CHAPTER13
RETURN, RISK, AND THE SECURITY MARKET LINE
Learning Objectives
LO1 The calculation for expected returns and standard deviation for individual securities and portfolios.
LO2 The principle of diversification and the role of correlation.
LO3 Systematic and unsystematic risk.
LO4 Beta as a measure of risk and the security market line.
Answers to Concepts Review and Critical Thinking Questions
1. (LO3) Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of
assets, this unique portion of the total risk can be eliminated at little cost. On the other hand, there are some
risks that affect all investments. This portion of the total risk of an asset cannot be costlessly eliminated. In
other words, systematic risk can be controlled, but only by a costly reduction in expected returns.
2. (LO3) If the market expected the growth rate in the coming year to be 2 percent, then there would be no
change in security prices if this expectation had been fully anticipated and priced. However, if the market had
been expecting a growth rate different than 2 percent and the expectation was incorporated into security prices,
then the government’s announcement would most likely cause security prices in general to change; prices
would drop if the anticipated growth rate had been more than 2 percent, and prices would rise if the anticipated
growth rate had been less than 2 percent.
3. (LO3)
a. systematic
b. unsystematic
c. both; probably mostly systematic
d. unsystematic
e. unsystematic
f. systematic
4. (LO3)
a. a change in systematic risk has occurred; market prices in general will most likely decline.
b. no change in unsystematic risk; company price will most likely stay constant.
c. no change in systematic risk; market prices in general will most likely stay constant.
d. a change in unsystematic risk has occurred; company price will most likely decline.
e. no change in systematic risk; market prices in general will most likely stay constant.
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to
space and readability constraints, when these intermediate steps are included in this solutions manual, rounding
may appear to have occurred. However, the final answer for each problem is found without rounding during any
step in the problem.
Basic
17. (LO1, 4)
a. Again we have a special case where the portfolio is equally weighted, so we can sum the returns of each
asset and divide by the number of assets. The expected return of the portfolio is:
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E(Rp) = (.16 + .048)/2 = .1040 or 10.40%
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b. We need to find the portfolio weights that result in a portfolio with a of 0.95. We know the of the
risk-free asset is zero. We also know the weight of the risk-free asset is one minus the weight of the stock
since the portfolio weights must sum to one, or 100 percent. So:
p = 0.95 = wS(1.35) + (1 – wS)(0)
0.95 = 1.35wS + 0 – 0wS
wS = 0.95/1.35
wS = .7037
And, the weight of the risk-free asset is:
wRf = 1 – .7037 = .2963
c. We need to find the portfolio weights that result in a portfolio with an expected return of 8 percent. We
also know the weight of the risk-free asset is one minus the weight of the stock since the portfolio
weights must sum to one, or 100 percent. So:
E(Rp) = .08 = .16wS + .048(1 – wS)
.08 = .16wS + .048 – .048wS
.032 = .112wS
wS = .2857
So, the of the portfolio will be:
p = .2857(1.35) + (1 – .2857)(0) = 0.386
d. Solving for the of the portfolio as we did in part a, we find:
p = 2.70 = wS(1.35) + (1 – wS)(0)
wS = 2.70/1.35 = 2
wRf = 1 – 2 = –1
The portfolio is invested 200% in the stock and –100% in the risk-free asset. This represents borrowing
at the risk-free rate to buy more of the stock.
18. (LO1, 4) First, we need to find the of the portfolio. The of the risk-free asset is zero, and the weight of the
risk-free asset is one minus the weight of the stock, the of the portfolio is:
ßp = wW(1.25) + (1 – wW)(0) = 1.25wW
So, to find the of the portfolio for any weight of the stock, we simply multiply the weight of the stock times
its .
Even though we are solving for the and expected return of a portfolio of one stock and the risk-free asset for
different portfolio weights, we are really solving for the SML. Any combination of this stock, and the risk-free
asset will fall on the SML. For that matter, a portfolio of any stock and the risk-free asset, or any portfolio of
stocks, will fall on the SML. We know the slope of the SML line is the market risk premium, so using the
CAPM and the information concerning this stock, the market risk premium is:
E(RW) = .152 = .053 + MRP(1.25)
MRP = .099/1.25 = .0792 or 7.92%
So, now we know the CAPM equation for any stock is:
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E(Rp) = .053 + .0793p
The slope of the SML is equal to the market risk premium, which is 0.0792. Using these equations to fill in the table,
we get the following results:
wW E(Rp) ßp
0.00% 5.30% 0.000
25.00% 7.78% 0.313
50.00% 10.25% 0.625
75.00% 12.73% 0.938
100.00% 15.20% 1.250
125.00% 17.68% 1.563
150.00% 20.15% 1.875
19. (LO4) There are two ways to correctly answer this question. We will work through both. First, we can use the
CAPM. Substituting in the value we are given for each stock, we find:
E(RY) = .08 + .075(1.30) = .1775 or 17.75%
It is given in the problem that the expected return of Stock Y is 18.5 percent, but according to the CAPM, the
return of the stock based on its level of risk, the expected return should be 17.75 percent. This means the stock
return is too high, given its level of risk. Stock Y plots above the SML and is undervalued. In other words, its
price must increase to reduce the expected return to 17.75 percent. For Stock Z, we find:
E(RZ) = .08 + .075(0.70) = .1325 or 13.25%
The return given for Stock Z is 12.1 percent, but according to the CAPM the expected return of the stock
should be 13.25 percent based on its level of risk. Stock Z plots below the SML and is overvalued. In other
words, its price must decrease to increase the expected return to 13.25 percent.
