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Risk and Return QUESTIONS

1. The document contains 4 practice questions regarding risk and return involving calculations of expected returns, standard deviation, correlation coefficients, and portfolio risk and return for various combinations of securities and stocks. 2. The questions require calculating metrics like expected return, variance, standard deviation, correlation, and portfolio risk and return for individual securities and combinations of securities in different portfolios. 3. The securities and stocks have different returns depending on the state of the economy, and the questions involve calculating portfolio-level metrics based on combining individual assets according to different allocation strategies.

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Julian
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48 views4 pages

Risk and Return QUESTIONS

1. The document contains 4 practice questions regarding risk and return involving calculations of expected returns, standard deviation, correlation coefficients, and portfolio risk and return for various combinations of securities and stocks. 2. The questions require calculating metrics like expected return, variance, standard deviation, correlation, and portfolio risk and return for individual securities and combinations of securities in different portfolios. 3. The securities and stocks have different returns depending on the state of the economy, and the questions involve calculating portfolio-level metrics based on combining individual assets according to different allocation strategies.

Uploaded by

Julian
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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BSF 1102: Principles of Finance


RISK AND RETURN
PRACTICE QUESTIONS
Question 1
An investor has two securities A and B whose returns under the different states of economy are
as follows
Probability A B
0.2 22 25
0.1 10 10
0.4 16 20
0.3 14 15

The investor has put 60% of his wealth in security A and the rest in security B.
Required:
a) Calculate the expected return for each of the securities.
b) Calculate the standard deviation of each of the securities’ returns.
c) Rank the shares based on their coefficient of variation.
d) Assuming the two securities form a portfolio, determine the portfolio risk and return.
e) Determine the portfolio risk assuming
i. Zero correlation
ii. Perfect positive correlation
iii. Perfect negative correlation
iv. – 0.5 correlation

Question 2
You are thinking about investing your money in the stock market. You have the following two
stocks in mind: stock A and stock B. You know that the economy can either go in recession or it
will boom. Being an optimistic investor, you believe the likelihood of observing an economic
boom is two times as high as observing an economic depression. You also know the following
about your two stocks:

Strathmore University BBS 1st Year


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State of the Economy Probability RA RB


Boom 10% –2%
Recession 6% 40%

a) Calculate the expected return for stock A and stock B (2 marks)


b) Calculate the total risk (variance and standard deviation) for stock A and for stock B
(4 marks)
c) Calculate the expected return on a portfolio consisting of equal proportions in both stocks.
(2 marks)
d) Calculate the expected return on a portfolio consisting of 10% invested in stock A and the
remainder in stock B. (2 marks)
e) Calculate the covariance between stock A and stock B. (4 marks)
f) Calculate the correlation coefficient between stock A and stock B. (2 marks)
g) Calculate the variance of the portfolio with equal proportions in both stocks using the
covariance from answer (e). (3 marks)
(Total: 19 marks)
Question 3
Consider the following information about two stocks where the probability of an economic boom
is 40%:

Economic State Return A (RA) Return B (RB)


Boom 38% 6%
Recession –4% 12%

a. Calculate the expected return for stock A and stock B. (2 marks)


b. Calculate the standard deviation of stock A and stock B. (4 marks)
c. Calculate the correlation between stock A and stock B. (4 marks)
d. Calculate the total risk (standard deviation) of a portfolio, where 1/8 of your money is
invested in stock A, and 7/8 of your money is invested in stock B. (Hint: use both the method
with the formula for the risk of a portfolio (i.e., using the covariance) and the method of
calculating the variance (and standard deviation) from the portfolio returns.

Strathmore University BBS 1st Year


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(3 marks)
e. Calculate the expected return on a portfolio with equal proportions in the risky assets, and
30% in a risk-free asset. (Tip: Use your answer in (d) to find out what the rate of return is on
a risk-free asset). (3 marks)
(Total: 16 marks)
Question 4
You are thinking about investing your money in the stock market. You have the following three
stocks in mind: stock A, B, and C. You know that the economy is expected to behave according to
the following table. You believe the likelihood of each scenario is identical (all states of nature
have equal probabilities. You also know the following about your two stocks:

State of the Economy RA RB RC

Depression -20% 5% –5%


Recession 10% 20% 5%
Normal 30% -12% 5%
Boom 50% 9% -3%

a. Calculate the expected returns for stock A, B, and C (3 marks)


b. Calculate the total risk for stock A, B, and C (6 marks)
c. Calculate the correlation coefficient between stock A and B (4 marks)
d. Calculate the correlation coefficient between stock A and C (4 marks)
e. Calculate the correlation coefficient between stock B and C (4 marks)
f. Based on your previous answers, if you have to form a portfolio consisting of two stocks,
which two stocks would you put in your portfolio in terms of risk reduction? (2 marks)
g. What is the expected return of a portfolio with equal investments in stock B and C? (2 marks)
h. What is the covariance between the returns of the portfolio in part (g) and those of stock A?
(3 marks)
i. Based on your previous answer, does it make sense to add stock A to the portfolio? Why?
(2 marks)
j. Calculate the expected return of a portfolio with equal investments in stock A and in the

Strathmore University BBS 1st Year


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portfolio from part (g)? (2 marks)

k. What is the total risk of this portfolio? (3 marks)


l. How can you tell that you have improved your risk-return tradeoff relative to the individual
investments in A, B, and C? (3 marks)

(Total 38 marks)

Strathmore University BBS 1st Year

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