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Problem Set 4 Solution

Investments (Macquarie University)

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Problem Set 4 Solution

Arithmetic vs. Geometric Returns

What is the difference between arithmetic and geometric returns? Suppose you have invested in a
stock for the last 10 years. Which number is more important to you, the arithmetic or geometric
return?

To calculate an arithmetic return, you sum the returns and divide by the number of returns. As such,
arithmetic returns do not account for the effects of compounding. Geometric returns do account for
the effects of compounding. As an investor, the more important return of an asset is the geometric
return.

10.1 Calculating Returns

Suppose a stock had an initial price of $64 per share, paid a dividend of $1.20 per share during the
year, and had an ending share price of $73. Compute the percentage total return.

The return of any asset is the increase in price, plus any dividends or cash flows, all divided by the
initial price. The return of this stock is:

R = [($73 – 64) + 1.20] / $64

R = .1594, or 15.94%

10.2 Calculating Yields

In the previous problem, what was the dividend yield? The capital gains yield?

The dividend yield is the dividend divided by the price at the beginning of the period, so:
Dividend yield = $1.20 / $64
Dividend yield = .0188, or 1.88%

And the capital gains yield is the increase in price divided by the initial price, so:
Capital gains yield = ($73 – 64) / $64
Capital gains yield = .1406, or 14.06%

10.4 Calculating Returns

Suppose you bought a bond with a 5.8 percent coupon rate one year ago for $1,030. The bond sells
for $1,059 today.
a. Assuming a $1,000 face value, what was your total dollar return on this investment over the
past year?

The total dollar return is the change in price plus the coupon payment, so:
Total dollar return = $1,059 – 1,030 + 58
Total dollar return = $87

b. What was your total nominal rate of return on this investment over the past year?

The total nominal percentage return of the bond is:

R = [($1,059 – 1,030) + 58] / $1,030
R = .0845, or 8.45%
Notice here that we could have used the total dollar return of $87 in the numerator of this equation.

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c. If the inflation rate last year was 3 percent, what was your total real rate of return on this
investment?

Using the Fisher equation, the real return was:

(1 + R) = (1 + r)(1 + h)
r = (1.0845 / 1.030) – 1
r = .0529, or 5.29%

10.12 Holding Period Return

A stock has had returns of 14.38 percent, 8.43 percent, 11.97 percent, 25.83 percent, and −9.17
percent over the past five years, respectively. What was the holding period return for the stock?

Applying the five-year holding-period return formula to calculate the total return of the stock over the
five-year period, we find:
5-year holding-period return = [(1 + R1)(1 + R2)(1 + R3)(1 + R4)(1 + R5)] – 1
5-year holding-period return = [(1 + .1438)(1 + .0843)(1 + .1197)(1 + .2583)(1 – .0917)] – 1
5-year holding-period return = .5871, or 58.71%

10.19 Calculating Returns and Variability

You find a certain stock that had returns of 12 percent, -15 percent, 13 percent, and 27 percent for
four of the last five years. If the average return of the stock over this period was 10.5 percent, what
was the stock’s return for the missing year? What is the standard deviation of the stock’s returns?

Here we know the average stock return, and four of the five returns used to compute the average return.
We can work the average return equation backward to find the missing return. The average return
is calculated as:
5(.105) = .12 – .15 + .13 + .27 + R
R = .155, or 15.50%

The missing return has to be 15.5 percent. Now we can use the equation for the variance to find:
Variance = 1/4[(.12 – .105)2 + (–.15 – .105)2 + (.13 – .105)2 + (.27 – .105)2 + (.155 – .105)2]
Variance = .02390

And the standard deviation is:

Standard deviation = (.02390)1/2
Standard deviation = .1546, or 15.46%

10.20 Arithmetic and Geometric Returns

A stock has had returns of 24 percent, 12 percent, 38 percent, -2 percent, 21 percent, and -16 percent
over the last six years. What are the arithmetic and geometric returns for the stock?

