + 0.12(3.0) = 0.16 + 0.48 + 0.64 + 0.16 + 0.36 = 1.8. Next, use bF = 1.8 in the SML determined in Part a:

ˆF = 6% + (11% - 6%)1.8 = 6% + 9% = 15%. k c. kN = Required rate of return on new stock = 6% + (5%)2.0 = 16%. An expected return of 15 percent on the new stock is below the 16 percent required rate of return on an investment with a risk of b ˆ N = 15%, the new stock should not be = 2.0. Since kN = 16% > k purchased. The expected rate of return that would make the fund indifferent to purchasing the stock is 16 percent.

5-21

The answers to a, b, c, and d are given below:

1998 1999 2000 2001 2002 Mean Std. Dev. Coef. Var.

kA (18.00%) 33.00 15.00 (0.50) 27.00

kB (14.50%) 21.80 30.50 (7.60) 26.30

11.30 20.79 1.84

11.30 20.78 1.84

Portfolio (16.25%) 27.40 22.75 (4.05) 26.65 11.30 20.13 1.78

e. A risk-averse investor would choose the portfolio over either Stock A or Stock B alone, since the portfolio offers the same expected return but with less risk. This result occurs because returns on A and B are not perfectly positively correlated (rAB = 0.88).