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Chapter 7 Risk and Rates of Return

Learning Objectives

After reading this chapter, students should be able to:

Explain the difference between stand-alone risk and risk in a portfolio context. Explain how risk aversion affects a stocks required rate of return. Discuss the difference between diversifiable risk and
t!pe of risk affects well-diversified investors. arket risk, and explain how each

Explain what the "A#$ is and how it can be used to esti ate a stocks required rate of
return.

Discuss how changes in the general stock and the bond


the required rate of return on a fir s stock.

arkets could lead to changes in

Discuss how changes in a fir s operations


return on the fir s stock.

ight lead to changes in the required rate of

Chapter 8: Risk and Rates of Return

Learning Objectives 117

Lecture Suggestions

%isk anal!sis is an i portant topic, but it is difficult to teach at the introductor! level. &e 'ust tr! to give students an intuitive overview of how risk can be defined and easured, and leave a technical treat ent to advanced courses. (ur pri ar! goals are to be sure students understand )*+ that invest ent risk is the uncertaint! about returns on an asset, ),+ the concept of portfolio risk, and )-+ the effects of risk on required rates of return. &hat we cover, and the wa! we cover it, can be seen b! scanning the slides and .ntegrated "ase solution for "hapter /, which appears at the end of this chapter solution. 0or other suggestions about the lecture, please see the 12ecture 3uggestions4 in "hapter 5, where we describe how we conduct our classes. DA S O! C"A#$%R: & O' (8 DA S )(*+,inute periods-

118 Lecture Suggestions

Chapter 7: Risk and Rates of Return

Ans.ers to %nd+of+Chapter /uestions

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a0 6o, it is not riskless. 7he portfolio would be free of default risk and liquidit! risk, but inflation could erode the portfolios purchasing power. .f the actual inflation rate is greater than that expected, interest rates in general will rise to incorporate a larger inflation pre iu ).#+ and8as we saw in "hapter 98the value of the portfolio would decline. b0 6o, !ou would be sub'ect to reinvest ent rate risk. :ou ight expect to 1roll over4 the 7reasur! bills at a constant )or even increasing+ rate of interest, but if interest rates fall, !our invest ent inco e will decrease. c0 A ;.3. govern ent-backed bond that provided interest with constant purchasing power )that is, an indexed bond+ would be close to riskless. 7he ;.3. 7reasur! currentl! issues indexed bonds.

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a0 7he probabilit! distribution for co plete certaint! is a vertical line. b0 7he probabilit! distribution for total uncertaint! is the <-axis fro - to =.

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a0 7he expected return on a life insurance polic! is calculated 'ust as for a co on stock. Each outco e is ultiplied b! its probabilit! of occurrence, and then these products are su ed. 0or exa ple, suppose a *-!ear ter polic! pa!s >*?,??? at death, and the probabilit! of the polic!holders death in that !ear is ,@. 7hen, there is a AB@ probabilit! of Cero return and a ,@ probabilit! of >*?,???: Expected return D ?.AB)>?+ = ?.?,)>*?,???+ D >,??. 7his expected return could be co pared to the pre iu paid. Eenerall!, the pre iu will be larger because of sales and ad inistrative costs, and insurance co pan! profits, indicating a negative expected rate of return on the invest ent in the polic!. b0 7here is a perfect negative correlation between the returns on the life insurance polic! and the returns on the polic!holders hu an capital. .n fact, these events )death and future lifeti e earnings capacit!+ are utuall! exclusive. 7he prices of goods and services ust cover their costs. "osts include labor, aterials, and capital. "apital costs to a borrower include a return to the saver who supplied the capital, plus a ark-up )called a 1spread4+ for the financial inter ediar! that brings the saver and the borrower together. 7he ore efficient the financial s!ste , the lower the costs of inter ediation, the lower the costs to the borrower, and, hence, the lower the prices of goods and services to consu ers. c0 #eople are generall! risk averse. 7herefore, the! are willing to pa! a pre iu decrease the uncertaint! of their future cash flows. A life insurance polic! guarantees an inco e )the face value of the polic!+ to the polic!holders beneficiaries when the polic!holders future earnings capacit! drops to Cero. to

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:es, if the portfolios beta is equal to Cero. .n practice, however, it a! be i possible to find individual stocks that have a nonpositive beta. .n this case it would also be i possible to have a stock portfolio with a Cero beta. Even if such a portfolio could Answers and Solutions 113

Chapter 7: Risk and Rates of Return

be constructed, investors would probabl! be better off 'ust purchasing 7reasur! bills, or other Cero beta invest ents. 7+( 3ecurit! A is less risk! if held in a diversified portfolio because of its negative correlation with other stocks. .n a single-asset portfolio, 3ecurit! A would be ore risk! because A F G and "HA F "HG. 6o. 0or a stock to have a negative beta, its returns would have to logicall! be expected to go up in the future when other stocks returns were falling. Iust because in one !ear the stocks return increases when the arket declined doesnt ean the stock has a negative beta. A stock in a given !ear a! ove counter to the overall arket, even though the stocks beta is positive. 7he risk pre iu stock. %#' D %isk #re iu on a high-beta stock would increase for 3tock ' D )r$ J r%0+b'. ore than that on a low-beta

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.f risk aversion increases, the slope of the 3$2 will increase, and so will the arket risk pre iu )r$ J r%0+. 7he product )r$ J r%0+b' is the risk pre iu of the 'th stock. .f b' is low )sa!, ?.5+, then the product will be s allK %# ' will increase b! onl! half the increase in %#$. Lowever, if b' is large )sa!, ,.?+, then its risk pre iu will rise b! twice the increase in %#$. 7+8 According to the 3ecurit! $arket 2ine )3$2+ equation, an increase in beta will increase a co pan!s expected return b! an a ount equal to the arket risk pre iu ti es the change in beta. 0or exa ple, assu e that the risk-free rate is 9@, and the arket risk pre iu is 5@. .f the co pan!s beta doubles fro ?.B to *.9 its expected return increases fro *?@ to *M@. 7herefore, in general, a co pan!s expected return will not double when its beta doubles. a0 A decrease in risk aversion will decrease the return an investor will require on stocks. 7hus, prices on stocks will increase because the cost of equit! will decline. b0 &ith a decline in risk aversion, the risk pre iu will decline as co pared to the historical difference between returns on stocks and bonds. c0 7he i plication of using the 3$2 equation with historical risk pre iu s )which would be higher than the 1current4 risk pre iu + is that the "A#$ esti ated required return would actuall! be higher than what would be reflected if the ore current risk pre iu were used. 7+1* %#$ D r$ J r%0 r$ D %#$ = r%0 D 9@ = 5.-@ D **.-@ %equired return on stock D %isk-free return = )3tocks beta+)$arket risk pre iu + D 5.-@ = *., N 9@ D *,.5@.

