Q1 Mr Ram is curious to know whether the following 5 stocks are appropriately

valued in the market. Accordingly, he creates a table (shown below) listing the betas
of each stock along with their ex-ante expected return values that have been
calculated using a probability distribution. He also lists the current risk-free rate and
the expected rate of return on the broad market index. Help him out and state your
steps.
Stock Expected Return Beta
1 22% 1.8
2 8% 0.9
3 14% 1.2
4 10% 1.1
5 16% 1.4
Rf 3.5% ----
Rm 15% 1.0

ANSWER (a)
Step 1. Using the CAPM equation calculate the risk-based return of each stock
Stock
Stock Expected Return Beta CAPM E(Ri) Comment
1 26% 1.8 24.20% Undervalued
2 16% 0.9 13.85% Undervalued
3 14% 1.2 17.30% Overvalued
4 16.15% 1.1 16.15% Correctly valued
5 20% 1.4 19.60% Undervalued
Rf 3.50% ----
Rm 15% 1
Step 2. If CAPM-based E(R) is less than the ex-ante return listed, the stock is
undervalued, i.e. it is expected to earn a higher rate than it should, based on its beta.
Hence, Stocks 1, 2, and 5 are undervalued, while Stock3 is overvalued, and Stock 4 is
correctly valued.

b If Ram wants to form a 2-stock portfolio of the most undervalued stocks with a beta of
1.3, how much will she have to weight each of the stocks by?

ANSWER (b)
Based on the results in (A), Stocks 1 and 2 are most undervalued and would be chosen by
Ram to form the 2-stock portfolio with a beta = 1.3.
Stock 1’s beta = 1.8; Stock 2’s beta = 0.9; Desired Portfolio beta = 1.3
Since the portfolio beta = weighted average of individual stock betas
Let Stock 1’s Weight be X%; Thus Stock 2’s Weight would be (1-X)%
 1.8 × X% + 0.9 × (1 – X)% = 1.3
 1.8X + 0.9 – 0.9X = 1.3
 0.9X = 0.4
 X = 0.4/0.9 = 0.4444 or 44.44% = Stock 1’s Weight
 (1 – X) = 1 – 0.4444 = .5556 or 55.56 = Stock 2’s Weight
Check….0.4444 × 1.8 + 0.5556 × 0.9 = 0.79992+ 0.50004=1.3

Q2 Anita is curious to know what her portfolio’s CAPM-based expected rate of return
should be. After doing some research she figures out the market values and betas of each
of her 5 stocks (shown below) and is told by her consultant that the risk-free rate is 3%
and the market risk premium is 8%. Help Anita calculate her portfolio’s expected rateof
return.

ANSWER
Stock Value Weight Beta
1 Rs35,000 0.1400 1.6
2 Rs40,000 0.1600 1.2
3 Rs45,000 0.1800 1.0
4 Rs50,000 0.2000 -0.8
5 Rs80,000 0.3200 0.8
Rs250,000
First determine the portfolio beta using the following formula:

Portfolio Beta = 0.14 × 1.6+.16 × 1.2+.18 × 1.0+.2 × -0.8+.32 × 0.8

= 0.224 + 0.192 +0.18 + (-.16) + 0.256 =0.692
Next, using the CAPM equation and rf = 3%, E(rm-rf) = 8%; calculate the portfolio’s
expected rate.
E(rp) = 3% + 8% × (.692) = 8.54%

Q3 Using the probability distribution shown below, calculate the expected risk and
return estimates of each stock and of a portfolio comprised of 40% of Stock A and 60%
of Stock B.

State of Probability of State Stock A's Stock B's

Economy occurring Conditional return Conditional return
Recession 0.3 -12% 20%
Normal 0.5 14% 12%
Boom 0.2 25% -10%

