Solutions Problem Set 1

Source: Brealey, Myers and Allen, “Principles of Corporate Finance”, Instructor’s

Resources.

1. a. Average nominal return = (.172 + .010 + .161 + .331 + .127) / 5

Average nominal return = .1602, or 16.02%

Variance = [(.172 – .1602)2 + (.010 – .1602)2 + (.161 – .1602)2 + (.331

–
.1602)2 + (.127 – .1602)2] / 5
Variance = .010595

Standard deviation = .010595.5

Standard deviation = .1029, or 10.29%

b. Average real return = {[(1.172 / 1.015) – 1] + [(1.010 / 1.030) – 1] +

[(1.161
/ 1.017) – 1] + [(1.331 / 1.015) – 1] + [(1.127 /
1.008) – 1]} / 5
Average real return = .1412, or 14.12%

Est. Time: 01 – 05

2. Ms. Sauros:

Average return = [.249 + (–.009) + .186 + .421 + .152] / 5

Average return = .1998, or 19.98%

Variance = [(.249 – .1998)2 + (–.009 – .1998)2 + (.186 – .1998)2 + (.421

–
.1998)2 + (.152 – .1998)2] / 5
Variance = .019485

Standard deviation = .0194

Standard deviation = .1396, or 13.96%

S&P 500:

Average return = (.172 + .010 + .161 + .331 +.127) / 5

Average return = .1602, or 16.02%

Variance = [(.172 – .1602)2 + (.010 – .1602)2 + (.161 – .1602)2 + (.331

–
.1602)2 + (.127 – .1602)2
Variance = .010595

Standard deviation = .010595.5

 Standard deviation = .1029, or 10.29%

Est. Time: 01 – 05

3. a. False. Investors prefer diversified portfolios because diversification

reduces variability and therefore reduces risk. However, the diversification
of an individual company does not necessarily make it less risky.

b. True. Stocks must be less than perfectly positively correlated in order

to obtain diversification benefits.

c. False. The risk eliminated by diversification is called specific risk, or the

risk surrounding an individual company or industry. Market risk will still
exist in a fully diversified portfolio.

d. False. It is true that the greatest benefit to diversification occurs when

stocks are uncorrelated. However, most stocks tend to move in the
same direction. There are still benefits to diversification any time stocks
are less than perfectly positively correlated.

e. False. The contribution to portfolio risk depends on the relationship of

the stock to the market as a whole.

f. True. Market risk is the risk that relates to a diversified portfolio.

g. True. The only risk inherent in a diversified portfolio is market risk.

h. False. An undiversified portfolio with a beta of 2 is twice as risky as the

market portfolio. Part of that risk will be market risk and part will be
specific risk.

Est. Time: 01 – 05

4. Perfect negative correlation does the most to reduce risks because the stocks
always move in opposite directions. When one goes up, the other goes down,
and vice versa.

Est. Time: 01 – 05

5.
Est. Time: 01 – 05

6. βp = {(5 × 1.2) + [(10 – 5) × 1.4)]} / 10

βp = 1.3

Beta measures systematic risk which cannot be eliminated by diversification.

Est. Time: 01 – 05

7. a. A long-term United States government bond is always considered to be

safe in terms of the dollars received. However, the price of the bond
fluctuates as interest rates change, and the rate at which coupon
payments received can be invested also changes as interest rates
change. And, of course, the payments are all in nominal dollars, so
inflation risk must also be considered.

b. It is true that stocks offer higher long-run rates of return than do bonds,
but it is also true that stocks have a higher standard deviation of return.
So, which investment is preferable depends on the amount of risk one
is willing to tolerate. This is a complicated issue and depends on
numerous factors, one of which is the investment time horizon. If the
investor has a short time horizon, then stocks are generally not
preferred.

c. Unfortunately, 10 years is not generally considered a sufficient amount

of time for estimating average rates of return. Thus, using either a 5- or
10-year average is likely to be misleading.

Est. Time: 06 – 10

8. In the context of a well-diversified portfolio, the only risk characteristic of a

single security that matters is the security’s contribution to the overall portfolio
risk. This contribution is measured by beta. Lonesome Gulch is the safer
investment for a diversified investor because its beta of .10 is lower than the
beta of Amalgamated Copper of .66. For a diversified investor, the standard
deviations are irrelevant.

Est. Time: 01 – 05

9. a. σP2 = .602 × .102 + .402 × .202 + 2(.60 × .40 × 1 × .10 × .20)

σP2 = .0196

b. σP2 = .602 × .102 + .402 × .202 + 2(.60 × .40 × .50 × .10 × .20)
σP2 = .0148

c. σP2 = .602 × .102 + .402 × .202 + 2(.60 × .40 × 0 × .10 × .20)

σP2= .0100
Est. Time: 06 – 10

10. a-1. Change in stock’s rate of return = .05 × –.25 = –.0125, or –1.25%

a-2. Change in stock’s rate of return = –.05 × –.25 = .0125, or 1.25%

b. “Safest” implies lowest risk. Assuming the well-diversified portfolio is

invested in typical securities, the portfolio beta is approximately one.
The largest reduction in beta is achieved by investing the $20,000 in a
stock with the negative beta.

Est. Time: 06 – 10

11. E(r)P = .12 = .1wa + .15(1 – wa); wa = .60; (1 – wa) = .40

σp = (.602 × .202 + .402 × .402 + 2 × .60 × .40 × .50 × .20 × .40).5

σp = .2433, or 24.33%
Est. Time: 06 – 10

12. a. In general:

σP = (x1212 + x2222 + 2x1x21212).5

Thus:

P = (.52 × .35802 + .52 × .21002 + 2 × .5 × .5 × .30 × .3580 × .2100).5

P = .2331, or 23.31%

b. We can think of this in terms of Figure 7.13 in the text, with three
securities. One of these securities, T-bills, has zero risk and, hence,
zero standard deviation. Thus:

P = [(1/3)2 × .35802 + (1/3)2 × .21002 + 2 × (1/3) × (1/3) × .30 × .3580 ×

.2100].5
P = .1554, or 15.54%

Another way to think of this portfolio is that it is comprised of one-third

T-Bills and two-thirds a portfolio which is half Bank of America and half
 Starbucks. Because the risk of T-bills is zero, the portfolio standard
deviation is two-thirds of the standard deviation computed in Part (a)
above:
P = (2/3) × 23.31% = 15.54%

c. With 50% margin, the investor invests twice as much money in the
portfolio as he had to begin with. Thus, the risk is twice that found in
Part (a) when the investor is investing only his own money:

P = 2  23.31% = 46.62%

d. With 100 stocks, the portfolio is well diversified, and hence the portfolio
standard deviation depends almost entirely on the average covariance
of the securities in the portfolio (measured by beta) and on the
standard deviation of the market portfolio. Thus, for a portfolio made
up of 100 stocks each with Bank of America’s beta of 1.57, the portfolio
standard deviation is approximately:

P = 1.57  23.0% = 36.11%

For stocks like Starbucks, the approximate standard deviation is:

P = .83  23.0% = 19.09%

Est. Time: 11 – 15