CHAPTER 11

RISK, RETURN, AND THE CAPITAL

ASSET PRICING MODEL
Answers to Concepts Review and Critical Thinking Questions

1. 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. a. systematic
b. unsystematic
c. both; probably mostly systematic
d. unsystematic
e. unsystematic
f. systematic

3. No to both questions. The portfolio expected return is a weighted average of the asset’s returns, so it
must be less than the largest asset return and greater than the smallest asset return.

4. False. The variance of the individual assets is a measure of the total risk. The variance on a well-
diversified portfolio is a function of systematic risk only.

5. Yes, the standard deviation can be less than that of every asset in the portfolio. However, P cannot
be less than the smallest beta because P is a weighted average of the individual asset betas.

6. Yes. It is possible, in theory, to construct a zero beta portfolio of risky assets whose return would be
equal to the risk-free rate. It is also possible to have a negative beta; the return would be less than the
risk-free rate. A negative beta asset would carry a negative risk premium because of its value as a
diversification instrument.

7. The covariance is a more appropriate measure of a security’s risk in a well-diversified portfolio

because the covariance reflects the effect of the security on the variance of the portfolio. Investors
are concerned with the variance of their portfolios and not the variance of the individual securities.
Since covariance measures the impact of an individual security on the variance of the portfolio,
covariance is the appropriate measure of risk.
 CHAPTER 11 -2

8. If we assume that the market has not stayed constant during the past three years, then the lack in
movement of Midwest Co.’s stock price only indicates that the stock either has a standard deviation
or a beta that is very near to zero. The large amount of movement in Tennessee Instruments’ stock
price does not imply that the firm’s beta is high. Total volatility (the price fluctuation) is a function
of both systematic and unsystematic risks. The beta only reflects the systematic risk. Observing the
standard deviation of price movements does not indicate whether the price changes were due to
systematic factors or firm specific factors. Thus, if you observe large stock price movements like
that of Tennessee Instruments’ stock price movements, you cannot claim that the beta of the stock is
high. All you know is that the total risk of Tennessee Instruments is high.

9. The wide fluctuations in the price of oil stocks do not indicate that these stocks are a poor
investment. If an oil stock is purchased as part of a well-diversified portfolio, only its contribution to
the risk of the entire portfolio matters. This contribution is measured by systematic risk or beta.
Since price fluctuations in oil stocks reflect diversifiable plus nondiversifiable risks, observing the
standard deviation of price movements is not an adequate measure of the appropriateness of adding
oil stocks to a portfolio.

10. The statement is false. If a security has a negative beta, investors would want to hold the asset to
reduce the variability of their portfolios. Those assets will have expected returns that are lower than
the risk-free rate. To see this, examine the Capital Asset Pricing Model:

E(R) = RF + [E(RM) – RF]

If  < 0, then the E(R) < RF

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

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

Total portfolio value = 145($47) + 200($21)

Total portfolio value = $11,015

The portfolio weight for each stock is:

XA = 145($47)/$11,015
XA = .6187

XB = 200($21)/$11,015
XB = .3813
 CHAPTER 11 -3

2. The expected return of a portfolio is the sum of the weight of each asset times the expected return of
each asset. The total value of the portfolio is:

Total portfolio value = $4,450 + 9,680

Total portfolio value = $14,130

So, the expected return of this portfolio is:

E(RP) = ($4,450/$14,130)(.08) + ($9,680/$14,130)(.11)

E(RP) = .1006, or 10.06%

3. 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) = .15(.09) + .35(.15) + .50(.12)

E(RP) = .1260, or 12.60%

4. Here we are given the expected return of the portfolio and the expected return of each asset in the
portfolio and are asked to find the weight of each asset. We can use the equation for the expected
return of a portfolio to solve this problem. Since the total weight of a portfolio must equal 1 (100%),
the weight of Stock Y must be one minus the weight of Stock X. Mathematically speaking, this
means:

E(RP) = .1085 = .124wX + .101(1 – wX)

We can now solve this equation for the weight of Stock X as:

.1085 = .124wX + .101 – .101wX

.0075 = .023wX
wX = .3261

So, the dollar amount invested in Stock X is the weight of Stock X times the total portfolio value, or:

Investment in X = .3261($10,000)
Investment in X = $3,260.87

And the dollar amount invested in Stock Y is:

Investment in Y = (1 – .3261)($10,000)
Investment in Y = $6,739.13
 CHAPTER 11 -4

5. The expected return of an asset is the sum of each return times the probability of that return
occurring. So, the expected return of each stock asset is:

E(RA) = .15(.04) + .55(.09) + .30(.17)

E(RA) = .1065, or 10.65%

E(RB) = .15(–.17) + .55(.12) + .30(.27)