ANSWER
Stock A’s expected return = 0.3 × (-12%)+0.5 × (14%)+0.2 × (25%)=8.4%
Stock B’s expected return = 0.3 × (20%)+0.5 × (12%)+0.2 × (-10%)=10%
Stock A’s expected variance = 0.3 × (-12-8.4)2+0.5 × (14-8.4)2+0.2 × (25-8.4)2
= 124.848 + 15.68 + 55.112
= 195.64
 Stock A’s expected std. dev. = √195.64 = 13.99%
Stock B’s expected variance = 0.3 × (20-10)2+0.5 × (12-10)2+0.2 × (-10-10)2
= 30 + 2 + 80
= 112
Stock B’s expected std. dev. = √112 = 10.58%
Portfolio AB’s expected return = Wt. in A × E(RA) + Wt. in B × E(RB)
= .4 × 8.4% + .6 × 10% = 9.36%
OR
We can calculate the portfolio’s conditional returns and then compute the expected return
and standard deviation/variance.
Portfolio AB’s recession return = .4 × (-12) + .6 × (20) = 7.2%
Portfolio AB’s normal return = .4 × (14) + .6 × (12) = 12.8%
Portfolio AB’s boom return = .4 × (25) + .6 × (-10) = 4%
Portfolio AB’s expected return = 0.3 × 7.2+0.5 × 12.8+0.2 × 4 = 9.36%
Portfolio AB’s expected variance = 0.3 × (7.2-9.36)2+0.5 × (12.8-9.36)2+0.2 × (4-
9.36)2

= 1.39968 + 5.9168 + 5.74592

= 13.0624
Portfolio AB’s expected std. dev. = √13.0624 = 3.61%

Q4 Listed below are the annual rates of return earned on Stock × and Stock Y over the
past 6 years. Which stock was riskier and why?
Stock Stock
Year X Y
2014 20% 16%
2015 15% 17%
2016 -10% 20%
2017 30% 24%
2018 25% 23%
2019 14% -10%

ANSWER
Year Stock X Stock Y (X-Mean)2 (Y-Mean)2
2004 20% 16% 0.001877778 0.0001
2005 15% 17% 4.44444E-05 0.0004
2006 -10% 20% 0.065877778 0.0025
2007 30% 24% 0.020544444 0.0081
2008 25% 23% 0.008711111 0.0064
2009 14% -10% 0.000277778 0.0625
Average 16% 15% 0.019466667 0.016 Variance
13.95% 12.65% Std. dev.
 We calculate each stock’s average return, variance, and standard deviation over the past 6
years and compare their risk per unit of return i.e. σ/Average
Stock X Stock Y
Average return 16% 15%
Standard Deviation 13.95% 12.65%
Standard Deviation 0.8718% 0.8433%
Average Return
Stock × was riskier than Stock Y since it had the higher Standard Deviation of the two,
and its average return was not much higher than Stock Y’s average return resulting in
0.872% risk per unit of return versus Stock Y’s 0.843%risk per unit of return.

Q5 Use the information in the following to answer the questions below.

State of Probability Return on R Return on S Return on T

Economy of State in State in State in State
Boom .15 0.040 0.280 0.450
Growth .25 0.040 0.140 0.275
Stagnant .35 0.040 0.070 0.025
Recession .25 0.040 -0.035 -0.175
a. What is the expected return of each asset?

ANSWER (a)
Expected Return R = 0.15 × 0.04 + 0.25 × 0.04 + 0.35 × 0.04 + 0.25 × 0.04
= 0.0060 + 0.0100 + 0.0140 + 0.0100= 0.0040 or 4.0%
Expected Return S = 0.15 × 0.28 + 0.25 × 0.14 + 0.35 × 0.07 + 0.25 × -0.035
= 0.0420 + 0.0350 + 0.0245 – 0.0088 = 0.0928 or 9.28%
Expected Return T = 0.15 × 0.45 + 0.25 × 0.275 + 0.35 × 0.025 + 0.25 × -0.175
= 0.0675 + 0.0688 + 0.0088 – 0.0438 = 0.1013 or 10.13%

b. What are the variances and standard deviations of each asset?

