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Practice Questions Risk and Returns

The individual has a portfolio consisting of two stocks, one with a beta of 0.6 and $20,000 invested, and another with a beta of 2.5 and $75,000 invested, for a total portfolio value of $95,000. Using a weighted average calculation based on the investment amounts, the portfolio's overall beta is calculated to be 1.1. A second practice question provides the required return, risk-free rate, and market risk premium to calculate a stock's beta of 1.5. It then asks what would happen to the stock's required return if the market risk premium increased, keeping the risk-free rate and beta the same. The summary calculates the new required return would

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362 views6 pages

Practice Questions Risk and Returns

The individual has a portfolio consisting of two stocks, one with a beta of 0.6 and $20,000 invested, and another with a beta of 2.5 and $75,000 invested, for a total portfolio value of $95,000. Using a weighted average calculation based on the investment amounts, the portfolio's overall beta is calculated to be 1.1. A second practice question provides the required return, risk-free rate, and market risk premium to calculate a stock's beta of 1.5. It then asks what would happen to the stock's required return if the market risk premium increased, keeping the risk-free rate and beta the same. The summary calculates the new required return would

Uploaded by

Muhammad Yahya
Copyright
© © 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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Practice Questions:

8.2 An individual has $20,000 invested in a stock with a beta of 0.6 and another $75,000
invested in a stock with a beta of 2.5. If these are the only two investments in her portfolio,
what is her portfolio’s beta?

Investment Beta
$20,000 0.6
75,000 2.5
Total $95,000

bp = ($20,000/$95,000)(0.6) + ($75,000/$95,000)(2.5) = 2.10.


8.5 A stock has a required return of 9%, the risk-free rate is 4.5%, and the market risk
premium is 3%.
a. What is the stock’s beta?
b. If the market risk premium increased to 5%, what would happen to the stock’s
required rate of return? Assume that the risk-free rate and the beta remain unchanged.

8-5 a. r = 9%; rRF = 4.5%; RPM = 3%.

r = rRF + (rM – rRF)b


9% = 4.5% + 3%b
4.5% = 3%b
b = 1.5.
b. rRF = 4.5%; RPM = 5%; b = 1.5.

r = rRF + (rM – rRF)b


= 4.5% + (5%)1.5
= 12%.
8.6

N
r^ =∑ P i r i
i=1 .

r^B = 0.1(-35%) + 0.2(0%) + 0.4(20%) + 0.2(25%) + 0.1(45%)

= 14% versus 12% for A.

√
N
∑ (ri −r^ )2 Pi
b.  = i=1 .

σ 2A = (-10% – 12%)2(0.1) + (2% – 12%)2(0.2) + (12% – 12%)2(0.4)

+ (20% – 12%)2(0.2) + (38% – 12%)2(0.1) = 148.8.

A = 12.20% versus 20.35% for B.

CVA = A/ r^ A = 12.20%/12% = 1.02, while

CVB = 20.35%/14% = 1.45.

If Stock B is less highly correlated with the market than A, then it might have a
lower beta than Stock A, and hence be less risky in a portfolio sense.
8.7

$4 6 0,000 $ 5 00,000 $1,26 0,000 $2, 6 00,000


Portfolio beta = $4, 820,000 (1.50) + $4, 820,000 (-0.50) + $4,820,000 (1.25) + $4, 820,000
(0.75)
bp = (0.0954)(1.5) + (0.1037)(-0.50) + (0.2614)(1.25) + (0.5394)(0.75)
= 0.1431 + -0.0519 + 0.3268 + 0.4046
= 0.8226.

rp = rRF + (rM – rRF)(bp) = 4% + (8% – 4%)(0.8226) = 7.29%.

Alternative solution: First, calculate the return for each stock using the CAPM
equation
[rRF + (rM – rRF)b], and then calculate the weighted average of these returns.

rRF = 4% and (rM – rRF) = (8% – 4%) = 4%.

Stock Investment Beta r = rRF + (rM – rRF)b Weight


A $ 460,000 1.50 10% 0.0954
B 500,000(0.50) 2 0.1037
C 1,260,0001.25 9 0.2614
D 2,600,0000.75 7 0.5394
Total $4,820,000 1.00
rp = 10%(0.0954) + 2%(0.1037) + 9%(0.2614) + 7%(0.5394) = 0.0729 = 7.29%.

8.14 Suppose you held a diversified portfolio consisting of a $7,500 investment in each of 20
different common stocks. The portfolio’s beta is 1.25. Now suppose you decided to sell one
of the stocks in your portfolio with a beta of 1.0 for $7,500 and use the proceeds to buy
another stock with a beta of 0.80. What would your portfolio’s new beta be?
$142,500 $7,500
Old portfolio beta= $150,000 (b) + $150,000 (1.00)
1.25 = 0.95b + 0.05
1.20 = 0.95b
1.263158 = b.
New portfolio beta = 0.95(1.263158) + 0.05(0.80) = 1.24.
Alternative solutions:
1. Old portfolio beta = 1.25 = (0.05)b1 + (0.05)b2 + ... + (0.05)b20

1.25 = (∑ bi ) (0.05)

∑ bi = 1.25/0.05 = 25.
New portfolio beta = (25.0 – 1.0 + 0.80)(0.05) = 1.24.

∑ bi
2. excluding the stock with the beta equal to 1.0 is 25.0 – 1.0 = 24, so the beta
of the portfolio excluding this stock is b = 24.0/19 = 1.263158. The beta of the
new portfolio is:
1.263158(0.95) + 0.80(0.05) = 1.24.
8.17 PORTFOLIO BETA A mutual fund manager has a $20 million portfolio with a beta of
1.7. The risk-free rate is 4.5%, and the market risk premium is 7%. The manager expects to
receive an additional $5 million, which she plans to invest in a number of stocks. After
investing the additional funds, she wants the fund’s required return to be 15%. What should
be the average beta of the new stocks added to the portfolio?

After additional investments are made, for the entire fund to have an expected return of 15%,
the portfolio must have a beta of 1.50 as shown below:
15% = 4.5% + (7%)b
b = 1.50.
Since the fund’s beta is a weighted average of the betas of all the individual
investments, we can calculate the required beta on the additional investment as follows:
($ 20 ,000 ,000)(1.7) $5 ,000 ,000 X
1.50 = $25 ,000 ,000 + $ 25,000,000
1.50 = 1.36 + 0.2X
0.14 = 0.2X
X = 0.70.

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