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11* Answers and Solutions

Chapter 7: Risk and Rates of Return

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Estimated =

( r r )
t =1 t avg

N 1

rAvg D )*?.,5@ = B.99@ J /.M?@ J -./5@ = **.B@ = ,*.-9@+O9 D 9.B,@.

D sqrtP)*?.,5@ J 9.B,@+, = )B.99@ J 4081@+, = )J/.M?@ J 9.B,@+, = )J-./5@ J 9.B,@+,


=)**.B@ J 9.B,@+, = ),*.-9@ J 9.B,@+,O5+ D *?.9-@.

Chapter 7: Risk and Rates of Return

Answers and Solutions 111

So5utions to %nd+of+Chapter #rob5e,s

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D )?.*+)-5?@+ = )?.,+)-5@+ = )?.M+)*9@+ = )?.,+),5@+ = )?.*+)9?@+ Q r D **.M?@. , D )-5?@ J **.M?@+,)?.*+ = )-5@ J **.M?@+,)?.,+ = )*9@ J **.M?@+,)?.M+ = ),5@ J **.M?@+,)?.,+ = )9?@ J **.M?@+,)?.*+ , D /*,.MMK D ,9.9A@. "H D

,9.9A@ D ,.-M. **.M?@


Geta ?.B *.M

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.nvest ent >-5,??? M?,??? 7otal >/5,???

bp D )>-5,???O>/5,???+)?.B+ = )>M?,???O>/5,???+)*.M+ D *.*,. 7+& r%0 D B@K r$ D *,@K b D ?.BK r D R r D r%0 = )r$ J r%0+b D B@ = )*,@ J B@+?.B D **.,@. 7+2 r%0 D 5.5@K %#$ D 9.5@K r$ D R r$ D 5.5@ = )9.5@+* D *,@. r when b D *., D R r D 5.5@ = 9.5@)*.,+ D *-.-@. 7+( a0 r D **@K r%0 D /@K %#$ D M@. r **@ M@ b D D D D r%0 = )r$ J r%0+b /@ = M@b M@b *.

111 Answers and Solutions

Chapter 7: Risk and Rates of Return

b0 r%0 D /@K %#$ D 9@K b D *. r D r%0 = )r$ J r%0+b D /@ = )9@+* D *-@.

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r= a0 Q

#r .
i i i =*

Q r: D ?.*)--5@+ = ?.,)?@+ = ?.M),?@+ = ?.,),5@+ = ?.*)M5@+ D *M@ versus *,@ for <. b0 D

)r
i=*

Q r+ , #i .

, , , , < D )-*?@ J *,@+ )?.*+ = ),@ J *,@+ )?.,+ = )*,@ J *,@+ )?.M+ , , = ),?@ J *,@+ )?.,+ = )-B@ J *,@+ )?.*+ D *MB.B@.

< D *,.,?@ versus ,?.-5@ for :. "H< D <O Q r


<

D *,.,?@O*,@ D *.?,, while

"H: D ,?.-5@O*M@ D *.M5. .f 3tock : is less highl! correlated with the arket than <, then it ight have a lower beta than 3tock <, and hence be less risk! in a portfolio sense.
2 2 p = Wa2 a + Wb2 b2 + 2Wa Wb Cov ( R a , R b ) 2 2 = Wa2 a + Wb2 b + 2Wa Wb a ,b a b 2 2 = 0.6 0.22 + 0.4 2 0.082 + 2 0.6 0.4 a ,b 0.22 0.08

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2.69% if a ,b = 1, = 1.84% if a ,b = 0, 1.00% if = 1. a ,b


>M??,??? >9??,??? >*,???,??? )*.5?+ = )-?.5?+ = )*.,5+ = >M,???,??? >M,???,??? >M,???,???

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#ortfolio beta

>,,???,??? )?./5+ >M,???,??? bp D )?.*+)*.5+ = )?.*5+)-?.5?+ = )?.,5+)*.,5+ = )?.5+)?./5+ D ?.*5 J ?.?/5 = ?.-*,5 = ?.-/5 D ?./9,5.

rp D r%0 = )r$ J r%0+)bp+ D 9@ = )*M@ J 9@+)?./9,5+ D *,.*@.

Chapter 7: Risk and Rates of Return

Answers and Solutions 11&

Alternative solution: 0irst, calculate the return for each stock using the "A#$ equation Pr%0 = )r$ J r%0+bS, and then calculate the weighted average of these returns. r%0 D 9@ and )r$ J r%0+ D B@. 3tock A G " D 7otal .nvest ent > M??,??? 9??,??? *,???,??? ,,???,??? >M,???,??? Geta *.5? )?.5?+ *.,5 ?./5 r D r%0 = )r$ J r%0+b &eight *B@ ?.*? , ?.*5 *9 ?.,5 *, ?.5? *.??

rp D *B@)?.*?+ = ,@)?.*5+ = *9@)?.,5+ = *,@)?.5?+ D *,.*@. 7+3 .n equilibriu : rI D *,.5@. rI D Q rI D r%0 = )r$ J r%0+b *,.5@D M.5@ = )*?.5@ J M.5@+b b D *.--. 7+1* &e know that b% D *.5?, b3 D ?./5, r$ D *-@, r%0 D /@. ri D r%0 = )r$ J r%0+bi D /@ = )*-@ J /@+bi. r% D /@ = 9@)*.5?+D *9.?@ r3 D /@ = 9@)?./5+D **.5 M.5@ 7+11 An index fund will have a beta of *.?. .f r$ is *,.?@ )given in the proble + and the riskfree rate is 5@, !ou can calculate the arket risk pre iu )%#$+ calculated as r$ J r%0 as follows: r D r%0 = )%#$+b *,.?@D 5@ = )%#$+*.? /.?@ D %#$. 6ow, !ou can use the %#$, the r%0, and the two stocks betas to calculate their required returns. Gradford: rG D D D D r%0 = )%#$+b 5@ = )/.?@+*.M5 5@ = *?.*5@ *5.*5@.

0arle!: r0 D r%0 = )%#$+b D 5@ = )/.?@+?.B5 112 Answers and Solutions Chapter 7: Risk and Rates of Return

D 5@ = 5.A5@ D *?.A5@. 7he difference in their required returns is: *5.*5@ J *?.A5@ D M.,@. 7+11 r%0 D rT = .# D ,.5@ = -.5@ D 9@. rs D 9@ = )9.5@+*./ D */.?5@.

