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Lecture

SOC 202 Lecture Notes - Risk-Free Interest Rate, Risk Premium, Squared Deviations From The Mean


Department
Sociology
Course Code
SOC 202
Professor
Louis Pike

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CHAPTER13
RETURN, RISK, AND THE SECURITY MARKET LINE
Learning Objectives
LO1 The calculation for expected returns and standard deviation for individual securities and portfolios.
LO2 The principle of diversification and the role of correlation.
LO3 Systematic and unsystematic risk.
LO4 Beta as a measure of risk and the security market line.
Answers to Concepts Review and Critical Thinking Questions
1. (LO3) Some of the risk in holding any asset is unique to the asset in question. By investing in a variety of
assets, this unique portion of the total risk can be eliminated at little cost. On the other hand, there are some
risks that affect all investments. This portion of the total risk of an asset cannot be costlessly eliminated. In
other words, systematic risk can be controlled, but only by a costly reduction in expected returns.
2. (LO3) If the market expected the growth rate in the coming year to be 2 percent, then there would be no
change in security prices if this expectation had been fully anticipated and priced. However, if the market had
been expecting a growth rate different than 2 percent and the expectation was incorporated into security prices,
then the government’s announcement would most likely cause security prices in general to change; prices
would drop if the anticipated growth rate had been more than 2 percent, and prices would rise if the anticipated
growth rate had been less than 2 percent.
3. (LO3)
a. systematic
b. unsystematic
c. both; probably mostly systematic
d. unsystematic
e. unsystematic
f. systematic
4. (LO3)
a. a change in systematic risk has occurred; market prices in general will most likely decline.
b. no change in unsystematic risk; company price will most likely stay constant.
c. no change in systematic risk; market prices in general will most likely stay constant.
d. a change in unsystematic risk has occurred; company price will most likely decline.
e. no change in systematic risk; market prices in general will most likely stay constant.
5. (LO1) No to both questions. The portfolio expected return is a weighted average of the asset returns, so it must
be less than the largest asset return and greater than the smallest asset return.
6. (LO2) False. The variance of the individual assets is a measure of the total risk. The variance on a well-
diversified portfolio is a function of systematic risk only.
7. (LO2) Yes, the standard deviation can be less than that of every asset in the portfolio. However, βp cannot be
less than the smallest beta because βp is a weighted average of the individual asset betas.
8. (LO4) Yes. It is possible, in theory, to construct a zero beta portfolio of risky assets whose return would be
equal to the risk-free rate. It is also possible to have a negative beta; the return would be less than the risk-free
rate. A negative beta asset would carry a negative risk premium because of its value as a diversification
instrument.
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9. (LO1) Such layoffs generally occur in the context of corporate restructurings. To the extent that the market
views a restructuring as value-creating, stock prices will rise. So, it’s not layoffs per se that are being cheered
on. Nonetheless, Bay Street does encourage corporations to takes actions to create value, even if such actions
involve layoffs.
10. (LO1) Earnings contain information about recent sales and costs. This information is useful for projecting
future growth rates and cash flows. Thus, unexpectedly low earnings often lead market participants to
reduce estimates of future growth rates and cash flows; price drops are the result. The reverse is often true for
unexpectedly high earnings.
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to
space and readability constraints, when these intermediate steps are included in this solutions manual, rounding
may appear to have occurred. However, the final answer for each problem is found without rounding during any
step in the problem.
Basic
1. (LO1) The portfolio weight of an asset is total investment in that asset divided by the total portfolio value.
First, we will find the portfolio value, which is:
Total value = 180($45) + 140($27) = $11,880
The portfolio weight for each stock is:
WeightA = 180($45)/$11,880 = .6818
WeightB = 140($27)/$11,880 = .3182
2. (LO1) The expected return of a portfolio is the sum of the weight of each asset times the expected return of
each asset. The total value of the portfolio is:
Total value = $2,950 + 3,700 = $6,650
So, the expected return of this portfolio is:
E(Rp) = ($2,950/$6,650)(0.11) + ($3,700/$6,650)(0.15) = .1323 or 13.23%
3. (LO1) The expected return of a portfolio is the sum of the weight of each asset times the expected return of
each asset. So, the expected return of the portfolio is:
E(Rp) = .60(.09) + .25(.17) + .15(.13) = .1160 or 11.60%
4. (LO1) Here we are given the expected return of the portfolio and the expected return of each asset in the
portfolio, and are asked to find the weight of each asset. We can use the equation for the expected return of a
portfolio to solve this problem. Since the total weight of a portfolio must equal 1 (100%), the weight of Stock
Y must be one minus the weight of Stock X. Mathematically speaking, this means:
E(Rp) = .124 = .14wX + .105(1 – wX)
We can now solve this equation for the weight of Stock X as:
.124 = .14wX + .105 – .105wX
.019 = .035wX
wX = 0.542857
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So, the dollar amount invested in Stock X is the weight of Stock X times the total portfolio value, or:
Investment in X = 0.542857($10,000) = $5,428.57
And the dollar amount invested in Stock Y is:
Investment in Y = (1 – 0.542857)($10,000) = $4,571.43
5. (LO1) The expected return of an asset is the sum of the probability of each return occurring times the
probability of that return occurring. So, the expected return of the asset is:
E(R) = .25(–.08) + .75(.21) = .1375 or 13.75%
6. (LO1) The expected return of an asset is the sum of the probability of each return occurring times the
probability of that return occurring. So, the expected return of the asset is:
E(R) = .20(–.05) + .50(.12) + .30(.25) = .1250 or 12.50%
7. (LO1) The expected return of an asset is the sum of the probability of each return occurring times the
probability of that return occurring. So, the expected return of each stock asset is:
E(RA) = .15(.05) + .65(.08) + .20(.13) = .0855 or 8.55%
E(RB) = .15(–.17) + .65(.12) + .20(.29) = .1105 or 11.05%
To calculate the standard deviation, we first need to calculate the variance. To find the variance, we find the
squared deviations from the expected return. We then multiply each possible squared deviation by its
probability, then add all of these up. The result is the variance. So, the variance and standard deviation of each
stock is:
σA2 =.15(.05 – .0855)2 + .65(.08 – .0855)2 + .20(.13 – .0855)2 = .00060
σA = (.00060)1/2 = .0246 or 2.46%
σB2 =.15(–.17 – .1105)2 + .65(.12 – .1105)2 + .20(.29 – .1105)2 = .01830
σB = (.01830)1/2 = .1353 or 13.53%
8. (LO1) The expected return of a portfolio is the sum of the weight of each asset times the expected return of
each asset. So, the expected return of the portfolio is:
E(Rp) = .25(.08) + .55(.15) + .20(.24) = .1505 or 15.05%
If we own this portfolio, we would expect to get a return of 15.05 percent.
9. (LO1, 2)
a. To find the expected return of the portfolio, we need to find the return of the portfolio in each state of the
economy. This portfolio is a special case since all three assets have the same weight. To find the
expected return in an equally weighted portfolio, we can sum the returns of each asset and divide by the
number of assets, so the expected return of the portfolio in each state of the economy is:
Boom: E(Rp) = (.07 + .15 + .33)/3 = .1833 or 18.33%
Bust: E(Rp) = (.13 + .03 .06)/3 = .0333 or 3.33%
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