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Tutorial 4 Problem Set Answers - Final

The document contains solutions to practice problems from a chapter on portfolio theory and asset pricing models. It includes calculations of expected returns and variances for portfolios consisting of different stocks and under different economic states. It also calculates betas, covariances, and correlations. One question involves calculating expected returns, variances and standard deviations for individual stocks based on given return values under different economic states.

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180 views

Tutorial 4 Problem Set Answers - Final

The document contains solutions to practice problems from a chapter on portfolio theory and asset pricing models. It includes calculations of expected returns and variances for portfolios consisting of different stocks and under different economic states. It also calculates betas, covariances, and correlations. One question involves calculating expected returns, variances and standard deviations for individual stocks based on given return values under different economic states.

Uploaded by

Hello
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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AFW360 Corporate Finance

Tutorial 4: Problem Sets

Dr. Gary John Rangel


School of Management
Chapter 11 Concept Question 8
Consider the following quotation from a leading investment manager: “The
shares of Eastern Co. have traded close to $12 for most of the past three
years. Since Eastern's stock has demonstrated very little price movement,
the stock has a low beta. Texas Instruments, on the other hand, has traded
as high as $150 and as low as its current $75. Since TI's stock has
demonstrated a large amount of price movement, the stock has a very high
beta.” Do you agree with this analysis? Explain.
Answer:
If we assume that the market has not stayed constant during the past three
years, then the lack in movement of Eastern 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 Texas 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 risk. 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 TI, you cannot claim that the beta of the stock is high. All you know is
that the total risk of TI is high.
Chapter 11 Problem 3
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 of these three
stocks is 10.5 percent, 16.1 percent, and 12.4 percent, respectively. What
is the expected return on the portfolio?
Answer:
𝐸 𝑅𝑃 = 𝑋𝐴 𝐸 𝑅𝐴 + 𝑋𝐵 𝐸 𝑅𝐵
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
= 0.2 × 10.5% + 0.45 × 16.1% + 0.35 × 12.4% = 13.685 = 13.69%
Chapter 11 Problem 8
Consider the following information.
Rate of Return if State Occurs
State of Probability of State of
Economy Economy Stock A Stock B Stock C
Boom .75 .06 .16 .33
Bust .25 .14 .02 -.06
a. What is the expected return on an equally weighted portfolio?
b. What is the variance of a portfolio invested in 20 percent each in A and B
and 60 percent in C?
Answer:
a.
Step 1: Find the expected return for each stock.
𝐸 𝑅𝑆𝑡𝑜𝑐𝑘 = 𝑋𝐵𝑜𝑜𝑚 𝐸 𝑅𝐵𝑜𝑜𝑚 + 𝑋𝐵𝑢𝑠𝑡 𝐸 𝑅𝐵𝑢𝑠𝑡
𝐸 𝑅𝐴 = 0.75 × 0.06 + 0.25 × 0.14 = 0.08 = 8%
𝐸 𝑅𝐵 = 0.75 × 0.16 + 0.25 × 0.02 = 0.125 = 12.5%
𝐸 𝑅𝐶 = 0.75 × 0.33 + 0.25 × −0.06 = 0.2325 = 23.25%
Chapter 11 Problem 8
Answer:
a.
Step 2: Find the expected returns of the portfolio comprising of the three
stocks.
𝐸 𝑅𝑃 = 𝑋𝐴 𝐸 𝑅𝐴 + 𝑋𝐵 𝐸 𝑅𝐵
1 1 1
𝐸 𝑅𝑃 = × 0.08 + × 0.125 + × 0.2325 = 0.1458 = 14.58%
3 3 3
b.
Step 1: Find the expected return of the portfolio.
𝐸 𝑅𝑃 = 0.2 × 0.08 + 0.2 × 0.125 + 0.6 × 0.2325 = 0.1805 = 18.05%
Step 2: Find the expected return of the portfolio in boom state.
𝐸 𝑅𝐵𝑜𝑜𝑚 = 0.2 × 0.06 + 0.2 × 0.16 + 0.6 × 0.33 = 0.242
Step 3: Find the expected return of the portfolio in bust state.
𝐸 𝑅𝐵𝑢𝑠𝑡 = 0.2 × 0.14 + 0.2 × 0.02 + 0.6 × −0.06 = −0.004
Step 4: Find the variance of the portfolio.
𝑉𝑎𝑟 𝑅𝑃 = 𝜎 2 = ෍ 𝑅 − 𝐸 𝑅 2
Chapter 11 Problem 8
Answer:
𝑉𝑎𝑟 𝑅𝑃 = 0.75 0.242 − 0.1805 2 + 0.25 −0.004 − 0.1805 2
𝑉𝑎𝑟 𝑅𝑃 = 0.002836688 + 0.008510063 = 0.0113467505 = 0.011347
Chapter 11 Problem 10
You own a stock portfolio invested 20 percent in Stock Q, 30 percent in
Stock R, 15 percent in Stock S, and 35 percent in Stock T. The betas for
these four stocks are .75, 1.90, 1.38, and 1.16, respectively. What is the
portfolio beta?
Answer:
𝑁