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a0 ri D r%0 = )r$ J r%0+bi D A@ = )*M@ J A@+*.- D *5.5@. b0 *. r%0 increases to *?@: r$ increases b! * percentage point, fro *M@ to *5@.

ri D r%0 = )r$ J r%0+bi D *?@ = )*5@ J *?@+*.- D *9.5@. ,. r%0 decreases to B@: r$ decreases b! *@, fro *M@ to *-@.

ri D r%0 = )r$ J r%0+bi D B@ = )*-@ J B@+*.- D *M.5@. c0 *. r$ increases to *9@: ri D r%0 = )r$ J r%0+bi D A@ = )*9@ J A@+*.- D *B.*@. ,. r$ decreases to *-@: ri D r%0 = )r$ J r%0+bi D A@ = )*-@ J A@+*.- D *M.,@.
n

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b=

( x x ) ( y
i =1 i

y)
2

( x
i =1

x)

And ri D r%0 = )r$ J r%0+bi Stock A Stock 6 Stock C Expected return Hariance "ovariance with arket portfolio Geta %equired return *A@ ?.?, ?.??/ ?.-5 ?.*?B5 *5@ ?.**A9 ?.??M5 ?.?-B A@ ?.?,?5 ?.??*?.?9$+ bonds /@ ? ? ? 7arket portfo5io *B@ ?.??9M ?.??9M

?.?/M*B ?.?/9A-

Chapter 7: Risk and Rates of Return

Answers and Solutions 11(

7+1(

a0 ;sing 3tock < )or an! stock+: A@ D r%0 = )r$ J r%0+b< A@ D 5.5@ = )r$ J r%0+?.B )r$ J r%0+ D M.-/5@. b0 bU D *O-)?.B+ = *O-)*.,+ = *O-)*.9+ bU D ?.,99/ = ?.M??? = ?.5--bU D*.,. c0 rU D5.5@ = M.-/5@)*.,+ rU D*?./5@. d0 3ince the returns on the - stocks included in #ortfolio U are not perfectl! positivel! correlated, one would expect the standard deviation of the portfolio to be less than *5@.
>*M,,5?? >/,5?? )b+ = )*.??+ >*5?,??? >*5?,??? *.*, D ?.A5b = ?.?5 *.?/ D ?.A5b *.*,9- D b.

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(ld portfolio beta

6ew portfolio beta D ?.A5)*.*,9-+ = ?.?5)*./5+ D *.*5/5 *.*9. Alternative solutions: *. (ld portfolio beta D *.*, D )?.?5+b* = )?.?5+b, = ... = )?.?5+b,? bi + )?.?5+ *.*, D )
b
i

D *.*,O?.?5 D ,,.M.

6ew portfolio beta D ),,.M J *.? = *./5+)?.?5+ D *.*5/5 *.*9. ,. excluding the stock with the beta equal to *.? is ,,.M J *.? D ,*.M, so the beta of the portfolio excluding this stock is b D ,*.MO*A D *.*,9-. 7he beta of the new portfolio is:
i

*.*,9-)?.A5+ = *./5)?.?5+ D *.*5/5 *.*9. 7+17 bL%. D *.BK b2%. D ?.9. 6o changes occur. r%0 D 9@. Decreases b! *.5@ to M.5@. r$ D *-@. 0alls to *?.5@. 6ow 3$2: ri D r%0 = )r$ J r%0+bi. rL%. D M.5@ = )*?.5@ J M.5@+*.B D M.5@ = 9@)*.B+ D 114 Answers and Solutions *5.-@

Chapter 7: Risk and Rates of Return

r2%. D M.5@ = )*?.5@ J M.5@+?.9 D M.5@ = 9@)?.9+ D Difference /.,@ 7+18 3tep *: Deter ine the arket risk pre iu fro

B.*@

the "A#$:

?.*, D ?.?5,5 = )r$ J r%0+*.,5 )r$ J r%0+ D ?.?5M. 3tep ,: "alculate the beta of the new portfolio: )>5??,???O>5,5??,???+)?./5+ = )>5,???,???O>5,5??,???+)*.,5+ D *.,?M5. 3tep -: "alculate the required return on the new portfolio: 5.,5@ = )5.M@+)*.,?M5+ D **./5@. 7+13 After additional invest ents are ade, for the entire fund to have an expected return of *-@, the portfolio ust have a beta of *.5M55 as shown below: *-@ D M.5@ = )5.5@+b b D *.5M55. 3ince the funds beta is a weighted average of the betas of all the individual invest ents, we can calculate the required beta on the additional invest ent as follows: *.5M55 D
)>,? ,??? ,??? +)* .5+ >5,??? ,??? < = >,5 ,??? ,??? >,5 ,??? ,???

*.5M55 D *., = ?.,< ?.-M55 D ?.,< <D *./,/5. 7+1* a0 )>* illion+)?.5+ = )>?+)?.5+ D >?.5 illion. illion.

b0 :ou would probabl! take the sure >?.5 c0 %isk averter. d0 *. )>*.*5

illion+)?.5+ = )>?+)?.5+ D >5/5,???, or an expected profit of >/5,???.

,. >/5,???O>5??,??? D *5@. -. 7his depends on the individuals degree of risk aversion. M. Again, this depends on the individual. 5. 7he situation would be unchanged if the stocks returns were perfectl! positivel! correlated. (therwise, the stock portfolio would have the sa e expected return as the single stock )*5@+ but a lower standard deviation. .f the correlation coefficient between each pair of stocks was a negative one, the portfolio would be virtuall! riskless. 3ince for stocks is generall! in the

Chapter 7: Risk and Rates of Return

Answers and Solutions 117

range of =?.-5, investing in a portfolio of stocks would definitel! be an i prove ent over investing in the single stock. Q r< D *?@K b< D ?.AK < D -5@. Q r: D *,.5@K b: D *.,K : D ,5@. r%0 D 9@K %#$ D 5@. a0 "H< D -5@O*?@ D -.5. "H: D ,5@O*,.5@ D ,.?. b0 0or diversified investors the relevant risk is easured b! beta. 7herefore, the stock with the higher beta is ore risk!. 3tock : has the higher beta so it is ore risk! than 3tock <. c0 r< D 9@ = 5@)?.A+ D *?.5@. r: D 9@ = 5@)*.,+ D *,@. r< D *?@. d0 r< D *?.5@K Q r: D *,.5@. r: D *,@K Q 3tock : would be ost attractive to a diversified investor since its expected return of *,.5@ is greater than its required return of *,@. e0 bp D )>/,5??O>*?,???+?.A = )>,,5??O>*?,???+*., D ?.9/5? = ?.-? D ?.A/5?. rp D 9@ = 5@)?.A/5+ D *?.B/5@. f0 .f %#$ increases fro 5@ to 9@, the stock with the highest beta will have the largest increase in its required return. 7herefore, 3tock : will have the greatest increase. "heck: r< D 9@ = 9@)?.A+ D **.M@. r: D 9@ = 9@)*.,+ D *-.,@. 7+11 .ncrease *?.5@ to **.M@. .ncrease *,@ to *-.,@.

7+11

7he answers to a, b, c, and d are given below: ,??M ,??5 ,??9 rA )*B.??@+ --.?? *5.?? rG )*M.5?@+ ,*.B? -?.5? #ortfolio )*9.,5@+ ,/.M? ,,./5

118 Answers and Solutions

Chapter 7: Risk and Rates of Return

,??/ ,??B $ean 3td. Dev. "oef. Har.

