PORTFOLIO ANALYSIS AND MANAGEMENT

SOLUTIONS TO THE PROBLEM SET FOR MODULE 5

2. The risk-free rate of return is 8 percent, the required rate of return on the
market, E[Rm] is 12 percent, and Stock X has a beta coefficient of 1.4. If the
dividend expected during the coming year, D 1, is $2.50 and g = 5%, at what
price should Stock X sell?

(b) Now suppose the following events occur:

(1) The Federal Reserve Board increases the money supply, causing the riskless
rate to drop to 7 percent.
(2) Investors' risk aversion declines: this fact, combined with the decline in RF,
causes RM to fall to 10 percent.
(3) Firm X has a change in management. The new group institutes policies that
increase the growth rate to 6 percent. Also, the new management stabilizes
sales and profits, and thus causes the beta coefficient to decline from 1.4 to
1.1.

After all these changes, what is Stock X's new equilibrium price? (Note: D1 goes
to $2.52.)

(a)

E [ r ] =.08+1. 4 ( .12−. 08 )=.136

Div 2 .50
P= = =$ 29. 07
E [ r ] −g .136−. 05

(b)

E [ r ] =.07+1. 1 ( .1−.07 )=. 103

Div 2 .52
P= = =$ 58 . 6
E [ r ] −g . 103−. 06

3. (a) Suppose Carter Chemical Company's management conducts a study and concludes
that if Carter expands its consumer products division (which is less risky than its
primary business, industrial chemicals), the firm's beta will decline from 1.1 to 0.9.
However, consumer products have a somewhat lower profit margin, and this will
cause Carter's growth rate in earnings and dividends to fall from 7 percent to 6
percent. Should management make the change? Assume the following:

ERM= 10% ; RF=7.5%; D0 =$2.

(b) Assume all the facts as given in part (a), except the one about the changing beta
coefficient. By how much would the beta have to decline to cause the expansion to be
a good one? (Hint: set P0 under the new policy equal to P 0 under the old one, and
find the new beta that produces this equality.)

Assuming that the management’s objective is to maximize the stock’s price on behalf of
shareholders, management should choose the strategy, which results in the higher price.

(a)

E [ r 1 ]=. 075+ 1. 1 ( . 1−. 075 )=.1025

Div 1 2×1. 07
P1= = =$ 65. 85
E [ r 1 ]−g 1 . 1135−. 07
E [ r 2 ]=. 075+0 . 9 ( . 1−. 075 )=. 0975
Div 1 2×1 .06
P2 = = =$ 56 . 53
E [ r 2 ] −g 2 . 0975−. 06

The management should stick to the old policy

(b)
2×1. 06
≥65.85
. 075+β×(. 025)−. 06
β≤. 6878
The beta of the company should drop below .6878 to justify the new policy.

4. The beta coefficient for Stock C is bc = 0.4, while that for Stock D is bD = -0.5.
(Stock D's beta is negative, indicating that its rate of return rises whenever
returns on most other stocks fall. There are very few negative beta stocks,
although gold mining stocks are often cited as an example.)
(a) If the risk free rate is 7%, and the expected ROR on an average stock is 11
percent, what are the required rates of return on Stocks C and D?
(b) For Stock C suppose the current price, PO, is $25, the next expected
dividend, D1, is $1.50, and the stock's expected growth rate is 4 percent. Is
the stock in equilibrium? Explain, and describe what will happen if the
stock is not in equilibrium.

E [ r c ]=. 07+. 4 ( . 11−. 07 )=. 086

E [ r D ]=. 07−.5 ( . 11−. 07 ) =. 05

(b)
In equilibrium the price of the stock C should be:

1. 50
P0 = =$ 32. 61
. 086−. 04

Stock C is not in equilibrium, it is underpriced. Once investors notice it, they will buy the stock,
its price will go up and its return will drop.

42. Given that the risk-free rate is 10%, the expected return on the market
portfolio is 20%, and the standard deviation of returns to the market
portfolio is 20%, answer the following questions:

a. What is the slope of the capital market line?

The slope of the capital market line is given by

E [ r M ] −r f . 2−. 1
= =. 5
σM .2

b. You have $100,000 to invest. How should you allocate your

wealth among risk free assets and the market portfolio in
order to have a 25% expected return?

E ( r p ) =w M E ( r M ) + ( 1−w M ) r f
.25=. 2 w M +.1 ( 1−w M )
w M =1 . 5
w rf =−. 5

c. What is the standard deviation of your portfolio in b)?