We can also answer this question using the reward-to-risk ratio. All assets must have the same reward-to-risk
ratio. The reward-to-risk ratio is the risk premium of the asset divided by its . We are given the market risk
premium, and we know the of the market is one, so the reward-to-risk ratio for the market is 0.075, or 7.5
percent. Calculating the reward-to-risk ratio for Stock Y, we find:
Reward-to-risk ratio Y = (.185 – .08) / 1.30 = .0808
The reward-to-risk ratio for Stock Y is too high, which means the stock plots above the SML, and the stock is
undervalued. Its price must increase until its reward-to-risk ratio is equal to the market reward-to-risk ratio. For
Stock Z, we find:
Reward-to-risk ratio Z = (.121 – .08) / .70 = .0586
The reward-to-risk ratio for Stock Z is too low, which means the stock plots below the SML, and the stock is
overvalued. Its price must decrease until its reward-to-risk ratio is equal to the market reward-to-risk ratio.
20. (LO4) We need to set the reward-to-risk ratios of the two assets equal to each other, which is:
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(.185 – Rf)/1.30 = (.121 – Rf)/0.70
We can cross multiply to get:
0.70(.185 – Rf) = 1.30(.121 – Rf)
Solving for the risk-free rate, we find:
0.1295 – 0.70Rf = 0.1573 – 1.30Rf
Rf = .0463 or 4.63%
Intermediate
21. (LO1, 2) For a portfolio that is equally invested in large-company stocks and long-term bonds:
Return = (10.23% + 8.57%)/2 = 9.40%
For a portfolio that is equally invested in small stocks and Treasury bills:
Return = (12.12% + 6.44%)/2 = 9.28%
22. (LO4) We know that the reward-to-risk ratios for all assets must be equal. This can be expressed as:
[E(RA) – Rf]/A = [E(RB) – Rf]/ßB
The numerator of each equation is the risk premium of the asset, so:
RPA/A = RPB/B
We can rearrange this equation to get:
B/A = RPB/RPA
If the reward-to-risk ratios are the same, the ratio of the betas of the assets is equal to the ratio of the risk
premiums of the assets.
23. (LO1, 2)
a. We need to find the return of the portfolio in each state of the economy. To do this, we will multiply the
return of each asset by its portfolio weight and then sum the products to get the portfolio return in each
state of the economy. Doing so, we get:
Boom: E(Rp) = .4(.24) + .4(.36) + .2(.55) = .3500 or 35.00%
Normal: E(Rp) = .4(.17) + .4(.13) + .2(.09) = .1380 or 13.80%
Bust: E(Rp) = .4(.00) + .4(–.28) + .2(–.45) = –.2020 or –20.20%
And the expected return of the portfolio is:
E(Rp) = .35(.35) + .50(.138) + .15(–.202) = .1612 or 16.12%
To calculate the standard deviation, we first need to calculate the variance. To find the variance, we find
the squared deviations from the expected return. We then multiply each possible squared deviation by its
probability, than add all of these up. The result is the variance. So, the variance and standard deviation of
the portfolio is:
2p = .35(.35 – .1612)2 + .50(.138 – .1612)2 + .15(–.202 – .1612)2
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2p = .03253
p = (.03253)1/2 = .1804 or 18.04%
b. The risk premium is the return of a risky asset, minus the risk-free rate. T-bills are often used as the risk-
free rate, so:
RPi = E(Rp) – Rf = .1612 – .0380 = .1232 or 12.32%
c. The approximate expected real return is the expected nominal return minus the inflation rate, so:
Approximate expected real return = .1612 – .035 = .1262 or 12.62%
To find the exact real return, we will use the Fisher equation. Doing so, we get:
1 + E(Ri) = (1 + h)[1 + e(ri)]
1.1612 = (1.0350)[1 + e(ri)]
e(ri) = (1.1612/1.035) – 1 = .1219 or 12.19%
The approximate real risk premium is the expected return minus the risk-free rate, so:
Approximate expected real risk premium = .1612 – .038 = .1232 or 12.32%
The exact expected real risk premium is the approximate expected real risk premium, divided by one plus
the inflation rate, so:
Exact expected real risk premium = .1232/1.035 = .1190 or 11.90%
24. (LO2) Since the portfolio is as risky as the market, the of the portfolio must be equal to one. We also know the
of the risk-free asset is zero. We can use the equation for the of a portfolio to find the weight of the third stock.
Doing so, we find:
p = 1.0 = wA(.85) + wB(1.20) + wC(1.35) + wRf(0)
Solving for the weight of Stock C, we find:
wC = .324074
So, the dollar investment in Stock C must be:
Invest in Stock C = .324074($1,000,000) = $324,074.07
We know the total portfolio value and the investment of two stocks in the portfolio, so we can find the weight
of these two stocks. The weights of Stock A and Stock B are:
wA = $210,000 / $1,000,000 = .210
wB = $320,000/$1,000,000 = .320
We also know the total portfolio weight must be one, so the weight of the risk-free asset must be one minus the
asset weight we know, or:
1 = wA + wB + wC + wRf = 1 – .210 – .320 – .324074 – wRf
wRf = .145926
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So, the dollar investment in the risk-free asset must be:
Invest in risk-free asset = .145926($1,000,000) = $145,925.93
Challenge
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