)?.5?+ ,/.?? **.-? ,?./A *.BM

)/.9?+ ,9.-? **.-? ,?./B *.BM

)M.?5+ ,9.95 **.-? ,?.**./B

e0 A risk-averse investor would choose the portfolio over either 3tock A or 3tock G alone, since the portfolio offers the sa e expected return but with less risk. 7his result occurs because returns on A and G are not perfectl! positivel! correlated )rAG D ?.BB+. 7+1&
r a0 Q $ D ?.*)-,B@+ = ?.,)?@+ = ?.M)*,@+ = ?.,)-?@+ = ?.*)5?@+ D *-@.

r%0 D 9@. )given+ 7herefore, the 3$2 equation is: ri D r%0 = )r$ J r%0+bi D 9@ = )*-@ J 9@+bi D 9@ = )/@+bi. b0 0irst, deter ine the funds beta, b0. 7he weights are the percentage of funds invested in each stock: A D >*9?O>5?? D ?.-,. G D >*,?O>5?? D ?.,M. " D >B?O>5?? D ?.*9. D D >B?O>5?? D ?.*9. E D >9?O>5?? D ?.*,. b0 D ?.-,)?.5+ = ?.,M)*.,+ = ?.*9)*.B+ = ?.*9)*.?+ = ?.*,)*.9+ D ?.*9 = ?.,BB = ?.,BB = ?.*9 = ?.*A, D *.?BB. 6ext, use b0 D *.?BB in the 3$2 deter ined in #art a:
Q r0 D 9@ = )*-@ J 9@+*.?BB D 9@ = /.9*9@ D *-.9*9@.

c0 r6 D %equired rate of return on new stock D 9@ = )/@+*.5 D *9.5@. An expected return of *5@ on the new stock is below the *9.5@ required rate of r6 D *5@, the return on an invest ent with a risk of b D *.5. 3ince r6 D *9.5@ F Q new stock should not be purchased. 7he expected rate of return that would ake the fund indifferent to purchasing the stock is *9.5@.

Chapter 7: Risk and Rates of Return

Answers and Solutions 113

Co,prehensive8Spreadsheet #rob5e,

Note to Instructors: 7he solution to this proble is not provided to students at the back of their text. .nstructors can access the Excel file on the textbooks web site or the .nstructors %esource "D. 7+12 a0

#!!8 #!!7 #!!" #!!5 #!!$ &v' Returns


b0 Standard deviation of return

Bartman #$.7% %$.#% "#.8% #.9% "1.!% #9.$%

Reynolds %1.1% 13.#% %1!.!% %!.$% 11.7% #.7%


Bartman 31.5%

Index 3#.8% 1.#% 3$.9% 1$.8% 19.!% #!."%


Reynolds 9.7% Index 13.8%

(n a stand-alone basis, it would appear that Gart an is the the least risk!. c0
Coefficient of ariation Bartman 1.!7

ost risk!, %e!nolds


Index !."7

Reynolds 3."3

%e!nolds now looks d0

ost risk!, because its risk )3D+ per unit of return is highest.

Stoc( Returns s. Index


Stoc(s) Returns "0% 60% !0% 40% 0% 20% 10% 0% -10%0.0% -20%

#artma$ Re%$o&ds

10.0%

20.0%

0.0%

40.0%

Index Returns

.t is clear that Gart an oves with the arket and %e!nolds oves counter to the arket. 3o, Gart an has a positive beta and %e!nolds a negative one. e0 Gart ans calculations: 1&* Comprehensive/Spreadsheet Problem Chapter 7: Risk and Rates of Return

%e!nolds calculations:
SUMMARY OUTPUT Regression Statistics Multiple R 0.79735 R Square 0.63576 Ad$usted R Square 0.5%&35 Standard 'rror 0.06769 O!ser(ations 5 A)O*A df Re+ression Residual Total % 3 & SS 0.0,399 0.0%37& 0.0377& MS 0.0,399 0.00&5F Significance F 5.,36&% 0.%06%,

Reynolds !eta "

#0.560

.nter/ept 0 *aria!le %

Coefficients Standard Error 0.%&%96 0.05-7& #0.560&6 0.,&&9,

t Stat ,.&%659 #,.,--3,

P-value 0.09&&6 0.%06%,

Lower 95% Upper 95% Lower 95 !% Upper 95 !% #0.0&&99 0.3,-9, #0.0&&99 0.3,-9, #%.3399% 0.,%-99 #%.3399% 0.,%-99

R'S.1UA2 OUTPUT "#servation % , 3 & 5 Predicted $ #0.0&%65 0.%35%& #0.05360.05-75 0.035,, Residuals 0.03%%3 #0.00,-3 #0.0&676 #0.06,9, 0.0-%3-

6ote that these betas are consistent with the scatter diagra s we constructed earlier. %e!noldsV beta suggests that it is less risk! than average in a "A#$ sense, whereas Gart an is ore risk! than average.

Chapter 8: Risk and Rates of Return

Comprehensive/Spreadsheet Problem 1&1

f0

0ar(et Return , Ris(%free rate , Re-uired return Bartman1 Re-uired return Re-uired return Reynolds1 Re-uired return Re-uired return ,

11.!!!% ".!$!% Ris(%free rate / 0ar(et Ris( *remium 3 Beta

, ,

".!$!% 13."75%

$.9"!%

1.539

, ,

".!$!% 3.#"!%

$.9"!%

%!.5"!

7his suggests that %e!noldsV stock is like an insurance polic! that has a low expected return, but it will pa! off in the event of a arket decline. Actuall!, it is hard to find negative-beta stocks, so we would not be inclined to believe the %e!noldsV data. g0 7he beta of a portfolio is si pl! a weighted average of the betas of the stocks in the portfolio, so this portfolioVs beta would be:
*ortfolio +eta , !.$9 / 0ar(et Ris( *remium $.9"!% Beta !.$89

Re-uired return on .ortfolio , Ris(%free rate Re-uired return , ".!$!% *ortfolio re-uired return , 8.$"8%

h0
Bartman Stoc( & Stoc( B Stoc( C *ortfolio Beta , Re-uired return on .ortfolio , Re-uired return on .ortfolio , Re-uired return on .ortfolio , Beta 1.539 !.7"9 !.985 1.$#3 1.179

*ortfolio 2ei'3t #5% 15% $!% #!% 1!!%

Ris(%free rate / ".!$% 11.89%

0ar(et Ris( *remium $.9"%

Beta 1.179

1&1 Comprehensive/Spreadsheet Problem

Chapter 7: Risk and Rates of Return

9ntegrated Case
7+1(

China Deve5op,ent 9ndustria5 6ank is! and eturn


Assu e that !ou recentl! graduated with a a'or in finance. :ou 'ust landed a 'ob as a financial planner with "hina Develop ent .ndustrial Gank )"D.G+, a large financial services corporation. :our first assign ent is to invest >*??,??? for a client. Gecause the funds are to be invested in a business at the end of * !ear, !ou have been instructed to plan for a *-!ear holding period. 0urther, !our boss has restricted !ou to the invest ent alternatives in the following table, shown with their probabilities and associated outco es. )0or now, disregard the ite s at the botto of the dataK !ou will fill in the blanks later.+
Returns on A5ternative 9nvest,ents %sti,ated Rate of Return "igh Co55ec+ ;0S0 7arket $ech tions Rubber #ortfo5i o a -,/.?@ ,/.?@ 9.?@ -*/.?@ -/.? *-.? -*M.? --.? *5.? ?.? -.? *?.? -?.? -**.? M*.? ,5.? M5.? -,*.? ,9.? -B.? *.?@ *-., *-., -?.B/ A.B@ *B.B *.A ?.BB *?.5@ *5., *.M

State of the %cono,: %ecession Gelow Avg. Average Above Avg. Goo

#rob0 ?.* ?., ?.M ?., ?.*

$+6i55s 5.5@ 5.5 5.5 5.5 5.5 ?.?