E(RB) = .1215, or 12.15%

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

A2 = .15(.04 – .1065)2 + .55(.09 – .1065)2 + .30(.17 – .1065)2

A2 = .00202

A = .002021/2
A = .0450, or 4.50%

B2 = .15(–.17 – .1215)2 + .55(.12 – .1215)2 + .30(.27 – .1215)2

B2 = .01936

B = .019361/2
B = .1392, or 13.92%

6. The expected return of an asset is the sum of the probability of each return occurring times the
probability of that return occurring. So, the expected return of the stock is:

E(RA) = .15(–.184) + .30(.029) + .45(.173) + .10(.372)

E(RA) = .0962, or 9.62%

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 are:

2 =.15(–.184 – .0962)2 + .30(.029 – .0962)2 + .45(.173 – .0962)2 + .10(.372 – .0962)2

2 = .02339

 = .023391/2
 = .1529, or 15.29%

7. 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) = .45(.11) + .40(.09) + .15(.15)

E(RP) = .1080, or 10.80%

If we own this portfolio, we would expect to get a return of 10.80 percent.

 CHAPTER 11 -5

8. a. 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 of an equally weighted portfolio, we can sum the returns of
each asset and divide by the number of assets, so the return of the portfolio in each state of the
economy is:

Boom: RP = (.07 + .18 + .27)/3 = .1733, or 17.33%

Bust: RP = (.12 – .08  .21)/3 = –.0567, or –5.67%

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 the products. Doing so, we find:

E(RP) = .75(.1733) + .25(–.0567)

E(RP) = .1158, or 11.58%

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: RP = .20(.07) +.20(.18) + .60(.27) = .2120, or 21.20%

Bust: RP = .20(.12) +.20(–.08) + .60(.21) = –.1180, or –11.80%

And the expected return of the portfolio is:

E(RP) = .75(.2120) + .25(.1180)

E(RP) = .1295, or 12.95%

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 of the portfolio is:

P2 = .75(.2120 – .1295)2 + .25(.1180 – .1295)2

P2 = .020419

9. a. This portfolio does not have an equal weight in each asset. We first 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 = .30(.35) + .40(.40) + .30(.28) = .3490, or 34.90%

Good: RP = .30(.16) + .40(.17) + .30(.09) = .1430, or 14.30%
Poor: RP = .30(–.01) + .40(–.03) + .30(.01) = –.0120, or –1.20%
Bust: RP = .30(–.10) + .40(–.12) + .30(–.09) = –.1050, or –10.50%

And the expected return of the portfolio is:

E(RP) = .15(.3490) + .45(.1430) + .30(–.0120) + .10(–.1050)

E(RP) = .1026, or 10.26%
 CHAPTER 11 -6

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

P2 = .15(.3490 – .1026)2 + .45(.1430 – .1026)2 + .30(–.0120 – .1026)2 + .10(–.1050 – .1026)2

P2 = .01809

P = .018091/2
P = .1345, or 13.45%

10. The beta of a portfolio is the sum of the weight of each asset times the beta of each asset. So, the
beta of the portfolio is:

P = .15(.79) + .20(1.23) + .30(1.13) + .35(1.36)

P = 1.18

11. The beta of a portfolio is the sum of the weight of each asset times the beta of each asset. If the
portfolio is as risky as the market, it must have the same beta as the market. Since the beta of the
market is one, we know the beta of our portfolio is one. We also need to remember that the beta of
the risk-free asset is zero. It has to be zero since the asset has no risk. Setting up the equation for the
beta of our portfolio, we get:

P = 1.0 = 1/3(0) + 1/3(1.34) + 1/3(X)

Solving for the beta of Stock X, we get:

X = 1.66

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

E(Ri) = RF + [E(RM) – RF] × i

Substituting the values we are given, we find:

E(Ri) = .036 + (.113 – .036)(1.15)

E(Ri) = .1246, or 12.46%

13. We are given the values for the CAPM except for the beta of the stock. We need to substitute these
values into the CAPM, and solve for the beta 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) = .114 = .039 + .068i

i = 1.10
 CHAPTER 11 -7

14. Here we need to find the expected return of the market using the CAPM. Substituting the values
given, and solving for the expected return of the market, we find:

E(Ri) = .1185 = .039 + [E(RM) – .039](1.08)

E(RM) = .1126, or 11.26%

15. Here we need to find the risk-free rate using the CAPM. Substituting the values given, and solving
for the risk-free rate, we find:

E(Ri) = .1045 = RF + (.118 – RF)(.85)

.1045 = RF + .1003 – .85RF

RF = .0280, or 2.80%

16. 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:

E(RP) = (.124 + .027)/2

E(RP) = .0755, or 7.55%

b. We need to find the portfolio weights that result in a portfolio with a beta of .92. We know the
beta 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 = .92 = XS(1.19) + (1 – XS)(0)

.92 = 1.19XS + 0 – 0XS
XS = .92/1.19
XS = .7731

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

XRf = 1 – .7731
XRf = .2269

c. 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 = .124XS + .027(1 – XS)

.10 = .124XS + .027 – .027XS
.073 = .097XS
XS = .7526

So, the beta of the portfolio will be:

P = .7526(1.19) + (1 – .7526)(0)
P = .896
 CHAPTER 11 -8

d. Solving for the beta of the portfolio as we did in part b, we find:

P = 2.38 = XS(1.19) + (1 – XS)(0)

XS = 2.38/1.19 = 2

XRf = 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.