The arithmetic average return is the sum of the known returns divided by the number of returns, so:
Arithmetic average return = (.24 + .12 + .38 –.02 + .21 – .16) / 6
Arithmetic average return = .1283, or 12.83%

Using the equation for the geometric return, we find:

Geometric average return = [(1 + R1) × (1 + R2) × … × (1 + RT)]1/T – 1
Geometric average return = [(1 + .24)(1 + .12)(1 + .38)(1 – .02)(1 + .21)(1 – .16)](1/6) – 1
Geometric average return = .1138, or 11.38%

Remember, the geometric average return will always be less than the arithmetic average return if
the returns have any variation.

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11.3 Portfolio Expected Return

You own a portfolio that is 20 percent invested in Stock X , 45 percent in Stock Y , and 35 percent in
Stock Z . The expected returns on these three stocks are 11 percent, 17 percent, and 14 percent,
respectively. What is the expected return on the portfolio?

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) = .20(.11) + .45(.17) + .35(.14)

E(Rp) = .1475, or 14.75%

11.8 Returns and Standard Deviations

Consider the following information:
Probability of State of Rate of Return if State Occurs
State of Economy
Economy Stock A Stock B Stock C
Boom 0.65 0.06 0.16 0.33
Bust 0.35 0.14 0.02 -0.06

a. What is the expected return on an equally weighted portfolio of these three stocks?

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: Rp = (.06 + .16 + .33) / 3

Rp = .1833, or 18.33%

Bust: Rp = (.14 + .02 −.06) / 3

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

E(Rp) = .1308, or 13.08%

b. What is the variance of a portfolio invested 20 percent each in A and B, and 60 percent in C?

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: Rp=.20(.06) +.20(.16) + .60(.33)

Rp =.2420, or 24.20%

Bust: Rp =.20(.14) +.20(.02) + .60(−.06)

Rp = –.0040, or –.40%

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And the expected return of the portfolio is:

E(Rp) = .65(.2420) + .35(−.004)

E(Rp) = .1559, or 15.59%

To find the variance, we find the squared deviations from the expected return. We then
multiply each possible squared deviation by its probability, and then add all of these up. The
result is the variance. So, the variance of the portfolio is:

σp2 = .65(.2420 – .1559)2 + .35(−.0040 – .1559)2

σp2 = .013767

11.12 Using CAPM

A stock has a beta of 1.15, the expected return on the market is 10.6 percent, and the risk-free rate is
4.5 percent. What must the expected return on this stock be?

CAPM states the relationship between the risk of an asset and its expected return. CAPM is:

E(Ri) = Rf + [E(RM) – Rf] × βi

Substituting the values we are given, we find:

E(Ri) = .045 + (.106 – .045)(1.15)

E(Ri) = .1152, or 11.52%

11.13 Using CAPM

A stock has an expected return of 13.4 percent, the risk-free rate is 3.8 percent, and the market risk
premium is 7 percent. What must the beta of this stock be?

We are given the values for the CAPM except for the β of the stock. We need to substitute these
values into the CAPM, and solve for the β of the stock. One important thing we need to realize is that
we are given the market risk premium. The market risk premium is the expected return of the market
minus the risk-free rate. We must be careful not to use this value as the expected return of the market.
Using the CAPM, we find:
E(Ri) = .134 = .038 + .07β i
βi = 1.37

11.16 Using CAPM

A stock has a beta of 1.13 and an expected return of 12.1 percent. A risk-free asset currently earns 3.6
percent.
a. What is the expected return on a portfolio that is equally invested in the two assets?

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:

E(Rp) = (.121 + .036) / 2

E(Rp) = .0785, or 7.85%

b. If a portfolio of the two assets has a beta of .50, what are the portfolio weights?