1+Stock #ortfo5i o ?.?@ /.5 *,.? -.M ?.5

r+hat ) < rStd0 dev0 ) Coeff0 of =ar0 )C=beta )ba

6ote that the esti ated returns of ;.3. %ubber do not alwa!s ove in the sa e direction as the overall econo !. 0or exa ple, when the econo ! is below average, consu ers purchase fewer tires than the! would if the econo ! were stronger. Lowever, if the econo ! is in a flat-out recession, a large nu ber of consu ers who were planning to purchase a new car a! choose to wait and instead purchase new tires for the car the! currentl! own. ;nder these circu stances, we would expect ;.3. %ubbers stock price to be higher if there was a recession than if the econo ! was 'ust below average.

Chapter 7: Risk and Rates of Return

Integrated Case 1&&

"D.Gs econo ic forecasting staff has developed probabilit! esti ates for the state of the econo !K and its securit! anal!sts have developed a sophisticated co puter progra , which was used to esti ate the rate of return on each alternative under each state of the econo !. Ligh 7ech .nc. is an electronics fir , "ollections .nc. collects past-due debts, and ;.3. %ubber various other rubber and plastics products. "D.G also portfolio4 that owns a anufactures tires and aintains a 1 arket arket results. Eiven

arket-weighted fraction of all publicl! traded stocksK !ou

can invest in that portfolio, and thus obtain average stock the situation as described, answer the following questions. A0

)1- >h: is the $+bi55?s return independent of the state of the econo,:@ Do $+bi55s pro,ise a co,p5ete5: risk+free return@ %Ap5ain0

Answer:

P3how 3/-* through 3/-/ here.S 7he 5.5@ 7-bill return does not depend on the state of the econo ! because the 7reasur! will+ redee ust )and the bills at par regardless of the state of the econo !.

7he 7-bills are risk-free in the default risk sense because the 5.5@ return will be realiCed in all possible econo ic states. Lowever, re e ber that this return is co posed of the real risk-free rate, sa! -@, plus an inflation pre iu , sa! ,.5@. 3ince there is uncertaint! about inflation, it is unlikel! that the realiCed real rate of return would equal the expected -@. 0or exa ple, if inflation averaged -.5@ over the !ear, then the realiCed real return would onl! be 5.5@ J -.5@ D ,@, not the expected -@. 7hus, in ter s of purchasing power, 7-bills are not riskless. Also, if !ou invested in a portfolio of 7-bills, and rates then declined, !our no inal inco e would fallK that is, 7-bills are exposed to reinvest ent rate risk. 3o, we conclude that there are no trul! risk-free securities in the ;nited 3tates. .f the 7reasur! sold inflation1&2 Integrated Case Chapter 7: Risk and Rates of Return

indexed, tax-exe pt bonds, the! would be trul! riskless, but all actual securities are exposed to so e t!pe of risk. A0 )1- >h: are "igh $ech?s returns eApected to ,ove .ith the econo,:B .hereas Co55ections? are eApected to ,ove counter to the econo,:@ Answer: P3how 3/-B here.S Ligh 7echs returns ove with, hence are

positivel! correlated with, the econo !, because the fir s sales, and hence profits, will generall! experience the sa e t!pe of ups and downs as the econo !. .f the econo ! is boo ing, so will Ligh 7ech. (n the other hand, "ollections is considered b! an! investors to be a hedge against both bad ti es and high inflation, so if the stock arket crashes, investors in this stock should do relativel! well. 3tocks such as "ollections are thus negativel! correlated with ) ove counter to+ the econo !. )6ote: .n actualit!, it is al ost i possible to find stocks that are expected to 60 ove counter to the econo !.+

Ca5cu5ate the eApected rate of return on each a5ternative and fi55 in the b5anks on the ro. for < r in the previous tab5e0

Answer:

P3how 3/-A and 3/-*? here.S 7he expected rate of return, < r , is expressed as follows:
< r=

# r 0
i=1 i i

Lere #i is the probabilit! of occurrence of the ith state, ri is the esti ated rate of return for that state, and ! is the nu ber of states. Lere is the calculation for Ligh 7ech:
< r "igh $ech C *01)+170*D- E *01)+70*D- E *02)1(0*D- E *01)&*0*D-

E *01)2(0*DC 1102D0
Chapter 7: Risk and Rates of Return Integrated Case 1&(

&e use the sa e for ula to calculate rs for the other alternatives:
< r $+bi55s C (0(D0 < r Co55ections C 10*D0 < r ;0S0 Rubber C 308D0 < r 7 C 1*0(D0

C0

ou shou5d recogniFe that basing a decision so5e5: on eApected returns is appropriate on5: for risk+neutra5 individua5s0 6ecause :our c5ientB 5ike ,ost peop5eB is risk+ averseB the riskiness of each a5ternative is an i,portant aspect of the decision0 One possib5e ,easure of risk is the standard deviation of returns0 )1- Ca5cu5ate this va5ue for each a5ternativeB and fi55 in the b5ank on the ro. for in the tab5e0

Answer:

P3how 3/-** and 3/-*, here.S 7he standard deviation is calculated as follows: C

)r
i=1

< r-1 #i 0

"igh $ech C G)+170* H 1102-1)*01- E )+70* H 1102-1)*01E )1(0* H 1102-1)*02- E )&*0* H 1102-1)*01E )2(0* H 1102-1)*01-IJ C 2*102 C 1*0*D0 Lere are the standard deviations for the other alternatives: $+bi55s C *0*D0 Co55ections C 1&01D0 ;0S0 Rubber C 1808D0

1&4 Integrated Case

Chapter 7: Risk and Rates of Return

7 C 1(01D0 C0 )1- >hat t:pe of risk is ,easured b: the standard deviation@ P3how 3/-*- through 3/-*5 here.S 7he standard deviation is a easure of a securit!s )or a portfolios+ stand-alone risk. 7he larger the standard deviation, the higher the probabilit! that actual realiCed returns will fall far below the expected return, and that losses rather than profits will be incurred. C0 )&- Dra. a graph that sho.s rough5: the shape of the probabi5it: distributions for "igh $echB ;0S0 RubberB and $+bi55s0 Ans.er:
P r o b a b i li t y o f O c c u rre n c e