෍ 𝑋𝑖 𝛽𝑖 = 1
𝑖=1
𝛽𝑃 = 𝑋1 𝛽1 + 𝑋2 𝛽2 + 𝑋3 𝛽3 + 𝑋4 𝛽4
𝛽𝑃 = 0.2 0.75 + 0.3 1.9 + 0.15 1.38 + 0.35 1.16
𝛽𝑃 = 1.333
Chapter 11 Problem 15
A stock has an expected return of 10.9, its beta is .9, and the expected
return on the market is 11.8 percent. What must the risk-free rate be?
Answer:
𝐸 𝑅 = 𝑅𝐹 + 𝛽 × 𝐸 𝑅𝑀 − 𝑅𝐹
10.9 = 𝑅𝐹 + 0.9 11.8 − 𝑅𝐹
10.9 = 𝑅𝐹 + 10.62 − 0.9𝑅𝐹
10.9 − 10.62 = 𝑅𝐹 − 0.9𝑅𝐹
0.1𝑅𝐹 = 0.28
0.28
𝑅𝐹 = = 2.8 = 2.8%
0.1
Chapter 11 Problem 22
Rate of Return if State Occurs
State of Economy Probability of State of Economy
Stock A Stock B Stock C
Boom .25 .25 .35 .40
Normal .55 .18 .13 .03
Bust .20 .03 -.18 -.45

a. If your portfolio is invested 40 percent each in A and B and 20 percent


in C, what is the portfolio expected return? The variance? The standard
deviation?
b. If the expected T-bill rate is 3.80 percent, what is the expected risk
premium on the portfolio?
c. If the expected inflation is 3.50 percent, what is the approximate and
exact expected real returns on the portfolio? What is the approximate
and exact expected real risk premiums on the portfolio?
Chapter 11 Problem 22
Answer:
(a)
Step 1: Calculate the expected returns in each state.
𝐸 𝑅𝑃 = 𝑋𝐴 𝐸 𝑅𝐴 + 𝑋𝐵 𝐸 𝑅𝐵
𝐸 𝑅𝐵𝑜𝑜𝑚 = 0.4 × 0.25 + 0.4 × 0.35 + 0.2 × 0.40 = 0.32 = 32%
𝐸 𝑅𝑁𝑜𝑟𝑚𝑎𝑙 = 0.4 × 0.18 + 0.4 × 0.13 + 0.2 × 0.03 = 0.13 = 13%
𝐸 𝑅𝐵𝑢𝑠𝑡 = 0.4 × 0.03 + 0.4 × −0.18 + 0.2 × −0.45 = −0.15 = −15%
Step 2: Calculate the expected return of the portfolio
𝐸 𝑅𝑃 = 0.25 0.32 + 0.55 0.13 + 0.2 −0.15 = 0.1215 = 12.15%
Step 3: Calculate the variance of the portfolio.
𝑉𝑎𝑟 𝑅𝑃 = 𝜎 2 = ෍ 𝑅 − 𝐸 𝑅 2

𝑉𝑎𝑟 𝑅𝑃
= 0.25 0.32 − 0.1215 2 + 0.55 0.13 − 0.1215 2
+ 0.20 −0.15 − 0.1215 2
𝑉𝑎𝑟 𝑅𝑃 = 0.009850563 + 0.000039738 + 0.01474245 = 0.0024632751
Chapter 11 Problem 22
Answer:
(a)
Step 4: From the variance, calculate the standard deviation of the portfolio.
𝜎𝑃 = 𝑉𝑎𝑟 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝜎𝑃 = 0.0024632751 = 0.1569482431 = 15.69%

(b)
𝑅𝑃𝑃 = 𝐸 𝑅𝑃 − 𝑅𝐹
𝑅𝑃𝑃 = 12.15% − 3.8% = 8.35%

(c)
Approximate real rate of return
𝑅~𝑟 + ℎ
𝑟 =𝑅−ℎ
𝑟 = 12.15% − 3.5% = 8.65%
Chapter 11 Problem 22
Answer:
(c)
Exact real rate of return
1+𝑅 = 1+𝑟 1+ℎ
1 + 0.1215 = 1 + 𝑟 1 + 0.035
1.1215 = 1 + 𝑟 1 + 0.035
1.1215 = 1 + 0.035 + 𝑟 + 0.035𝑟
1.1215 = 1.035 + 1.035𝑟
1.1215 − 1.035 = 1.035𝑟
1.035𝑟 = 0.0865
0.0865
𝑟= = 0.08357487923 = 8.36%
1.035

The approximate real risk-free rate.