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We need to find the portfolio weights that result in a portfolio with a β of .50. We know the β 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:

βp = .50 = XS(1.13) + (1 – XS)(0)

.50 = 1.13XS + 0 – 0XS
XS = .50 / 1.13
XS = .4425

And, the weight of the risk-free asset is:

XRf = 1 – .4425
XRf = .5575

c. If a portfolio of the two assets has an expected return of 10 percent, what is its beta?

We need to find the portfolio weights that result in a portfolio with an expected return of 10 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) = .10 = .121XS + .036(1 – XS)

.10 = .121XS + .036 – .036XS
XS = .7529

So, the β of the portfolio will be:

βp = .7529(1.13) + (1 – .7529)(0)
βp = .851

d. If a portfolio of the two assets has a beta of 2.26, what are the portfolio weights? How do you
interpret the weights for the two assets in this case? Explain.

Solving for the β of the portfolio as we did in part b, we find:

βp = 2.26 = XS(1.13) + (1 – XS)(0)

XS = 2.26 / 1.13
XS = 2

XRf = 1 – 2
XRf = –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.

11.24 Analyzing a Portfolio

You have $100,000 to invest in a portfolio containing Stock X, Stock Y. Your goal is to create a
portfolio that has an expected return of 12.9%. If Stock X has an expected return of 11.2% and a beta
of 1.30 and Stock Y has an expected return of 7.7% and a beta of 0.80, how much money will you
invest in Stock Y? How do you interpret your answer? What is the beta of your portfolio?

We are given the expected return of the assets in the portfolio. We also know the sum of the weights
of each asset must be equal to one. Using this relationship, we can express the expected return of
the portfolio as:
E(Rp) = .129 = XX(.112) + XY(.077)

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.129 = XX(.112) + (1 – XX)(.077)

.129 = .112XX + .077 – .077XX
.052 = .035XX
XX = 1.48571

And the weight of Stock Y is:

XY = 1 – 1.48571
XY = –.48571

The amount to invest in Stock Y is:

Investment in Stock Y = –.48571($100,000)
Investment in Stock Y = –$48,571.43

A negative portfolio weight means that you short sell the stock. If you are not familiar with short
selling, it means you borrow a stock today and sell it. You must then purchase the stock at a later
date to repay the borrowed stock. If you short sell a stock, you make a profit if the stock
decreases in value.

11.26 Covariance and Correlation

Based on the following information, calculate the expected return and standard deviation for each of
the following stocks. What are the covariance and correlation between the returns of the two stocks?
State of Economy Probability of State of Return on Stock J Return on Stock K
Economy
Bear 0.30 -0.020 0.034
Normal 0.55 0.138 0.062
Bull 0.15 0.218 0.092

The expected return of an asset is the sum of the probability of each state occurring times the rate of
return if that state occurs. So, the expected return of each stock is:

E(RJ) = .30(–.020) + .55(.138) + .15(.218)

E(RJ) = .1026, or 10.26%

E(RK) = .30(.034) + .55(.062) + .15(.092)

E(RK) = .0581, or 5.81%

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, and then add all of these up. The result is the variance. So, the variance
and standard deviation of Stock J are:

σ =.30(–.020 – .1026)2 + .55(.138 – .1026)2 + .15(.218 – .1026)2

σ = .00720

σJ = .007201/2
σJ = .0848, or 8.48%

And the standard deviation of Stock K is:

σ =.30(.034 – .0581)2 + .55(.062 – .0581)2 + .15(.092 – .0581)2

σ = .00035

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σK = .000351/2
σK = .0188, or 1.88%

To find the covariance, we multiply each possible state times the product of each asset’s deviation
from the mean in that state. The sum of these products is the covariance. So, the covariance is:

Cov(J,K) = .30(–.020 – .1026)(.034 – .0581) + .55(.138 – .1026)(.062 – .0581)

+ .15(.218 – .1026)(.092 – .0581)
Cov(J,K) = .001549

And the correlation is:

ρJ,K = Cov(J,K) / σJ σK
ρJ,K = .001549 / (.0848)(.0188)
ρJ,K = .9693

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