Answer:

T # 4 ills

5 i+ 6 T e / 6

U .S . R u ! ! e r

-6 0

-4 5

-3 0

-1 5

15

30

45

60

R a te o f R e tu rn (% )

(n the basis of these data, Ligh 7ech is the 7-bills the least risk!. D0

ost risk! invest ent,

Suppose :ou sudden5: re,e,bered that the coefficient of variation )C=- is genera55: regarded as being a better ,easure of stand+a5one risk than the standard deviation .hen the a5ternatives being considered have .ide5: differing eApected returns0 Ca5cu5ate the ,issing C=sB and fi55 in the b5anks on the ro. for C= in the tab5e0 Does the C=

Chapter 7: Risk and Rates of Return

Integrated Case 1&7

produce the sa,e risk rankings as the standard deviation@ %Ap5ain0 Answer: P3how 3/-*9 through 3/-*A here.S 7he coefficient of variation )"H+ is a standardiCed easure of dispersion about the expected valueK it shows the a ount of risk per unit of return. C= C 8 < r0 C=$+bi55s C *0*D8(0(D C *0*0 C="igh $ech C 1*0*D81102D C 1040 C=Co55ections C 1&01D810*D C 1&010 C=;0S0 Rubber C 1808D8308D C 1030 C=7 C 1(01D81*0(D C 1020 &hen we easure risk per unit of return, "ollections, with its low ost risk! stock. 7he "H is a better

expected return, beco es the

easure of an assets stand-alone risk than because "H considers both the expected value and the dispersion of a distribution8a securit! with a low expected return and a low standard deviation could have a higher chance of a loss than one with a high but a high < r. %0 Suppose :ou created a 1+stock portfo5io b: investing K(*B*** in "igh $ech and K(*B*** in Co55ections0
r )1- Ca5cu5ate the eApected return ) < p -B the standard deviation

) p-B and the coefficient of variation )C=p- for this portfo5io and fi55 in the appropriate b5anks in the tab5e0 Answer: P3how 3/-,? through 3/-,- here.S 7o find the expected rate of return on the two-stock portfolio, we first calculate the rate of return on the portfolio in each state of the econo !. 3ince we have half of our

1&8 Integrated Case

Chapter 7: Risk and Rates of Return

one! in each stock, the portfolios return will be a weighted average in each t!pe of econo !. 0or a recession, we have: rp D ?.5)-,/@+ = ?.5),/@+ D ?@. &e would do si ilar calculations for the other states of the econo !, and get these results: State #ortfo5io %ecession ?.?@ Gelow average -.? Average /.5 Above average A.5 *,.? Goo 6ow we can ultipl! the probabilit! ti es the outco e in each state to get the expected return on this two-stock portfolio, 9./@. Alternativel!, we could appl! this for ula, r C .i ri C *0()1102D- E *0()10*D- C 407DB which finds r as the weighted average of the expected returns of the individual securities in the portfolio. .t is te pting to find the standard deviation of the portfolio as the weighted average of the standard deviations of the individual securities, as follows: p .i) i- E .j) j- C *0()1*D- E *0()1&01D- C 1404D0 Lowever, this is not correct8it is necessar! to use a different for ula, the one for that we used earlier, applied to the two-stock portfolios returns. 7he portfolios depends 'ointl! on )*+ each securit!s and ),+ the correlation between the securities returns. 7he best wa! to approach the proble is to esti ate the portfolios risk and return in each state of the econo !, and then to esti ate p with the for ula. Eiven the distribution of returns for the portfolio, we can calculate the portfolios and "H as shown below:

Chapter 7: Risk and Rates of Return

Integrated Case 1&3

p C G)*0* H 407-1)*01- E )&0* H 407-1)*01- E )70( H 407-1)*02E )30( + 407-1)*01- E )110* H 407-1)*01-IJ C &02D0 C=p C &02D8407D C *0(10 %0 )1- "o. does the riskiness of this t.o+stock portfo5io co,pare .ith the riskiness of the individua5 stocks if the: .ere he5d in iso5ation@ Answer: P3how 3/-,M through 3/-,B here.S ;sing either or "H as our standalone risk easure, the stand-alone risk of the portfolio is significantl! less than the stand-alone risk of the individual stocks. 7his is because the two stocks are negativel! correlated8when Ligh 7ech is doing poorl!, "ollections is doing well, and vice versa. "o bining the two stocks diversifies awa! so e of the risk inherent in each stock if it were held in isolation, i.e., in a *-stock portfolio.

Optiona5 /uestion
Does the eApected rate of return on the portfo5io depend on the percentage of the portfo5io invested in each stock@ >hat about the riskiness of the portfo5io@ Answer: ;sing a spreadsheet odel, its eas! to var! the co position of the

portfolio to show the effect on the portfolios expected rate of return and standard deviation: D in "igh $ech ?@ *? ,? -? M? 5? 9?
12* Integrated Case

"igh $ech #5us Co55ections < r p p *.?@ ,.* -.M.M 5.9 9./ /.B *-.,@ A.A 9.9 -., ?.M -.M 9.B

Chapter 7: Risk and Rates of Return

/? B? A? *??

A.? *?.* **.*,.M

*?.* *-.M *9./ ,?.? erel! a linear

7he expected rate of return on the portfolio is portfolio risk is another

co bination of the two stocks expected rates of return. Lowever, atter. p begins to fall as Ligh 7ech and

"ollections are co binedK it reaches near Cero at M?@ Ligh 7echK and then it begins to rise. Ligh 7ech and "ollections can be co bined to for a near Cero risk portfolio because the! are ver! close to being perfectl! negativel! correlatedK their correlation coefficient is -?.AAA5. )6ote: ;nfortunatel!, we cannot find an! actual stocks with r D -*.?.+ '0 Suppose an investor starts .ith a portfo5io consisting of one rando,5: se5ected stock0 >hat .ou5d happen: )1- to the riskiness and to the eApected return of the portfo5io as ,ore rando,5: se5ected stocks .ere added to the portfo5io@ )1>hat is the i,p5ication for investors@ Dra. a graph of the t.o portfo5ios to i55ustrate :our ans.er0 Answer: P3how 3/-,A here.S
Density Portfolio of Stocks it! r" # 10$5%