ANSWER (b)
σ2 (R) = 0.15 × (0.04 – 0.04)2 + 0.25 × (0.04 – 0.04)2 + 0.35 × (0.04-
0.04)2 + 0.25 × (0.04 – 0.04)2
= 0.15 × 0.0000 + 0.25 × 0.0000 + 0.35 × 0.0000 + 0.25 × 0.0000
= 0.0000+ 0.0000 + 0.0000 + 0.0000 = 0.0000
Standard Deviation of R = (0.0000)1/2 = 0.0000 or 0.00%
σ (S) = 0.15 × (0.28 – 0.0928)2 + 0.25 × (0.14 – 0.0928)2 + 0.35 × (0.07
2

– 0.0928)2 + 0.25 × (-0.035 – 0.0928)2

= 0.15 × 0.0350 + 0.25 × 0.0022 + 0.35 × 0.0005 + 0.25 × 0.0163
= 0.0053 + 0.0006 + 0.0002 + 0.0041 = 0.0101
Standard Deviation of S = (0.0101)1/2 = 0.1004 or 10.04%
σ (T) = 0.15 × (0.45 – 0.1013)2 + 0.25 × (0.275 – 0.1013)2 + 0.35 ×
2

(0.025 – 0.1013)2 + 0.25 × (-0.175 – 0.1013)2

= 0.15 × 0.1216 + 0.25 × 0.0302 + 0.35 × 0.0058 + 0.25 × 0.0763
 = 0.0182 + 0.0075 + 0.0020 + 0.0191 = 0.0469
Standard Deviation of T = (0.0469)1/2 = 0.2166 or 21.66%

c. What is the expected return of a portfolio with equal investment in all three
assets?

ANSWER (c)
Expected Return Portfolio = 0.3333 × 0.04 + 0.3333 × 0.0928 + 0.3333 ×
0.1013
= 0.0133 + 0.0309 + 0.0338 = 0.0780 or 7.80%
OR
First determine the portfolio’s return in each state of the economy with the allocation of
assets at 1/3 in R, 1/3 in S, and 1/3 in T.
Expected Return Portfolio in Boom = 0.3333 × 0.04 + 0.3333 × 0.28 + 0.3333 × 0.45
= 0.0133 + 0.0933 + 0.1500 = 0.2567 or 25.67%
Expected Return Portfolio in Growth = 0.3333 × 0.04 + 0.3333 × 0.14 + 0.3333 × 0.275
= 0.0133 + 0.0467 + 0.0917 = 0.1517 or 15.17%
Expected Return Portfolio in Stagnant = 0.3333 × 0.04 + 0.3333 × 0.07 + 0.3333 ×
0.025
= 0.0133 + 0.0233 + 0.0083 = 0.0450 or 4.50%
Expected Return Portfolio in Recession = 0.3333 × 0.04 + 0.3333 × (-0.035) + 0.3333 ×
(-0.175)
= 0.0133 – 0.0117 – 0.0583 = -0.0567 or -5.67%
Now take the probability of each state times the portfolio outcome in that state:
Expected Return Portfolio = 0.15 × 0.2567 + 0.25 × 0. 1517 + 0.35 × 0.0450 +
0.25 × -0.0567
= 0.0385+ 0.0379 + 0.0158 – 0.0142 = 0.0780 or
7.80%
Note that either way produces the same expected return but that for the variance
calculation the portfolio returns in the three economic states are needed.

d. What is the portfolio’s variance and standard deviation using the same asset
weights in part c?
ANSWER (d)
Variance of Portfolio = 0.15 × (0.2567 – 0.0780)2 + 0.25 × (0.1517 –
0.0780)2 + 0.35 × (0.045 – 0.0780)2 + 0.25 × (-
0.0567 – 0.0780)2
= 0.15 × 0.0319 + 0.25 × 0.0054 + 0.35 × 0.00.11 +
0.25 × 0.0181
= 0.0048+ 0.0014 + 0.0004 + 0.0045 = 0.0111
Standard Deviation of Portfolio = (0.0111)1/2 = 0.1052 or 10.52%

Q6 B C Inc. originally purchased the rookie card of Aaron for Rs35.00. After holding the
card for five years, B C auctioned off the card for Rs180.00. What are the holding period
return and the annual return on this investment?
ANSWER
Holding Period Return = (Rs180 – Rs35) / Rs35 = 4.1429 or
414.29% Annual Percentage return= HPR/n =
414.29%/5=82.86%
EAR = (1 + 4.1429)1/5 – 1 = 1.3875 – 1 = 0.3875 or 38.75%
OR
Using a financial calculator:
PV= -35; FV = 180; N = 5; PMT = 0; I = 38.75% ==>

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