Prof. Thomas J.

Chemmanur
MF807 Corporate Finance

Problem Set - IV
Introduction to Risk, Return, and
The Opportunity Cost of Capital
1. You can find monthly adjusted prices for most or all of the
companies in Table 8.3 on Standard & Poors Market Insight Web
site
(www.mhhe.
com/edumarketinsight)
or
on
finance.yahoo.com. Download the prices for three of these
companies to an Excel spreadsheet. Calculate each companys
variance and standard deviation of the monthly returns. The
Excel functions are VAR and STDEV. Convert the standard
deviations from monthly to annual units by multiplying by the
square root of 12. How has the stand-alone risk of these stocks
changed, compared with the figures reported in Table 8.3?
Table 8.3: Standard deviations for selected US common stocks,
July 2001 June 2006 (figures in percent per year):

Stock
Amazon
Starbuck
s
Boeing

Standar
d
Deviati
on
56.0

Microsoft

Standar
d
Deviati
on
24.4

29.9

Wal-Mart

19.8

29.8

Stock

Pfizer
19.2
ExxonMobi
2.
Download
IBM
29.7
19.2
l
into
a
Disney
27.7
Heinz
16.5
spreadsheet monthly adjusted prices for Coca-Cola, Citigroup,
and Pfizer from finance.yahoo.com or from Standard & Poors
Market Insight Web site (www.mhhe.com/edumarketinsight).
a. Calculate the annual standard deviation of returns for each
company, using the most recent three years of monthly
returns. Use the Excel function STDEV. Multiply by the
square root of 12 to convert to annual units.

b. Use the Excel function CORREL to calculate the correlation

coefficient between the monthly returns for each pair of
stocks.
c. Calculate the standard deviation of returns for a portfolio
with equal investments in each of the three stocks.
3. Most of the companies in Table 8.5 are covered either in
finance.yahoo.com or in the Standard & Poors Market Insight
Web site (www.mhhe.com/edumarketinsight). For those that
are covered, you can easily calculate beta. Download the
Monthly Adjusted Prices spreadsheet, and note the columns for
returns on the stock and the S&P 500 index. Beta is calculated by
the Excel function SLOPE, where the y range refers to the
companys return (the dependent variable) and the x range
refers to the market returns (the independent variable). Calculate
the betas. How have they changed from the betas reported in
Table 8.5?
Table 8.5: Betas for selected US common stocks, July 2001 June
2006
Stock
Amazon
IBM
Disney
Microsoft
Boeing

Beta
2.20
1.59
1.26
1.13
1.09

Stock
Starbucks
ExxonMobil
Wal-Mart
Pfizer
Heinz

Beta
.69
.65
.57
.55
.36

4. There are few, if any, real companies with negative betas. But
suppose you found one with =-.25.
a. How would you expect this stocks rate of return to change
if the overall market rose by an extra 5%? What if the
market fell by an extra 5%?
b. You have $1 million invested in a well-diversified portfolio
of stocks. Now you receive an additional $20,000 bequest.
Which of the following actions will yield the safest overall
portfolio return?
1) Invest $20,000 in Treasury bills (which have
=0).
2) Invest $20,000 in stocks with =1.
3) Invest $20,000 in the stock with =-.25.
Explain your answer.

5. You can form a portfolio of two assets, A and B, whose returns

have the following characteristics:

Sto
ck
A
B

Expected
Return
10%
15%

Standard
Deviation
20%
40%

Correlat
ion
.5

If you demand an expected return of 12%, what are the portfolio

weights? What is the portfolios standard deviation?

Risk and Return

1. Here are returns and standard deviations for four investments.

Treasury Bills
Stock P
Stock Q
Stock R

Retur
n
6%
10%
14.5%
21.0%

Standard
Deviation
0%
14%
28%
26%

Calculate the standard deviations of the following portfolios.

a. 50% in Treasury bills, 50% in stock P.
b. 50% each in Q and R, assuming the shares have
i. perfect positive correlation
ii. perfect negative correlation
iii. no correlation
c. Plot a figure to illustrate how expected return (Y-axis) and
standard deviation (X-axis) change as you hold different
combination of Q and R, assuming a correlation coefficient
of .5.
d. Stock Q has a lower return than R but a higher standard
deviation. Does that mean that Qs price is too high or that
Rs price is too low?