One Stock

10$5

7he standard deviation gets s aller as

ore stocks are co bined in

the portfolio, while rp )the portfolios return+ re ains constant. 7hus,


Chapter 7: Risk and Rates of Return Integrated Case 121

b! adding stocks to !our portfolio, which initiall! started as a *-stock portfolio, risk has been reduced. .n the real world, stocks are positivel! correlated with one another8if the econo ! does well, so do stocks in general, and vice versa. "orrelation coefficients between stocks generall! range in the vicinit! of =?.-5. A single stock selected at rando would on average have a standard deviation of about -5@. As additional stocks are added to the portfolio, the portfolios standard deviation decreases because the added stocks are not perfectl! positivel! correlated. Lowever, as ore and ore stocks are added, each new stock has less of a risk-reducing i pact, and eventuall! adding additional stocks has virtuall! no effect on the portfolios risk as easured b! . .n fact, stabiliCes at about ,?@ when M? or ore

rando l! selected stocks are added. 7hus, b! co bining stocks into well-diversified portfolios, investors can eli inate al ost one-half the riskiness of holding individual stocks. )6ote: .t is not co pletel! costless to diversif!, so even the largest institutional investors hold less than all stocks. Even index funds generall! hold a s aller portfolio that is highl! correlated with an index such as the 3W# 5?? rather than holding all the stocks in the index.+ 7he i plication is clear: .nvestors should hold well-diversified portfolios of stocks rather than individual stocks. ).n fact, individuals can hold diversified portfolios through individual stocks. L0 )1- Shou5d the effects of a portfo5io i,pact the .a: investors think about the riskiness of individua5 stocks@ utual fund invest ents.+ G! doing so, the! can eli inate about half of the riskiness inherent in

121 Integrated Case

Chapter 7: Risk and Rates of Return

Answer:

P3how 3/--? and 3/--* here.S #ortfolio diversification does affect investors views of risk. A stocks stand-alone risk as or "H, is easured b! its a! be i portant to an undiversified investor, but it is not

relevant to a well-diversified investor. A rational, risk-averse investor ore interested in the i pact that the stock has on the riskiness of his or her portfolio than on the stocks stand-alone risk. 3tand-alone risk is co posed of diversifiable risk, which can be eli inated b! holding the stock in a well-diversified portfolio, and the risk that re ains is called entire L0 arket risk because it is present even when the arket portfolio is held.

)1- 9f :ou decided to ho5d a one+stock portfo5io )and conseMuent5: .ere eAposed to ,ore risk than diversified investors-B cou5d :ou eApect to be co,pensated for a55 of :our riskN that isB cou5d :ou earn a risk pre,iu, on the part of :our risk that :ou cou5d have e5i,inated b: diversif:ing@

Answer:

P3how 3/--, here.S .f !ou hold a one-stock portfolio, !ou will be exposed to a high degree of risk, but !ou wont be co pensated for it. .f the return were high enough to co pensate !ou for !our high risk, it would be a bargain for ore rational, diversified investors. 7he! would start bu!ing it, and these bu! orders would drive the price up and the return down. 7hus, !ou si pl! could not find stocks in the arket with returns high enough to co pensate !ou for the stocks diversifiable risk.

"0

$he eApected rates of return and the beta coefficients of the a5ternatives as supp5ied b: CD96?s co,puter progra, are as fo55o.s: Securit: Return ) < rRisk )6etaIntegrated Case 12&

Chapter 7: Risk and Rates of Return

"igh $ech 7arket ;0S0 Rubber $+6i55s Co55ections

1102D 1*0( 308 (0( 10*

10&1 10** *088 *0** )*087-

)1- >hat is a beta coefficientB and ho. are betas used in risk ana5:sis@ Answer: P3how 3/--- through 3/--A here.S
Return on Stock i %i&! 'ec! (%) (slo"e # beta # 1$3() 40
)arket (slo"e # beta # 1$0)

(0

'-*ills (slo"e # beta # 0)


-(0 (0 40

Return on t!e )arket (%)

-(0

)Draw the fra ework of the graph, put up the data, then plot the points for the arket )M5 line+ and connect the , and then get the

slope as 8 O D *.?.+ 3tate that an average stock, b! definition, oves with the Geta coefficients arket. 7hen do the sa e with Ligh 7ech and 7-bills. easure the relative volatilit! of a given stock vis-X-

vis an average stock. 7he average stocks beta is *.?. $ost stocks have betas in the range of ?.5 to *.5. 7heoreticall!, betas can be negative, but in the real world the! are generall! positive. Getas are calculated as the slope of the 1characteristic4 line, which is the regression line showing the relationship between a given stock and the general stock arket.

122 Integrated Case

Chapter 7: Risk and Rates of Return

As explained in &eb Appendix /A, we could esti ate the slopes, and then use the slopes as the betas. .n practice, 5 !ears of would be used to obtain a least squares regression line. "0 )1- Do the eApected returns appear to be re5ated to each a5ternative?s ,arket risk@ Answer: P3how 3/-M? here.S 7he expected returns are related to each alternatives arket risk8that is, the higher the alternatives rate of return the higher its beta. Also, note that 7-bills have Cero risk. "0 )&- 9s it possib5e to choose a,ong the a5ternatives on the basis of the infor,ation deve5oped thus far@ ;se the data given at the start of the prob5e, to construct a graph that sho.s ho. the $+bi55?sB "igh $ech?sB and the ,arket?s beta coefficients are ca5cu5ated0 $hen discuss .hat betas ,easure and ho. the: are used in risk ana5:sis0 Answer: &e do not !et have enough infor ation to choose a ong the various alternatives. &e need to know the required rates of return on these alternatives and co pare the with their expected returns. onthl! data, with 9? observations, would generall! be used, and a co puter

Chapter 7: Risk and Rates of Return

Integrated Case 12(

90

$he :ie5d curve is current5: f5atN that isB 5ong+ter, $reasur: bonds a5so have a (0(D :ie5d0 ConseMuent5:B CD96 assu,es that the risk+free rate is (0(D0 )1- >rite out the Securit: 7arket Line )S7L- eMuationB use it to ca5cu5ate the reMuired rate of return on each a5ternativeB and graph the re5ationship bet.een the eApected and reMuired rates of return0

Answer:

P3how 3/-M* through 3/-M- here.S Lere is the 3$2 equation: ri C rR' E )r7 H rR'-bi0 "D.G has esti ated the risk-free rate to be rR' D 5.5@. 0urther, our esti ate of r7 D < r 7 is *?.5@. 7hus, the required rates of return for the alternatives are as follows: "igh $ech: 7arket: (0(D E )1*0(D H (0(D-10&1 C 1101*D0 (0(D E )1*0(D H (0(D-10** C 1*0(*D0

;0S0 Rubber: (0(D E )1*0(D H (0(D-*088 C 303*D0 $+bi55s: Co55ections: 90 (0(D E )1*0(D H (0(D-* C (0(*D0 (0(D E )1*0(D H (0(D-+*087 C 101(D0

)1- "o. do the eApected rates of return co,pare .ith the reMuired rates of return@

Answer:

P3how 3/-MM and 3/-M5 here.S &e have the following relationships: %Apected ReMuired Return Return )< )rr*,.M@ *?.5 A.B 5.5 *,.*@ *?.5 A.A 5.5

Securit: Ligh 7ech $arket ;.3. %ubber 7-bills


124 Integrated Case

Condition ;ndervalued: < r Fr 0airl! valued ) arket equilibriu + (vervalued: r F < r 0airl! valued
Chapter 7: Risk and Rates of Return

"ollections

*.?