17. First, we need to find the beta of the portfolio. The beta of the risk-free asset is zero, and the weight
of the risk-free asset is one minus the weight of the stock, so the beta of the portfolio is:

ßP = XW(.85) + (1 – XW)(0) = .85XW

So, to find the beta of the portfolio for any weight of the stock, we multiply the weight of the stock
times its beta.
Even though we are solving for the beta 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) = .088 = .026 + MRP(.85)

MRP = .062/.85
MRP = .0729, or 7.29%

So, now we know the CAPM equation for any stock is:

E(RP) = .026 + .0729P

The slope of the SML is equal to the market risk premium, which is .0729. Using these equations to fill in
the table, we get the following results:

  XW E(RP) ßP
  0% 2.60% 0.00
  25 4.15 .213
  50 5.70 .425
  75 7.25 .638
  100 8.80 .850
  125 10.35 1.063
  150 11.90 1.275

18. There are two ways to correctly answer this question so we will work through both. First, we can use
the CAPM. Substituting in the value we are given for each stock, we find:
 CHAPTER 11 -9

E(RY) = .032 + .068(1.20)

E(RY) = .1136, or 11.36%

It is given in the problem that the expected return of Stock Y is 11.5 percent, but according to the
CAPM the expected return of the stock should be 11.36 percent based on its level of risk. 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 11.36 percent.

For Stock Z, we find:

E(RZ) = .032 + .068(.80)

E(RZ) = .0864, or 8.64%

The return given for Stock Z is 8.5 percent, but according to the CAPM the expected return of the
stock should be 8.64 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 8.64 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 beta. We
are given the market risk premium, and we know the beta of the market is one, so the reward-to-risk
ratio for the market is .068, or 6.8 percent. Calculating the reward-to-risk ratio for Stock Y, we find:

Reward-to-risk ratio Y = (.1150 – .032)/1.20

Reward-to-risk ratio Y = .0692, or 6.92%

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 = (.0850 – .032)/.80

Reward-to-risk ratio Z = .0663, or 6.63%

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.

19. We need to set the reward-to-risk ratios of the two assets equal to each other, which is:

(.1150 – RF)/1.20 = (.0850 – RF)/.80

We can cross multiply to get:

.80(.1150 – RF) = 1.20(.0850 – RF)

 CHAPTER 11 -10

Solving for the risk-free rate, we find:

.0920 – .80RF = .1020 – 1.20RF

RF = .0250, or 2.50%

Intermediate

20. For a portfolio that is equally invested in large-company stocks and long-term bonds:

Return = (12.1% + 6.0%)/2

Return = 9.05%

For a portfolio that is equally invested in small stocks and Treasury bills:

Return = (16.5% + 3.5%)/2

Return = 10.00%

21. We know that the reward-to-risk ratios for all assets must be equal (See Question 19). This can be
expressed as:

[E(RA) – RF]/A = [E(RB) – RF]/B

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.

22. 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: RP = .4(.13) + .4(.29) + .2(.60) = .2880, or 28.80%

Normal: RP = .4(.08) + .4(.11) + .2(.13) = .1020, or 10.20%
Bust: RP = .4(.02) + .4(–.18) + .2(–.45) = –.1540, or –15.40%

And the expected return of the portfolio is:

E(RP) = .25(.288) + .60(.102) + .15(–.154)

E(RP) = .1101, or 11.01%
 CHAPTER 11 -11

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

P2 = .25(.288 – .1101)2 + .60(.102 – .1101)2 + .15(–.154 – .1101)2

P2 = .01841

P = .018411/2
P = .1357, or 13.57%

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 = .1101 – .0370

E(RP) – RF = .0731, or 7.31%

c. The approximate expected real return is the expected nominal return minus the inflation rate,
so:

Approximate expected real return = .1101 – .0330

Approximate expected real return = .0771, or 7.71%

To find the exact real return, we will use the Fisher equation. Doing so, we get:

1 + E(Ri) = (1 + h)[1 + e(ri)]

1.1101 = (1.0330)[1 + e(ri)]
e(ri) = (1.1101/1.0330) – 1
e(ri) = .0746, or 7.46%

The approximate real risk-free rate is:

Approximate expected real return = .037 – .033

Approximate expected real return = .004, or .40%

And using the Fisher effect for the exact real risk-free rate, we find:

1 + E(Ri) = (1 + h)[1 + e(ri)]

1.037 = (1.033)[1 + e(ri)]
e(ri) = (1.037/1.033) – 1
e(ri) = .0039, or .39%

The approximate real risk premium is the approximate expected real return minus the risk-free
rate, so:

Approximate expected real risk premium = .0771 – .004

Approximate expected real risk premium = .0731, or 7.31%
 CHAPTER 11 -12

The exact real risk premium is the exact real return minus the exact risk-free rate, so:

Exact expected real risk premium = .0746 – .0039

Exact expected real risk premium = .0708, or 7.08%

23. We know the total portfolio value and the investment in two stocks in the portfolio, so we can find
the weight of these two stocks. The weights of Stock A and Stock B are:

XA = $195,000/$1,000,000 = .195

XB = $365,000/$1,000,000 = .365

Since the portfolio is as risky as the market, the beta of the portfolio must be equal to one. We also know
the beta of the risk-free asset is zero. We can use the equation for the beta of a portfolio to find the weight
of the third stock. Doing so, we find:

P = 1 = XA(.80) + XB(1.09) + XC(1.23) + XRf(0)

1 = .195(.80) + .365(1.09) + XC(1.23)

Solving for the weight of Stock C, we find:

XC = .36272358

So, the dollar investment in Stock C must be:

Investment in Stock C = .36272358($1,000,000)

Investment in Stock C = $362,723.58

We also know the total portfolio weight must be one, so the weight of the risk-free asset must be one
minus the asset weights we know, or:

1 = XA + XB + XC + XRf
XRf = 1 – .195 – .365 – .36272358
XRf = .07727642

So, the dollar investment in the risk-free asset must be:

Investment in risk-free asset = .07727642($1,000,000)

Investment in risk-free asset = $77,276.42

24. 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) = .1210 = XX(.1028) + XY(.0752)

.1210 = XX(.1028) + (1 – XX)(.0752)
.1210 = .1028XX + .0752 – .0752XX
.0458 = .0276XX
XX = 1.6594
 CHAPTER 11 -13

And the weight of Stock Y is:

XY = 1 – 1.6594
XY = –.6594

The amount to invest in Stock Y is:

Investment in Stock Y = –.6594($100,000)

Investment in Stock Y = –$65,942.03

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.

To find the beta of the portfolio, we can multiply the portfolio weight of each asset times its beta and
sum. So, the beta of the portfolio is:

P = 1.6594(1.20) + (–.6594)(.80)
P = 1.464

25. 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(RA) = .33(.073) + .33(.134) + .33(.062)

E(RA) = .0897, or 8.97%

E(RB) = .33(–.094) + .33(.142) + .33(.321)

E(RB) = .1230, or 12.30%

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 sum. The result is the variance. So, the variance and standard
deviation of Stock A are:
2
 A = .33(.073 – .0897)2 + .33(.134 – .0897)2 + .33(.062 – .0897)2
2
 A = .00100

A = .001001/2
A = .0317, or 3.17%

And the standard deviation of Stock B is:

2
 B = .33(–.094 – .1230)2 + .33(.142 – .1230)2 + .33(.321 – .1230)2
2
 B = .02888

B = .028881/2
B = .1700, or 17.00%
 CHAPTER 11 -14

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(A,B) = .33(.073 – .0897)(–.094 – .1230) + .33(.134 – .0897)(.142 – .1230)

+ .33(.062 – .0897)(.321 – .1230)
Cov(A,B) = –.000340

And the correlation is:

A,B = Cov(A,B)/AB
A,B = –.000340/(.0317)(.1700)
A,B = –.0631

26. 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(–.063) + .55(.109) + .15(.293)

E(RJ) = .0850, or 8.50%

E(RK) = .30(.014) + .55(.081) + .15(.104)

E(RK) = .0644, or 6.44%

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 sum. The result is the variance. So, the variance and standard
deviation of Stock J are:

2
 J = .30(–.063 – .0850)2 + .55(.109 – .0850)2 + .15(.293 – .0850)2
2
 J = .01338

J = .013381/2
J = .1157, or 11.57%

And the variance and standard deviation of Stock K are:

2
 K = .30(.014 – .0644)2 + .55(.081 – .0644)2 + .15(.104 – .0644)2
2
 K = .00115

K = .001151/2
K = .0339, or 3.39%

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(–.063 – .0850)(.014 – .0644) + .55(.109 – .0850)(.081 – .0644)

+ .15(.293 – .0850)(.104 – .0644)
Cov(J,K) = .003692
 CHAPTER 11 -15

And the correlation is:

J,K = Cov(J,K)/JK
J,K = .003692/(.1157)(.0339)
J,K = .9419

27. a. The expected return of the portfolio is the sum of the weight of each asset times the expected
return of each asset, so:

E(RP) = XFE(RF) + XGE(RG)

E(RP) = .40(.09) + .60(.12)
E(RP) = .1080, or 10.80%

b. The variance of a portfolio of two assets can be expressed as:

2 2 2 2 2
 P = X F  F + X G  G + 2XFXG FGF,G
2
 P = .402(.432) + .602(.762) + 2(.40)(.60)(.43)(.76)(.25)
2
 P = .27674

So, the standard deviation is:

P = .276741/2
P = .5261, or 52.61%

28. a. The expected return of the portfolio is the sum of the weight of each asset times the expected
return of each asset, so:

E(RP) = XAE(RA) + XBE(RB)

E(RP) = .40(.10) + .60(.12)
E(RP) = .1120, or 11.20%

The variance of a portfolio of two assets can be expressed as:

2 2 2 2 2
 P = X A  A + X B  B + 2XAXBABA,B
2
 P = .402(.392) + .602(.722) + 2(.40)(.60)(.39)(.72)(.50)
2
 P = .27835

So, the standard deviation is:

P = .278351/2
P = .5276, or 52.76%
2 2 2 2 2
b.  P = X A  A + X B  B + 2XAXBABA,B
2
 P = .402(.392) + .602(.722) + 2(.40)(.60)(.39)(.72)(–.50)
2
 P = .14357
 CHAPTER 11 -16

So, the standard deviation is:

 = .143571/2
 = .3789, or 37.89%

c. As Stock A and Stock B become less correlated, or more negatively correlated, the standard
deviation of the portfolio decreases.

29. a. (i) Using the equation to calculate beta, we find:

A = (A,M)(A)/M
.90 = (A,M)(.38)/.18
A,M = .43

(ii) Using the equation to calculate beta, we find:

B = (B,M)(B)/M
1.35 = (.45)(B)/.18
B = .54

(iii) Using the equation to calculate beta, we find:

C = (C,M)(C)/M
C = (.32)(.74)/.18
C = 1.32

(iv) The market has a correlation of 1 with itself.

(v) The beta of the market is 1.

(vi) The risk-free asset has zero standard deviation.

(vii) The risk-free asset has zero correlation with the market portfolio.

(viii) The beta of the risk-free asset is 0.

b. Using the CAPM to find the expected return of the stock, we find:

Firm A:
E(RA) = RF + A[E(RM) – RF]
E(RA) = .04 + .90(.12 – .04)
E(RA) = .1120, or 11.20%
 CHAPTER 11 -17

According to the CAPM, the expected return on Firm A’s stock should be 11.20 percent.
However, the expected return on Firm A’s stock given in the table is only 10 percent.
Therefore, Firm A’s stock is overpriced, and you should sell it.

Firm B:
E(RB) = RF + B[E(RM) – RF]
E(RB) = .04 + 1.35(.12 – .04)
E(RB) = .1480, or 14.80%

According to the CAPM, the expected return on Firm B’s stock should be 14.80 percent.
However, the expected return on Firm B’s stock given in the table is 14 percent. Therefore,
Firm B’s stock is overpriced, and you should sell it.

Firm C:
E(RC) = RF + C[E(RM) – RF]
E(RC) = .04 + 1.32(.12 – .04)
E(RC) = .1452, or 14.52%

According to the CAPM, the expected return on Firm C’s stock should be 14.52 percent.
However, the expected return on Firm C’s stock given in the table is 15 percent. Therefore,
Firm C’s stock is underpriced, and you should buy it.

30. Because a well-diversified portfolio has no unsystematic risk, this portfolio should lie on the Capital
Market Line (CML). The slope of the CML equals:

SlopeCML = [E(RM) – RF]/M

SlopeCML = (.113 – .045)/.18
SlopeCML = .37778

a. The expected return on the portfolio equals:

E(RP) = RF + SlopeCML(P)
E(RP) = .045 + .37778(.14)
E(RP) = .0979, or 9.79%

b. The standard deviation for the portfolio equals:

E(RP) = RF + SlopeCML(P)
.19 = .045 + .37778(P)
P = .3838, or 38.38%
 CHAPTER 11 -18

31. First, we can calculate the standard deviation of the market portfolio using the Capital Market Line
(CML). We know that the risk-free asset has a return of 4.3 percent and a standard deviation of zero
and the portfolio has an expected return of 9 percent and a standard deviation of 14 percent. These
two points must lie on the Capital Market Line. The slope of the Capital Market Line equals:

SlopeCML = Rise/Run
SlopeCML = Increase in expected return/Increase in standard deviation
SlopeCML = (.09 – .043)/(.14 – 0)
SlopeCML = .3357

According to the Capital Market Line:

E(RI) = RF + SlopeCML(I)

Since we know the expected return on the market portfolio, the risk-free rate, and the slope of the
Capital Market Line, we can solve for the standard deviation of the market portfolio which is:

E(RM) = RF + SlopeCML(M)
.115 = .043 + (.3357)(M)
M = (.115 – .043)/.3357
M = .2145, or 21.45%

Next, we can use the standard deviation of the market portfolio to solve for the beta of a security
using the beta equation. Doing so, we find the beta of the security is:

I = (I,M)(I)/M
I = (.29)(.55)/.2145
I = .74

Now we can use the beta of the security in the CAPM to find its expected return, which is:

E(RI) = RF + I[E(RM) – RF]

E(RI) = .043 + .74(.115 – .043)
E(RI) = .0965, or 9.65%

32. First, we need to find the standard deviation of the market and the portfolio, which are:

M = .03151/2
M = .1775, or 17.75%

Z = .31921/2
Z = .5650, or 56.50%

Now, we can use the equation for beta to find the beta of the portfolio, which is:

Z = (Z,M)(Z)/M
Z = (.32)(.5650)/.1775
Z = 1.02
 CHAPTER 11 -19

Now, we can use the CAPM to find the expected return of the portfolio, which is:

E(RZ) = RF + Z[E(RM) – RF]

E(RZ) = .039 + 1.02(.114 – .039)
E(RZ) = .1154, or 11.54%

Challenge

33. The amount of systematic risk is measured by the beta of an asset. Since we know the market risk
premium and the risk-free rate, if we know the expected return of the asset we can use the CAPM to
solve for the beta of the asset. The expected return of Stock I is:

E(RI) = .15(.05) + .70(.18) + .15(.07)

E(RI) = .1440, or 14.40%

Using the CAPM to find the beta of Stock I, we find:

.1440 = .035 + .07I

I = 1.56

The total risk of the asset is measured by its standard deviation, so we need to calculate the standard
deviation of Stock I. Beginning with the calculation of the stock’s variance, we find:

I2 = .15(.05 – .1440)2 + .70(.18 – .1440)2 + .15(.07 – .1440)2

I2 = .00305

I = .003051/2
I = .0553, or 5.53%

Using the same procedure for Stock II, we find the expected return to be:

E(RII) = .15(–.21) + .70(.10) + .15(.39)

E(RII) = .0970, or 9.70%

Using the CAPM to find the beta of Stock II, we find:

.0970 = .035 + .07II

II = .89

And the standard deviation of Stock II is:

II2 = .15(–.21 – .0970)2 + .70(.10 – .0970)2 + .15(.39 – .0970)2

II2 = .02702

II = .027021/2
II = .1644, or 16.44%
 CHAPTER 11 -20

Although Stock II has more total risk than I, it has much less systematic risk, since its beta is much
smaller than I’s. Thus, I has more systematic risk, and II has more unsystematic and total risk. Since
unsystematic risk can be diversified away, I is actually the “riskier” stock despite the lack of
volatility in its returns. Stock I will have a higher risk premium and a greater expected return.

34. Here we have the expected return and beta for two assets. We can express the returns of the two
assets using CAPM. If the CAPM is true, then the security market line holds as well, which means
all assets have the same risk premium. Setting the risk premiums of the assets equal to each other
and solving for the risk-free rate, we find:

(.108 – RF)/1.25 = (.082 – RF)/.87

.87(.108 – RF) = 1.25(.082 – RF)
.09396 – .87RF = .1025 – 1.25RF
.38RF = .00854
RF = .0225, or 2.25%

Now using CAPM to find the expected return on the market with both stocks, we find:

.108 = .0225 + 1.25(RM – .0225) .082 = .0225 + .87(RM – .0225)

RM = .0909, or 9.09% RM = .0909, or 9.09%

35. a. 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. 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 sum. The result is the
variance. So, the expected return and standard deviation of each stock are:

Asset 1:
E(R1) = .15(.20) + .35(.15) + .35(.10) + .15(.05) = .1250, or 12.50%
2
 1 =.15(.20 – .1250)2 + .35(.15 – .1250)2 + .35(.10 – .1250)2 + .15(.05 – .1250)2 = .00213

1 = .002131/2 = .0461, or 4.61%

Asset 2:
E(R2) = .15(.20) + .35(.10) + .35(.15) + .15(.05) = .1250, or 12.50%
2
 2 =.15(.20 – .1250)2 + .35(.10 – .1250)2 + .35(.15 – .1250)2 + .15(.05 – .1250)2 = .00213

2 = .002131/2 = .0461, or 4.61%

Asset 3:
E(R3) = .15(.05) + .35(.10) + .35(.15) + .15(.20) = .1250, or 12.50%
2
 3 =.15(.05 – .1250)2 + .35(.10 – .1250)2 + .35(.15 – .1250)2 + .15(.20 – .1250)2 = .00213

3 = .002131/2 = .0461, or 4.61%

 CHAPTER 11 -21

b. 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. The
correlation is the covariance divided by the product of the two standard deviations. So, the
covariance and correlation between each possible set of assets are:

Asset 1 and Asset 2:

Cov(1,2) = .15(.20 – .1250)(.20 – .1250) + .35(.15 – .1250)(.10 – .1250)
+ .35(.10 – .1250)(.15 – .1250) + .15(.05 – .1250)(.05 – .1250)
Cov(1,2) = .00125

1,2 = Cov(1,2)/1 2
1,2 = .00125/(.0461)(.0461)
1,2 = .5882

Asset 1 and Asset 3:

Cov(1,3) = .15(.20 – .1250)(.05 – .1250) + .35(.15 – .1250)(.10 – .1250)
+ .35(.10 – .1250)(.15 – .1250) + .15(.05 – .1250)(.20 – .1250)
Cov(1,3) = –.002125

1,3 = Cov(1,3)/1 3
1,3 = –.002125/(.0461)(.0461)
1,3 = –1

Asset 2 and Asset 3:

Cov(2,3) = .15(.20 – .1250)(.05 – .1250) + .35(.10 – .1250)(.10 – .1250)
+ .35(.15 – .1250)(.15 – .1250) + .15(.05 – .1250)(.20 – .1250)
Cov(2,3) = –.00125

2,3 = Cov(2,3)/2 3
2,3 = –.00125/(.0461)(.0461)
2,3 = –.5882

c. The expected return of the portfolio is the sum of the weight of each asset times the expected
return of each asset, so, for a portfolio of Asset 1 and Asset 2:

E(RP) = X1E(R1) + X2E(R2)

E(RP) = .50(.1250) + .50(.1250)
E(RP) = .1250, or 12.50%

The variance of a portfolio of two assets can be expressed as:

2 2 2 2 2
 P = X 1  1 + X 2  2 + 2X1X2121,2
2
 P = .502(.04612) + .502(.04612) + 2(.50)(.50)(.0461)(.0461)(.5882)
2
 P = .001688

And the standard deviation of the portfolio is:

P = .0016881/2
P = .0411, or 4.11%
 CHAPTER 11 -22

d. The expected return of the portfolio is the sum of the weight of each asset times the expected
return of each asset, so, for a portfolio of Asset 1 and Asset 3:

E(RP) = X1E(R1) + X3E(R3)

E(RP) = .50(.1250) + .50(.1250)
E(RP) = .1250, or 12.50%

The variance of a portfolio of two assets can be expressed as:

2 2 2 2 2
 P = X 1  1 + X 3  3 + 2X1X3131,3
2
 P = .502(.04612) + .502(.04612) + 2(.50)(.50)(.0461)(.0461)(–1)
2
 P = .000000

Since the variance is zero, the standard deviation is also zero.

e. The expected return of the portfolio is the sum of the weight of each asset times the expected
return of each asset, so, for a portfolio of Asset 2 and Asset 3:

E(RP) = X2E(R2) + X3E(R3)

E(RP) = .50(.1250) + .50(.1250)
E(RP) = .1250, or 12.50%

The variance of a portfolio of two assets can be expressed as:

2 2 2 2 2
 P = X 2  2 + X 3  3 + 2X2X3232,3
2
 P = .502(.04612) + .502(.04612) + 2(.50)(.50)(.0461)(.0461)(–.5882)
2
 P = .000438

And the standard deviation of the portfolio is:

P = .0004381/2
P = .0209, or 2.09%

f. As long as the correlation between the returns on two securities is below 1, there is a benefit to
diversification. A portfolio with negatively correlated assets can achieve greater risk reduction
than a portfolio with positively correlated assets, holding the expected return on each asset
constant. Applying proper weights on perfectly negatively correlated assets can reduce
portfolio variance to 0.
 CHAPTER 11 -23

36. a. The expected return of an asset is the sum of the probability of each return occurring times the
probability of that return occurring. So, the expected return of each stock is:

E(RA) = .15(–.08) + .60(.11) + .25(.30)

E(RA) = .1290, or 12.90%

E(RB) = .15(–.10) + .60(.09) + .25(.27)

E(RB) = .1065, or 10.65%

b. We can use the expected returns we calculated to find the slope of the SML. We know that the
beta of Stock A is .35 greater than the beta of Stock B. Therefore, as beta increases by .35, the
expected return on a security increases by .0225 (= .1290 – .1065). The slope of the SML
equals:

SlopeSML = Rise/Run
SlopeSML = Increase in expected return/Increase in beta
SlopeSML = (.1290 – .1065)/.35
SlopeSML = .0643, or 6.43%

Since the market’s beta is 1 and the risk-free rate has a beta of zero, the slope of the SML
equals the expected market risk premium. So, the expected market risk premium must be 6.43
percent.

