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Chapter 22 Solution To Problems 1

The document provides 7 problems related to estimating risk and return of financial assets and portfolios. [1] It calculates the expected returns and variances of two individual assets. [2] It finds the expected return of a portfolio as the weighted average of the individual asset returns. [3] It calculates the expected return of an equally weighted portfolio in different economic states. [4] It determines the portfolio weights based on amounts invested in each asset. [5] It calculates expected returns, risks, and coefficients of variation for two individual stocks. [6] It estimates expected returns and standard deviations for two other individual stocks. [7] It finds the expected return and variance of a portfolio consisting of two assets.

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137 views3 pages

Chapter 22 Solution To Problems 1

The document provides 7 problems related to estimating risk and return of financial assets and portfolios. [1] It calculates the expected returns and variances of two individual assets. [2] It finds the expected return of a portfolio as the weighted average of the individual asset returns. [3] It calculates the expected return of an equally weighted portfolio in different economic states. [4] It determines the portfolio weights based on amounts invested in each asset. [5] It calculates expected returns, risks, and coefficients of variation for two individual stocks. [6] It estimates expected returns and standard deviations for two other individual stocks. [7] It finds the expected return and variance of a portfolio consisting of two assets.

Uploaded by

Jayvee M Felipe
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd
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FINANCIAL MANAGEMENT

ESTIMATING RISK AND RETURN ON ASSETS


SOLUTION IN SEATWORK PROBLEMS

Problem 1

The expected returns are just the possible returns multiplied by the associated probabilities:
E (RA) = (.20 x -.15) + (.50 x .20) + (.30 x .60) = 25%
E (RB) = (.20 x.20) + (.50 x .30) + (.30 x .40) = 31%

The variances are given by the sums of the squared deviations from the expected returns multiplied
by their probabilities:
σ2A = .20 x (-.15 − .25) 2 + .50 x (.20 − .25) 2 + .30 x (.60 − .25) 2
= (.20 x -.402) + (.50 x -.052) + (.30 x .352)
= (.20 x .16) + (.50 x .0025) + (.30 x .1225)
= .0700

σ2B = .20 x (.20 − .31) 2 + .50 x (.30 − .31) 2 + .30 x (.40 − .31) 2
= (.20 x -.112) + (.50 x -.012) + (.30 x .092)
= (.20 x .0121) + (.50 x .0001) + (.30 x .0081)
= .0749

The standard deviations are thus:


σA = √ .0700 σB = √ .0049
= 26.46% = 7%

The portfolio weights are P15,000/20,000 = .75 and P5,000/20,000 = .25. The expected return is
thus:
E (RP) = .75 x E (RA) + .25 x E (RB)
= (.75 x 25%) + (.25 x 31%)
= 26.5%

Problem 2
The expected return of a portfolio is the sum of the weight of each asset times the expected return of
each asset. So, the expected return of the portfolio is:

E (Rp) = .25(.08) + .55(.15) + .20(.24)


= .1505 or 15.05%

If we own this portfolio, we would expect to get a return of 15.05 percent.


Problem 3

To find the expected return of the portfolio, we need to find the return of the portfolio in each state of
the economy. This portfolio is a special case since all three assets have the same weight. To find
the expected return in an equally weighted portfolio, we can sum the returns of each asset and
divide by the number of assets, so the expected return of the portfolio in each state of the
economy is:

Boom: E (Rp) = (.07 + .15 + .33)/3 = .1833 or 18.33%


Recession: E (Rp) = (.13 + .03 .06)/3 = .0333 or 3.33%

To find the expected return of the portfolio, we multiply the return in each state of the economy
by the probability of that state occurring, and then sum. Doing this, we find:

E (Rp) = .35(.1833) + .65(.0333)


= .0858 or 8.58%

(b) This portfolio does not have an equal weight in each asset. We still 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) = .20(.07) +.20(.15) + .60(.33) =.2420 or 24.20%


Recession: E (Rp) = .20(.13) +.20(.03) + .60(.06) = –.0040 or –0.40%

And the expected return of the portfolio is:

E (Rp) = .35(.2420) + .65(.004)


= .0821 or 8.21%
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:

p2 = .35(.2420 – .0821)2 + .65(.0040 – .0821)2


= √.013767
= 11.73%

Problem 4

The portfolio weight of an asset is total investment in that asset divided by the total portfolio value.
First, we will find the portfolio value, which is:

Total value = 180 (P45) + 140 (P27)


= P11,880

The portfolio weight for each stock is:

WeightA = 180 (P45) / P11,880


= .6818

WeightB = 140 (P27) / P11,880


= .3182

Problem 5

1. Calculate the Expected Return for individual stocks.


E(RA) = .2 (.15) + .2 (-.05) + .2 (.05) + .2 (.35) + .2 (.25) = 15%
E(RB) = .2 (-.05) + .2 (.15) + .2 (.25) + .2 (.05) + .2 (.35) = 15%
2. Calculate the Risk for individual stocks.
𝜎2A = .20 (.15 - .15)2 + .20 (-.05 - .15)2 + .20 (.05 - .15)2 + .20 (.35 - .15)2 + .20 (.25 - .15)2
𝜎2A = .02 = √. 02 = 14.14%
𝜎2B = .20 (-.05 - .15)2 + .20 (.15 - .15)2 + .20 (.25 - .15)2 + .20 (.05 - .15)2 + .20 (.35 - .15)2
𝜎2B = .02 = √. 02 = 14.14%
3. Calculate the Coefficient of Variation for individual stocks.
CVA = (.1414/.15) = .94267 = 94.27%
CVB = (.1414/.15) = .94267 = 94.27%

Problem 6

1. Calculate the expected return of each stock.


E(RA) = (7.3 + 11.5 + 16.6)/3 = 11.8%
E(RB) = (-4.7 + 5.4 + 24.3)/3 = 8.3%
2. Calculate the standard deviation of returns of each stock.
𝜎2A = {(0.073 – 0.118)2 + (0.115 – 0.118)2 + (0.166 – 0.118)2}/3 = 0.001446
𝜎2A = √0.001446 = 0.0380 = 3.80%
𝜎2B = {(-0.047 – 0:083)2 + (0.054 – 0.083)2 + (0.243 – 0.083)2}/3 = 0.014447
𝜎2B = √0.014447 = 0.1202 = 12.02%

Problem 7

E(Rp) = .4(.05) + .06(.15) = .02 + .09 = .11 = 11%


𝜎2p = √(.4)2 (.10)2 + (.6)2 (.25)2 + 2(. 4)(. 6)(−.25)(. 10)(.25)
𝜎2p = √. 0211 = .145258 = 14.53%

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