*.,

(vervalued: r F < r
S)23 r i # rR4 5 (r) ' rR4 )bi # 5$5% 5 5%(bi) %i&! 'ec! r)

Re,uire- an- ./"ecteRates of Return (%)


(( 1+ 14 10 6 ( -( -6 -($0 -1$0 0$0

1$S$ Rubber

r R4

0ollections
*eta

1$0

($0

)6ote: 7he plot looks so ewhat unusual in that the <-axis extends to the left of Cero. &e have a negative-beta stock, hence a required return that is less than the risk-free rate.+ 7he 7-bills and and ;.3. %ubber plot below it. 7hus, the 7-bills and the arket arket portfolio plot on the 3$2, Ligh 7ech plots above it, and "ollections portfolio pro ise a fair return, Ligh 7ech is a good deal because its expected return is above its required return, and "ollections and ;.3. %ubber have expected returns below their required returns. 90 )&- Does the fact that Co55ections has an eApected return that is 5ess than the $+bi55 rate ,ake an: sense@ %Ap5ain0 Answer: "ollections is an interesting stock. .ts negative beta indicates negative arket risk8including it in a portfolio of 1nor al4 stocks will eans that "ollections is a ake an lower the portfolios risk. 7herefore, its required rate of return is below the risk-free rate. Gasicall!, this valuable securit! to rational, well-diversified investors. 7o see wh!, consider this question: &ould an! rational investor ever invest ent that has a negative expected returnR 7he answer is 1!es48'ust think of the purchase of a life or fire insurance polic!. 7he
Chapter 7: Risk and Rates of Return Integrated Case 127

fire insurance polic! has a negative expected return because of co issions and insurance co pan! profits, but businesses bu! fire insurance because the! pa! off at a ti e when nor al operations are in bad shape. 2ife insurance is si ilar8it has a high return when work inco e ceases. A negative-beta stock is conceptuall! si ilar to an insurance polic!. 90 )2- >hat .ou5d be the ,arket risk and the reMuired return of a (*+(* portfo5io of "igh $ech and Co55ections@ Of "igh $ech and ;0S0 Rubber@ Answer: P3how 3/-M9 and 3/-M/ here.S 6ote that the beta of a portfolio is si pl! the weighted average of the betas of the stocks in the portfolio. 7hus, the beta of a portfolio with 5?@ Ligh 7ech and 5?@ "ollections is:
bp =
!

.b 0
i= 1 i i

bp C *0()b"igh $ech- E *0()bCo55ections- C *0()10&1- E *0()H*087C *011(B rp C rR' E )r7 H rR'-bp C (0(D E )1*0(D H (0(D-)*011(-

C (0(D E (D)*011(- C 404&D 404D0 0or a portfolio consisting of 5?@ Ligh 7ech plus 5?@ ;.3. %ubber, the required return would be: bp C *0()10&1- E *0()*088- C 101*0 rp C (0(D E (D)101*- C 110**D0 P0 )1- Suppose investors raised their inf5ation eApectations b: & percentage points over current esti,ates as ref5ected in the (0(D risk+free rate0 >hat effect .ou5d higher inf5ation have

128 Integrated Case

Chapter 7: Risk and Rates of Return

on the S7L and on the returns reMuired on high+ and 5o.+risk securities@ Answer: P3how 3/-MB here.S
Required return (5$0% (0$0% 15$0% 6ncrease- 6nflation 10$0% 5$0% 0$0% 0 0$5 1 4eta 1$5 ( Ori&inal scenario 6ncrease- Risk 78ersion 0!an&es in t!e S)2

Lere we have plotted the 3$2 for betas ranging fro

? to ,.?. 7he

base-case 3$2 is based on rR' D 5.5@ and r7 D *?.5@. .f inflation expectations increase b! - percentage points, with no change in risk aversion, then the entire 3$2 is shifted upward )parallel to the base case 3$2+ b! - percentage points. 6ow, rR' D B.5@, r7 D *-.5@, and all securities required returns rise b! - percentage points. 6ote that the P0 arket risk pre iu , r7 H rR', re ains at 5 percentage points.

)1- Suppose instead that investors? risk aversion increased enough to cause the ,arket risk pre,iu, to increase b: & percentage points0 )9nf5ation re,ains constant0- >hat effect .ou5d this have on the S7L and on returns of high+ and 5o.+ risk securities@

Answer:

P3how 3/-MA through 3/-5* here.S &hen investors risk aversion increases, the 3$2 is rotated upward about the :-intercept )rR'+. rR' re ains at 5.5@, but now r7 increases to *-.5@, so the arket risk

Chapter 7: Risk and Rates of Return

Integrated Case 123

pre iu

increases to B@. 7he required rate of return will rise sharpl! uch on low-beta securities.

on high-risk )high-beta+ stocks, but not

1(* Integrated Case

Chapter 7: Risk and Rates of Return

Optiona5 /uestion
'inancia5 ,anagers are ,ore concerned .ith invest,ent decisions re5ating to rea5 assets such as p5ant and eMuip,ent than .ith invest,ents in financia5 assets such as securities0 "o. does the ana5:sis that .e have gone through re5ate to rea5+asset invest,ent decisionsB especia55: corporate capita5 budgeting decisions@ Answer: 7here is a great deal of si ilarit! between !our financial asset decisions and a fir s capital budgeting decisions. Lere is the linkage: 10 A co pan! a! be thought of as a portfolio of assets. .f the

co pan! diversifies its assets, and especiall! if it invests in so e pro'ects that tend to do well when others are doing badl!, it can lower the variabilit! of its returns. 10 "o panies obtain their invest ent funds fro securities, the! require a risk pre iu investors, who

bu! the fir s stocks and bonds. &hen investors bu! these that is based on the co pan!s risk as the! )investors+ see it. 0urther, since investors in general hold well-diversified portfolios of stocks and bonds, the risk that is relevant to the fro &0 a arket-risk perspective. anager akes a decision to build a new arket risk, not is the securit!s arket risk, not its stand-alone risk. 7hus, investors view the fir s risk

7herefore, when a

plant, the riskiness of the invest ent in the plant that is relevant to the fir s investors )its owners+ is its its stand-alone risk. Accordingl!, coefficient. A particular asset anagers need to know how

ph!sical-asset invest ent decisions affect their fir s beta a! look quite risk! when viewed in isolation, but if its returns are negativel! correlated with
Chapter 7: Risk and Rates of Return Integrated Case 1(1

returns on discussion.

ost other stocks, the asset

a! reall! have low risk.

&e will discuss all this in

ore detail in our capital budgeting

1(1 Integrated Case

Chapter 7: Risk and Rates of Return

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