We could also solve this problem using CAPM. The equations for the expected returns of the
two stocks are:

E(RA) = .1290 = RF + (B + .35)(MRP)

E(RB) = .1065 = RF + B(MRP)

Subtracting the CAPM equation for Stock B from the CAPM equation for Stock A yields:

.0225 = .35MRP
MRP = .0643, or 6.43%

which is the same answer as our previous result.

37. a. A typical, risk-averse investor seeks high returns and low risks. For a risk-averse investor
holding a well-diversified portfolio, beta is the appropriate measure of the risk of an individual
security. To assess the two stocks, we need to find the expected return and beta of each of the
two securities.

Stock A:
Since Stock A pays no dividends, the return on Stock A is: (P1 – P0)/P0. So, the return for each
state of the economy is:

RRecession = ($56 – 68)/$68 = –.1765, or –17.65%

RNormal = ($78 – 68)/$68 = .1471, or 14.71%
RExpanding = ($86 – 68)/$68 = .2647, or 26.47%
 CHAPTER 11 -24

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

E(RA) = .20(–.1765) + .60(.1471) + .20(.2647) = .1059, or 10.59%

And the variance of the stock is:

2
 A = .20(–.1765 – .1059)2 + .60(.1471 – .1059)2 + .20(.2647 – .1059)2
2
 A = .0220

Which means the standard deviation is:

A = .02201/2
A = .1483, or 14.83%

Now we can calculate the stock’s beta, which is:

A = (A,M)(A)/M
A = (.65)(.1483)/.19
A = .508

For Stock B, we can directly calculate the beta from the information provided. So, the beta for
Stock B is:

Stock B:

B = (B,M)(B)/M
B = (.20)(.44)/.19
B = .463

The expected return on Stock B is higher than the expected return on Stock A. The risk of
Stock B, as measured by its beta, is lower than the risk of Stock A. Thus, a typical risk-averse
investor holding a well-diversified portfolio will prefer Stock B. Note, this situation implies
that at least one of the stocks is mispriced since the higher risk (beta) stock has a lower return
than the lower risk (beta) stock.

b. The expected return of the portfolio is the sum of the weight of each asset times the expected
return of each asset, so:

E(RP) = XAE(RA) + XBE(RB)

E(RP) = .70(.1059) + .30(.13)
E(RP) = .1131, or 11.31%

To find the standard deviation of the portfolio, we first need to calculate the variance. The
variance of the portfolio is:
2 2 2 2 2
 P = X A  A + X B  B + 2XAXBABA,B
2
 P = (.70)2(.1483)2 + (.30)2(.44)2 + 2(.70)(.30)(.1483)(.44)(.38)
2
 P = .03862
 CHAPTER 11 -25

And the standard deviation of the portfolio is:

P = .038621/2
P = .1965, or 19.65%

c. The beta of a portfolio is the weighted average of the betas of its individual securities. So the
beta of the portfolio is:

P = .70(.508) + .30(.463)
P = .494

38. a. The variance of a portfolio of two assets equals:

2 2 2 2 2
 P = X A  A + X B  B + 2XAXBCov(A,B)

Since the weights of the assets must sum to one, we can write the variance of the portfolio as:
2 2 2 2
 P = X A  A + (1 – XA)2 B + 2XA(1 – XA)Cov(A,B)

To find the minimum for any function, we find the derivative and set the derivative equal to
zero. Finding the derivative of the variance function with respect to the weight of Asset A,
setting the derivative equal to zero, and solving for the weight of Asset A, we find:
2 2 2
XA = [ B – Cov(A,B)]/[ A +  B – 2Cov(A,B)]

Using this expression, we find the weight of Asset A must be:

XA = (.652 – .003)/[.432 + .652 – 2(.003)]

XA = .6975

This means the weight of Stock B is:

XB = 1 – XA
XB = 1 – .6975
XB = .3025

b. Using the weights calculated in part a, the expected return of the portfolio is:

E(RP) = XAE(RA) + XBE(RB)

E(RP) = .6975(.11) + .3025(.15)
E(RP) = .1221, or 12.21%

c. Using the derivative from part a, with the new covariance, the weight of each stock in the
minimum variance portfolio is:
2 2 2
XA = [ B – Cov(A,B)]/[ A +  B – 2Cov(A,B)]
XA = (.652 – .05)/[.432 + .652 – 2(–.05)]
XA = .6679
 CHAPTER 11 -26

This implies the weight of Stock B is:

XB = 1 – XA
XB = 1 – .6679
XB = .3321

d. The variance of the portfolio with the weights in part c is:

2 2 2 2 2
 P = X A  A + X B  B + 2XAXBCov(A,B)
2
 P = (.6679)2(.43)2 + (.3321)2(.65)2 + 2(.6679)(.3321)(–.05)
2
 P = .1069

And the standard deviation of the portfolio is:

P = .10691/2
P = .3270, or 32.70%
CHAPTER 11 -27