𝑟𝐹 = 3.8% − 3.5% = 0.3%
Chapter 11 Problem 22
Answer:
(c)
Exact real rate of return of the risk-free rate
1+𝑅 = 1+𝑟 1+ℎ
1 + 0.038 = 1 + 𝑟 1 + 0.035
1.038 = 1 + 𝑟 1 + 0.035
1.038 = 1 + 0.035 + 𝑟 + 0.035𝑟
1.038 = 1.035 + 1.035𝑟
1.038 − 1.035 = 1.035𝑟
1.038𝑟 = 0.003
0.003
𝑟= = 0.002890173 = 0.29%
1.038

The approximate real risk premium is the approximate expected real


return minus the risk-free rate, so:
8.65% – 0.3% = 8.35%
Chapter 11 Problem 22
Answer:
(c)
The exact real risk premium is the exact real return minus the risk-free
rate, so:
8.36% – 0.29% = 8.07%
Chapter 11 Problem 26
Based on the following information, calculate the expected return and
standard deviation for each of the following stocks. What is the covariance
and correlation between the returns of the two stocks?
State of Economy Probability of State of Return on Return on
Economy Stock J Stock K
Bear .30 -.050 .029
Normal .55 .118 .074
Bull .15 .274 .098
Chapter 11 Problem 26
Answer:
Step 1: Calculate the expected return for both Stock J and Stock K
𝐸 𝑅𝑃 = 𝑋𝐴 𝐸 𝑅𝐴 + 𝑋𝐵 𝐸 𝑅𝐵
𝐸 𝑅𝐽 = 0.30 −0.050 + 0.55 0.118 + 0.15 0.274 = 0.091 = 9.1%
𝐸 𝑅𝐾 = 0.30 0.029 + 0.55 0.074 + 0.15 0.098 = 0.112 = 6.41%
Step 2: Calculate the variance and the standard deviation for Stock J and
Stock K.
𝑉𝑎𝑟 𝑅𝑃 = 𝜎 2 = ෍ 𝑅 − 𝐸 𝑅 2

𝑉𝑎𝑟 𝑅𝐽
= 0.3 −0.050 − 0.091 2 + 0.55 0.118 − 0.091 2 + 0.15 0.274 − 0.091 2
𝑉𝑎𝑟 𝑅𝐽 = 0.0059643 + 0.00040095 + 0.00502335 = 0.0113886
𝑆𝐷 𝑅𝐽 = 0.0113886 = 0.1067173838 = 10.67%
𝑉𝑎𝑟 𝑅𝐾
= 0.3 0.029 − 0.0641 2 + 0.55 0.074 − 0.0641 2 + 0.15 0.098 − 0.0641 2
𝑉𝑎𝑟 𝑅𝐾 = 0.000369603 + 0.000053906 + 0.000172382 = 0.000595891
𝑆𝐷 𝑅𝐾 = 0.000595891 = 0.02441086848 = 2.44%
Chapter 11 Problem 26
Answer:
Step 3: Find the covariance for Stock J and Stock K.
𝜎𝐽𝐾 = 𝐶𝑜𝑣 𝑅𝐽 , 𝑅𝐾 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑅𝐽 − 𝑅ത𝐽 × 𝑅𝐾 − 𝑅ത𝐾
𝜎𝐴𝐵
= 0.3 −0.050 − 0.091 0.029 − 0.0641
+ 0.55 0.118 − 0.091 0.074 − 0.0641
+ 0.15 0.274 − 0.091 0.098 − 0.0641
𝜎𝐽𝐾 = 0.00148473 + 0.000147015 + 0.000930555 = 0.0025623
Step 4: Find the correlation of Stock J and Stock K.
𝐶𝑜𝑣 𝑅𝐽 , 𝑅𝐾
𝜌𝐽,𝐾 = 𝐶𝑜𝑟𝑟 𝑅𝐽 , 𝑅𝐾 =
𝜎𝐽 × 𝜎𝐾
0.0025623
𝜌𝐽,𝐾 = 𝐶𝑜𝑟𝑟 𝑅𝐽 , 𝑅𝐾 = = 0.9836
0.1067173838 × 0.02441086848
Chapter 11 Problem 32
Suppose the risk-free rate is 4.4 percent and the market portfolio has an
expected return of 10.9 percent. The market portfolio has a variance of
.0391. Portfolio Z has a correlation coefficient with the market of .31 and a
variance of .3407. According to the capital asset pricing model, what is the
expected on Portfolio Z?
Answer:
Step 1: Find the standard deviation of the market and of the portfolio.
𝜎𝑀 = 𝑉𝑎𝑟 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝜎𝑀 = 0.0391 = 0.1977371993 = 19.77%
𝜎𝑍 = 𝑉𝑎𝑟 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
𝜎𝑍 = 0.3407 = 0.5836951259 = 58.37%
Step 2: Find the beta of the portfolio.
𝐶𝑜𝑟𝑟 𝑅𝑍 , 𝑅𝑀 𝜎𝑍
𝛽𝑍 =
𝜎𝑀
0.31 0.5836951259
𝛽𝑍 = = 0.915 = 0.92
0.1977371993
Chapter 11 Problem 32
Answer:
Step 3: Use the CAPM to find the expected return of the portfolio
𝐸 𝑅𝑍 = 𝑅𝐹 + 𝛽𝑍 × 𝐸 𝑅𝑀 − 𝑅𝐹
𝐸 𝑅𝑍 = 4.4% + 0.915 × 10.9% − 4.4%
𝐸 𝑅𝑍 = 10.35%
Thank You

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