σ p =w M σ M =1. 5 ( .2 ) =.3

d. What is the correlation between the portfolio in b) and the

market portfolio?

The correlation is 1

e. Suppose that the market pays either 40% or 0% each with

probability one half. You alter your portfolio to a more risky
level by borrowing $50,000 and investing it and your own
$100,000 in M. Give the probability distribution of your wealth
(in dollars) next period.
 Probabilit Wealth
y
½ 150,0001.4-50,0001.1= $155,000
½ 150,0001-50,0001.1= $95,000

48. Ms. A invests $400,000, $60,000, and $25,000 in stocks X, Y, and Z, respectively.
The betas of these stocks are.25, .95, and 1.63, respectively. The market's expected
return is 8%, and the risk-free rate is 2%. What is the expected value of Ms. A's
investment?

According to CAPM, the expected returns on stocks X, Y and Z are as follows:

E [ r X ] =.02+. 25 ( . 08−. 02 )=. 035

E [ r Y ]=. 02+ .95 ( . 08−. 02 ) =.077
E [ r Z ]=. 02+1 .63 ( . 08−. 02 )=. 1178

The expected value of the investment is:

E ( V )=400 ,000×1. 035+60 ,000×1. 077+25 ,000×1.1178=$ 506 ,565

55. You are holding a portfolio of stocks where the beta of your portfolio is 2.5 and its
correlation with "M", the market portfolio, is.4. The risk-free rate is 6%, the
expected return on the market portfolio is 12%, and the standard deviation of the
return on the market portfolio is 20%. How much additional expected return could
you achieve, at no increase in risk (standard deviation), by making your portfolio
efficient?

Currently you are earning:

E[Rp] = .06 + 2.5 ( .12 - .06) = .21

If your portfolio is to become efficient its correlation with the market should be 1. The total risk
of the current portfolio is:

βσ m 2 .5 ( . 2 )
σ p= = =1 .25
ρ pm . 4
σ 1 .25
β efficient
p = p= =6 . 25
σm .2
E [ Refficient
p ] =. 06+6 . 25 (. 12−. 06 )=. 435
That is you earn 22.5% of additional return by making your portfolio efficient.

58. Consider two mutual funds, A and B. The beta for fund A is .60, and the standard
deviation of the rate of return = .20. The beta for fund B. is 1.30 and its standard
deviation of the rate of return = .325. The standard deviation of the market portfolio
is .25. Are these funds as well diversified as possible?

If funds are as well diversified as possible the correlation of their returns with the return on

the Market portfolio should be equal to 1.

ρ JM σ J .6 ( .25 ) 1.3 ( .25 )

βJ = t h ereforeρ AM = =0.75ρ BM = =1
σM .2 .325

Fund A is not as well diversified as possible but Fund B is.

60. Suppose that the standard deviation of the market return is 20%. The standard
deviation of a well-diversified portfolio is 10%. According to the CAPM, what is
the beta of the portfolio? How do you expect the portfolio's value to change if the
market rises by 5%.

According to CAPM, the beta of the portfolio is:

σP .1
β P= = =. 5
σM .2
If market rises by 5%, the expected return on this portfolio rises by 2.5%

62. Suppose that securities are priced according to the CAPM. You have forecast the
correlation coefficient between the rate of return on the High Value Mutual Fund
(HVMF) and the market portfolio (M) at 0.8. Your forecasts of the standard
deviations of the rate of return are 0.25 for HVFF and 0.20 for M. How would you
combine the HVMF and a risk free security to obtain a portfolio with a beta of 1.6?
Suppose that rf = 0.10 and E[rm ]= 0.15. If you were willing to tolerate the same risk
as in the above portfolio, how much additional return could you obtain if your
portfolio were efficient?

Beta of the risk free security is equal to zero. The beta of the portfolio of HVMF and the risk free
security is given by:
 β p =w HMVF β HMVF
ρ σ . 8(. 25 )
β HVMF = HMVF HVNF = =1
σM .2
1. 6
w HMVF = =1. 6
1
w rf =−0 . 6
The portfolio with 1.6 of the total wealth invested in HVMF and -0.6 in the risk free asset will
have beta of 1.6

The above portfolio is not efficient because its correlation with the market portfolio is the same
as the correlation of HVMF: 0.8 and not 1. Its risk is

σ p =w HVMF σ HMVF=1.6(.25)=.4
This portfolio currently commands the following return:

E [ r p ]=r f + β p ( E [ r M ]−r f )=0. 1+1 .6 ( . 15−. 1 )=. 18

The beta and expected return of the efficient portfolio with 40% standard deviation (total risk) is
given by:
ρ pM σ p 1 ( . 4 )
β ¿p = = =2
σM .2
E [ r p ]=0 . 1+2 ( . 15−. 1 )=. 2

Therefore, the efficient portfolio with the same total risk will command 2% extra return.

