Universit Ca Foscari di Venezia

Campus di Treviso

Finanza Aziendale
Secondo periodo: Novembre-Dicembre 2015

FINANZA AZIENDALE
Prof. Guido Max Mantovani - Prof. Giulia Baschieri
RISK and RETURN RELATION
EXERCISES & SOLUTIONS
Exercise 1
Consider three following portfolios:
Portfolio
A
B
C

Return
0.120
0.116
0.095

Beta
1.4
0.8
0.5

The risk-free rate offers the 6%. Compute:

1. which portfolio is NOT on the SML
2. the expected return of the inefficient portfolio
3. the market return
4. what should happen on the market to reinstate the equilibrium?
Solution
1. According to the CAPM equation: ri= rF + ( rM rF )
A: 0.120=0.06+1.4*MRP
MRP = 4.29%
B: 0.116=0.06+0.8*MRP
MRP = 7.00%
C: 0.095=0.06+0.5*MRP
MRP = 7.00%
A is not on the SML.
2. On the basis of data, A should have a return equal to 15.8% and not equal to 12% (0.158=0.06+1.4*0.07).
3. As MRP is 7% and RF is 6%, RM is equal to 6% + 7% = 13%
4. If the market is efficient, investors sell A.
High sales make the price to fall until the observed return rise. Portfolio return should come back to the
equilibrium, at a 15.8% level.
Exercise 2
Consider the following portfolio P:
Asset (i) E(ri) i Amount invested () - xi
A
12% 0.15
400
B
15% 0.18
100
The correlation between A and B is equal to 1 (i.e. A,B = 1). Find:
1. portfolio expected return (RP)
2. portfolio standard deviation (P)
3. the specific risk eliminated in portfolio through diversification (DB). Demonstrate your answer.
4. Given portfolio P, find the value of A,B that allows you to achieve the highest diversification benefit
(MDB). What is the value of the highest diversification benefit?
Solution
1. At first you have to find the weights of A and B in portfolio.
wA = 400 / (100+400) = 80%
wB = 100 / (100+400) = 20%

Universit Ca Foscari di Venezia

Campus di Treviso

Finanza Aziendale
Secondo periodo: Novembre-Dicembre 2015

Portfolio return is: RP = 12% * 80% + 15% * 20% = 12.60%

2. Its necessary to solve the following:
$*# =0.02434;

P=0.1560.

!"# $"# + !&# $&# + 2(",& !" !$" $&

3. As A,B = 1 theres no specific risk eliminated through diversification. Indeed by simply considering the
weighted average of the risk () of the asset included in portfolio (i.e. not considering the diversification
benefits)
P, ND = 15% * 80% + 18% * 20% = 15.60%
Therefore DB = P, ND - P = 0.
4. It is possible to achieve the maximum diversification benefit when A,B = -1.
To quantify the value of the maximum diversification benefit, as before you have to compute P when A,B = -1
(maximum diversification benefit, P,MAXD) and when A,B = +1 (no diversification benefit, P, ND). The difference
P, ND - P, MAXD is the value of the maximum diversification benefit.
2P,MAXD = 80%2 * 15%2 + 20%2 * 18%2 + 2 * -1 * 80% * 20% * 15% * 18% = 0.0071
P,MAXD = 0.0071 = 8.40%
MDB = P, ND - P,MAXD = 15.60% - 8.40% = 7.20%
Exercise 3
Using the data in the following table, estimate the average return and volatility for each stock.
Year

2004

2005

2006

2007

2008

2009

Stock A

-10%

20%

5%

-5%

2%

9%

Stock B

21%

7%

30%

-3%

-8%

25%

Solution
The average return for each stock is computed as average of past returns. Hence, RA = 3.5%; RB = 12%.
The volatility for the stock is SD(RA) = 9.67%; SD(RB) = 14.28%
Exercise 4
Use the data in Exercise 3, consider a portfolio that maintains a 50% weight on stock A and a 50% weight
on stock B.
1. What is the return each year of this portfolio?
2. Based on your results from part 1, compute the average return and volatility of the portfolio.
3. Given a correlation between stock A and B equal to 6.27%, show that the volatility of the portfolio
equals the same result as from the calculation in the following equation:
p2 = wA2 A2 + wB2B2 + 2wAwBABAB
4. Explain why the portfolio has a lower volatility than the average volatility of the two stocks.
Solution
1&2. The return each year of this portfolio is computed as average of stocks returns. On the basis of these data
it is possible to compute the average return and volatility of the portfolio.
Year

2004

2005

2006

2007

2008

2009

Portf 5.50% 13.50% 17.50% -4.00% -3.00% 17.00%

Portf avg 7.75%
Portf st.dev. 8.87%

Universit Ca Foscari di Venezia

Campus di Treviso

Finanza Aziendale
Secondo periodo: Novembre-Dicembre 2015

3. If we apply the formula we have:

2
= (.52)(.09672) + (.52)(.14282) + 2(.5)(.5)(.0967)(.1428)(.0627) = 0.787
and = 8.87%
4. The portfolio has a lower volatility than the average volatility of the two stocks because some of the
idiosyncratic risk of the stocks in the portfolio is diversified away.
Exercise 5
Consider the two following stocks:
JJ
WC

E(r)

7%
10%

16%
20%

The correlation between the stocks is equal to 22%. Calculate

1. the expected return and
2. the volatility (standard deviation) of a portfolio that is equally invested in JJ and WC.
If the correlation between JJ and WC were to increase,
3. would the expected return of the portfolio rise or fall or remain constant?
4. would the volatility of the portfolio rise or fall or remain constant?
Solution
1. E(R) = 8.5%
2. (R) = 14.1%
3. The expected return of the portfolio would remain constant
4. The volatility of the portfolio would increase.