Assignment 2 (Risk, Return & CAPM)

Total Marks = 30

Solve the following questions . (Each answer carries two marks) (15X 2= 30) 1. Stock A has the following probability distribution of expected returns: Probability Rate of Return 0.1 -15% 0.2 0 0.4 5 0.2 10 0.1 25

What is Stock As expected rate of return and standard deviation? a. b. c.

8.0%; 9.5% 8.0%; 6.5% 5.0%; 3.5%

d. e.

5.0%; 6.5% 5.0%; 9.5%

(e )

r A = 0.1 (-15%) + 0.2(0%) + 0.4(5%) + 0.2(10%) + 0.1(25) = 5.0%.

Variance = 0.1(-0.15 0.05)2 + 0.2(0.0 0.05)2 + 0.4(0.05 0.05)2 + 0.2(0.10 0.05)2 + 0.1(0.25 0.05)2 = 0.009. Standard deviation = 2.
0.009 = 0.0949 = 9.5%.

If rRF = 5%, rM = 11%, and b = 1.3 for Stock X, what is r X, the required rate of return for Stock X? a. 18.7% b. 16.7% c. 14.8% d. 12.8% e. rX = rRF + (rM rRF)bX = 5% + (11% 5%)1.3 = 12.8%. 11.9%

(d )

3. The risk-free rate is 5% and the expected return on the market portfolio is 13%. A stock has a beta of 1.5, what is its expected return? A. 17% B. 12 % C. 19.5 % D. 24.5 %

ANSWER E(R) = 5% + 1.5(13%-5%) = 5%+ 1.5(8%) =5%+ 12% = 17%

Question 4, 5 and 6 . IGNORE

Exhibit 2 Security 1 2 3 Weight 30% 10% Expected 10% 15% 21%

7. Given Exhibit 2, what is the weight of Security 2? A. 20 % B. 40 % ANS: C 100 - 30 - 10 = 60 C. 60 % D. 80 %

8. Given Exhibit 2, what is the expected return on the portfolio? A. 14.1 % B . 15 % C. 16.3 % ANS: A 0.3*0.1 + 0.6*0.15 + 0.1*0.21 = 0.141 D. 17.9 %

9. Jan Middleton owns a 3-stock portfolio with a total investment value equal to $300,000. Stock Investment Beta A $100,000 B 100,000 C 100,000 Total $300,000 What is the weighted average beta of Jans 3-stock portfolio? A. (c ) 0.9 B. 1.3 C. 1.0 D. 0.4 E. The calculation of the portfolios beta is as follows: bp = (1/3)(0.5) + (1/3)(1.0) + (1/3)(1.5) = 1.0. 10. The Apple Investment Fund has a total investment of $450 million in five stocks. Stock (Millions) Beta 1 2 3 4 $130 110 70 90 0.4 1.5 3.0 2.0 Investment 1.2 0.5 1.0 1.5

5 Total What is the funds overall, or weighted average, beta? A. (d) 1.14
5 i =1

50 $450

1.0

B.

1.22

C.

1.35

D.

1.46

E.

1.53

b p = w i bi = $130 $110 $70 $90 $50 (0.4) + (1.5) + (3.0) + ( 2 .0 ) + (1.0) = 1.46. $450 $450 $450 $450 $450

11.

Refer to Problem 10. If the risk-free rate is 12 percent and the market risk premium is 6 percent, what is the required rate of return on the Apple Fund? A. 20.76% B. 19.92% C. 18.81% E. 15.77% rp = rRF + (rM rRF)bp = 12% + (6%)1.46 = 20.76%. D. 17.62%

(a) 12.

Consider the following information for the Alachua Retirement Fund, with a total investment of $4 million. Stock A B C D Total Investment $ 400,000 600,000 1,000,000 2,000,000 $4,000,000 Beta 1.2 -0.4 1.5 0.8

The market required rate of return is 12 percent, and the risk-free rate is 6 percent. What is its required rate of return? a. (c) 9.98% b. 10.45% c. 11.01% d. 12.56% Determine the weight each stock represents in the portfolio: Stock A B C D Investment 400,000 600,000 1,000,000 2,000,000 . wi 0.10 0.15 0.25 0.50 11.50% e.

Beta wi x Beta. 1.2. 0.1200. -0.4. -0.0600. . 1.5. 0.3750. . 0.8. 0.4000. . bp = 0.8350 = Portfolio beta

Write out the SML equation, and substitute known values including the portfolio beta. Solve for the required portfolio return.

rp 13.

= rRF + (rM rRF)bp = 6% + (12% 6%)0.8350 = 6% + 5.01% = 11.01%.

You are given the following distribution of returns: Probability 0.4 0.5 0.1 Return $30 25 -20

What is the coefficient of variation of the expected dollar returns? (b) a. 206.2500 b. 0.6383 c. 14.3614 d. 0.7500 e. 1.2500 Use the given probability distribution of returns to calculate the expected value, variance, standard deviation, and coefficient of variation. 0.4 x $30 $ 22.500 0.5 x 25 6.25 3.125 0.1 x -20 1,806.25 180.625 56.25 Variance = $206.250 The standard deviation of is . Use the standard deviation and the expected return to calculate the coefficient of variation: $14.3614/$22.5 = 0.6383. 14. If the risk-free rate is 8 percent, the expected return on the market is 13 percent, and the expected return on Security J is 15 percent, then what is the beta of Security J? a. 1.40 b. 0.90 c. 1.20 d. 1.50 e. 0.75 (a) Use the SML equation, substitute in the known values, and solve for beta. rRF = 8%; rM = 13%; rJ = 15%. rJ = rRF + (rM rRF)bJ 15% = 8% + (13% 8%)bJ 7% = (5%)bJ bJ = 1.4. In a portfolio of three different stocks, which of the following could not be true? a. The riskiness of the portfolio is less than the riskiness of each stock held in isolation. b. The riskiness of the portfolio is greater than the riskiness of one or two of the = = = = $12.0 $30 12.5 25 $22.5 = 22.5 = 22.5 = $ 7.5 $ 2.5 -42.5 =

-2.0 -20 $22.5

15.

stocks. c. The beta of the portfolio is less than the beta of each of the individual stocks. The beta of the portfolio is a weighted average of the individual securities betas, so it could not be less than the betas of all of the stocks d. The beta of the portfolio is greater than the beta of one or two of the individual stocks. e. The beta of the portfolio is equal to the beta of one of the individual stocks.