66. You are given the following information on two securities, the market portfolio,
and the risk-free rate:

Expected Return Correlation with Standard

Market Portfolio Deviation

Security 1 15.5% 0.9 20%

Security 2 9.2% 0.8 9%

Market Portfolio 12% 1 12%

Risk-free Rate 5% 0 0%

For parts a, b, and c use the above table.

a. Draw the SML
b. What are the betas of the two securities?
 c. Plot the two securities on the SML.
d. Now assume that two other securities, A and B, constitute the
market portfolio. Their proportion in it and variances are 0.39,
160, and 0.61, 340 respectively. The covariance of the two securities
is 190. Calculate the betas of the two securities.

(a) SML

E[r]

1
12% M *
Slope = E[Rm] - rf = 7
2
*

5%

1 Beta

(b) The betas of the securities 1 and 2 are

. 9(. 2)
β 1= =1. 5
. 12
. 8(. 09 )
β 2= =. 6
. 12

(d) First, let us calculate the standard deviation of the market portfolio:

σ 2m=w 2A σ 2A + w2B σ 2B +2 w A w B Cov ( ~r A , ~r B )¿ ¿

The covariances between the returns on Security A and Security B and the Market portfolio
and their betas are given by:
 Cov(~r A ,~
r M )=Cov (~ r A , w A~
r A +wB ~
r B )=w A σ 2A +w B Cov ( ~ r A ,~
r B)
¿.39(160 )+. 61(190 )=178 . 3
Cov(~r B ,~
r M )=Cov (~ r B , w A~
r A +wB ~
r B ) =w A Cov ( ~ r B ) +w B σ 2B
r A ,~
¿.39(190 )+. 61(340 )=281 .5
Cov ( ~r A ,~
r M ) 178 . 3
β A= 2 = =. 739
σM 241 . 25
Cov ( ~r B ,~
r M ) 281. 5
β B= 2 = =1 . 167
σM 241. 25

76. You have been provided the following data on the securities of three firms and the
market:

Security E[Rj] j jM j

Firm A 0.13 .12 ? .90
Firm B 0.16 ? 0.40 1.10
Firm C 0.25 0.24 0.75 ?
Market 0.15 0.10 1 1
Risk-free 0.05 0 0 0

Assume the CAPM holds true.

a. Fill in the missing values in the table.

From the definition of beta of the stock:

ρℑ σ i
β i=
σm
For Firm A

β A σ m 0.9 ×0.1
ρ Am= = =0.75
σA 0.12

For Firm B

β B σ m 1.1 ×0.1
❑B = = =0.275
❑Bm 0.4
For Firm C
 0.75 0.24
β C= =1.8
0.1

b. What is your investment recommendation on each

asset? Buy or sell?

From the equations of SML:

E [~
Ri ] =r f + β i ( E [~
R m ]−r f )

For stock A:

E [ R A ]=0.05+0.9 × ( 0.15−0.05 ) =0.14

According to CAPM Stock A should pay 14% expected return. According

to our data, it pays only 13% return. Therefore this stock is overvalued.
The recommendation is SELL.

Using similar logic, we learn that Stock B is fairly prices. So we are

indifferent between BUY and SELL.

The expected return on Stock C,

E [ Rc ] =0.05+1.8 × ( 0.15−0.05 )=0.23

Firm C pays 25%, which is more that it is supposed to pay according to

CAPM, therefore this stock is undervalued. BUY.

c. Suppose that you are currently holding a portfolio

consisting of Firm B only. If you increase your portfolio weight on Firm
B by 0.2 (or 20%) and borrow the needed money at the risk-free rate,
what will be the new standard deviation of your portfolio?

σ 2pf =w 2B σ 2B +w 2rf σ 2rf + 2 wB w rf σ B ,rf =1.22 ×0.2752 =0.1089

σ pf =0.33∨33 %