2. For each of the following pairs of investments, state which would

always be preferred by a rational investor (assuming that these
are the only investments available to the investor):
a. Portfolio A r=18%
=20%
Portfolio B r=14%
=20%
b. Portfolio C r=15%
=18%
Portfolio D r=13%
=8%
c. Portfolio E r=14%
=16%
Portfolio F r=14%
=10%
3. True or false? Explain or qualify as necessary.
a. Investors demand higher expected rates of return on
stocks with more variable rates of return.
b. The CAPM predicts that a security with a beta of 0 will offer
a zero expected return.
c. An investor who puts $10,000 in Treasury bills and $20,000
in the market portfolio will have a beta of 2.0.
d. Investors demand higher expected rates of return from
stocks with returns that are highly exposed to
macroeconomic risk.
e. Investors demand higher expected rates of return from
stocks with returns that are very sensitive to fluctuations in
the stock market.
4. Ebenezer Scrooge has invested 60% of his money in share A and
the remainder in share B. He assesses their prospects as follows:
Expected return (%)
Standard deviation (%)
Correlation between returns

A
15
20

B
20
22
.5

a. What are the expected return and standard deviation of

returns on his portfolio?
b. How would your answer change if the correlation
coefficient was 0 or -.5?
c. Is Mr. Scrooges portfolio better or worse than one invested
entirely in share A, or is it not possible to say?
5. Percival Hygiene has $10 million invested in long-term corporate
bonds. This bond portfolios expected annual rate of return is 9%,
and the annual standard deviation is 10%.

Amanda Reckonwith, Percivals financial adviser, recommends

that Percival consider investing in an index fund that closely
tracks the Standard and Poors 500 Index. The index has an
expected return of 14%, and its standard deviation is 16%.
a. Suppose Percival puts all his money in a combination of the
index fund and Treasury bills. Can he thereby improve his
expected rate of return without changing the risk of his
portfolio? The Treasury bill yield is 6%.
b. Could Percival do even better by investing equal amounts
in the corporate bond portfolio and the index fund? The
correlation between the bond portfolio and the index fund
is +.1.
6. Some true or false questions about the APT:
a. The APT factors cannot reflect diversifiable risks.
b. The market rate of return cannot be an APT factor.
c. There is no theory that specifically identifies the APT
factors.
d. The APT model could be true but not very useful, for
example, if the relevant factors change unpredictably.
7. Consider the following simplified APT model:
Factor
Market
Interest rate
Yield spread

Expected Risk Premium

6.4%
-.6
5.1

Calculate the expected return for the following stocks. Assume r f

=5%.

Stock
P
P2
P3

Factor Risk Exposures

Market
Interest
Yield
Rate
Spread
(b1)
(b2)
(b3)
1.0
-2.0
-.2
1.2
0
.3
.3
.5
1.0

8. Look again at Question 7. Consider a portfolio with equal

investments in stocks P, P2 and P3.
a. What are the factor risk exposures for the portfolio?
b. What is the portfolios expected return?

9. The following table shows the sensitivity of four stocks to the

three Fama-French factors in the five years to June 2006.
Estimate the expected return on each stock assuming that the
interest rate is 5%, the expected risk premium on the market is
7.6%, the expected risk premium on the size factor is 3.7%, and
the expected risk premium on the book-to-market factor is 5.2%.
(These were the realized premia from 1926 2006.)

Factor
Market

Factor Sensitivities
CocaFor Pfize Microso
Cola
d
r
ft
.36
2.00
.58
.89

Size*
-.23
-.03 -.47
Book-to.38
1.10 -.15
market+
*
Return on small-firm stocks less return
stocks.
+
Return on high book-to-market-ratio stocks
low high book-to-market-ratio stocks.

-.07
-1.17
on large-firm
less return on

Note: Students are not responsible for Question 6, 7, 8 and 9

since related concepts are not covered in the course.
Efficient Markets and Behavioral Finance
1. How would you respond to the following comments?
a. Efficient market, my eye! I know lots of investors who do
crazy things.
b. Efficient market? Balderdash! I know at least a dozen
people who have made a bundle in the stock market.
c. The trouble with the efficient-market theory is that it
ignores investors psychology.
d. Despite all the limitations, the best guide to a companys
value is its written-down book value. It is much more stable
than market value, which depends on temporary fashions.
2. Respond to the following comments:
a. The random-walk theory, with its implication that investing
in stocks is like playing roulette, is a powerful indictment of
our capital markets.
b. If everyone believes you can make money by charting
stock prices, then price changes wont be random.

c. The random-walk theory implies that events are random,

but many events are not random. If it rains today, theres a
fair bet that it will rain again tomorrow.
3. Which of the following observations appear to indicate market
inefficiency? Explain whether the observation appears to
contradict the weak, semistrong, or strong form of the efficientmarket hypothesis.
a. Tax-exempt municipal bonds offer lower pretax returns
than taxable government bonds.
b. Managers make superior returns on their purchases of their
companys stock.
c. There is a positive relationship between the return on the
market in one quarter and the change in aggregate profits
in the next quarter.
d. There is disputed evidence that stocks that have
appreciated unusually in the recent past continue to do so
in the future.
e. The stock of an acquired firm tends to appreciate in the
period before the merger announcement.
f. Stocks of companies with unexpectedly high earnings
appear to offer high returns for several months after the
earnings announcement.
g. Very risky stocks on average give higher returns than safe
stocks.
4. What does the efficient-market hypothesis have to say about
these two statements?
a. I notice that short-term interest rates are about 1% below
long- term rates. We should borrow short-term.
b. I notice that interest rates in Japan are lower than rates in
the United States. We would do better to borrow Japanese
yen rather than U.S. dollars.