Chapter 8 Emba 503

CHAPTER 8 RISK AND RATE OF RETURN
8-1: The Based on the following probability distribution, what is the security
expected return?
State Probability r
1 0.2 -5.0%
2 0.4 10.0
3 0.4 30.0
Answer:
Expected rate of return= = Pr1r1+Pr2r2+Pr3r3
=0.2(-5.0%)+0.4(10.0%)+0.4(30.0%)
=(-0.01+0.16)
=0.15
or
=15.0%
8-2: What is the expected return of the following investment?
Probability Payoff
0.3 30.%
0.2 10.0%
0.5 -2.0%
Answer:
Expected rate of return= = Pr1r1+Pr2r2+Pr3r3
= 0.3(30%)+ 0.2(10.0%)+0.5(-2.0%)
=(0.11-0.01)
=0.10
or
=10.0%
8-3: Susan’s investment portfolio currently contains three stocks that have a
total value equal to $ 100000. The beta of this portfolio is 1.5. Susan is
considering investing and additional $50000 in a stock that has a beta equal
to 3. After she adds this stock, what will be the portfolio’s new beta?
Answer:
8-4: suppose are rRF = 5% ,rM= 12%. What is the appropriate required rate of
return for a stock that has a beta coefficient equal to 1.5?
Answer:
r= rRF+ (rM- rRF) β= 5%+ (12% - 5%)1.5=15.5%
8-5: The current risk free rate of return, rRF is 4% and the market risk
Premium, RPM is 5%. If the beta coefficient associated with a firm’s stock is
2.0, what should be the stock’s required rate of return?
Answer:
r= rRF+ (rM- rRF) β= 4%+ (5% )2.0=14.0%
8-6: Following is information for two stocks:

Investment Expected Return , Standard Deviation,σ
Stock D 10.0% 8.0%

Stock E 36.0 24.0%
Which investment has the greater relative risk?

Answer:
Coefficient of variation=CV= = = =0.8
Coefficient of variation=CV= = = =0.6667
8-7: ZR Corporation’s stock has a beta coefficient equal to 1.8 and a required
rate of return equal to 16%. If the expected rate of return on the market is
10%, what is the risk free rate of return, rRF ?
Answer:
rZR= rRF+ (rM- rRF) β
16%-= rRF+(10%-rRF)1.8
16%-= rRF+18%-1.8rRF
rRF=2.0%/0.8=2.5%
8-8: Currently the risk free rate is 3% and the expected market rate of return
is 10%, what is the expected return of the following three stock portfolio?
Amount Beta
Invested
$400,000 1.5
$500,000 2.0
$100,000 4.0
Answer:
Amount Weight Beta Portfolio Beta
Invested
$400,000 0.40 1.5 0.6

$500,000 0.50 2.0 1.0
$100,000 0.10 4.0 0.4
$10,00,000 2.0
Rp= rRF+ (rM- rRF) βp=3.0%+ (10.0%-3.0%)2=17.0%
8-9: The market and the stock S have the following probability distribution:
probability rM RS
0.3 15% 20%
0.4 9% 5%
0.3 18% 12%
a. Calculate the expected rate of return for the market and the stock S.
b. Calculate the standard deviation for the market and the stock S.
c. Calculate the coefficient of variation for the market and the stock S.
Answer:
a. Expected rate of return= M= Pr1r1+Pr2r2+Pr3r3
=0.3(15.0%) + 0.4(9.0%) + 0.3(18.0%)

=13.5%
Expected rate of return= S= Pr1r1+Pr2r2+Pr3r3
=0.3(20.0%)+0.4(5.0%)+0.3(12.0%)
=11.6%
= (0.3)( 15-0.1350)2+(0.4)(0.09-0.1350)2+(0.3)(0.18-0.1350)2 =.001485
=14.85%
σM= = 3.85%
= (0.3)(20.0-11.6)2+(0.4)(5.0-11.6)2+(0.3)(12.0-11.6)2= 38.64
σS= = 6.22%
b. Coefficient of variation=CVM= = = 3.85%/13.5%=0.29
Coefficient of variation=CVS= = = 6.22%/11.6%=0.536
8-10: Marvin has Investments with the following characteristics in his

portfolio:
Expected amount Invested
Investment return
ABC 30% $10,000
EFG 60% $15,000
QRP 20% $40,000
what is the expected return of Marvin’s portfolio investment, ?
Answer:
Expected amount Invested Weight Portfolio

Investment return (3) (4) return
(2) (5)=(2)*(4)
(1)
ABC 30% $10,000 0.1 3.0%
EFG 60% $15,000 0.5 8.0
QRP 20% $40,000 0.4 8.0
$100,000 19.0%
8-11: Stock X and Y have the following probability distribution of expected

future returns:
probability rX rY
0.1 -10% - 35%
0.2 2% 0%
0.4 12% 20%
0.2 20% 25%
0.1 38% 45%
a. Calculate the expected rate of return for Stock Y,
b. Calculate the standard deviationof expected rate of return for Stock X.

Also calculate the coefficient of variation for Stock Y. Is it possible that
most investors might regard as being less risky than Stock X? Explain.
Answer:
a. Expected rate of return= Y= Pr1r2+Pr2r2+Pr3r3+ Pr4r4+ Pr5r5
=0.1(-35.0%)+0.2 (0.0%)+0.4(20.0%)+0.2(25.0%)+0.1(45.0%)
=14.0%
b. = (0.1)(-10.0-12.0)2+(0.2)(2.0-12.0)2+(0.4)(12.0-12.0)2+ (0.2)(20-
12)2+(0.1)(38.0-12.0)2 += 148.8
σX= = 12.20%
Coefficient of variation=CVX= = = =1.02
Coefficient of variation=CVY= = = =1.45

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CHAPTER 8 RISK AND RATE OF RETURN

8-6: Following is information for two stocks:

Stock D 10.0% 8.0%

Which investment has the greater relative risk?

Coefficient of variation=CV= = = =0.6667

$400,000 0.40 1.5 0.6

=0.3(15.0%) + 0.4(9.0%) + 0.3(18.0%)

b. Coefficient of variation=CVM= = = 3.85%/13.5%=0.29

Coefficient of variation=CVS= = = 6.22%/11.6%=0.536

8-10: Marvin has Investments with the following characteristics in his

what is the expected return of Marvin’s portfolio investment, ?

Expected amount Invested Weight Portfolio

8-11: Stock X and Y have the following probability distribution of expected

b. Calculate the standard deviationof expected rate of return for Stock X.

Coefficient of variation=CVX= = = =1.02

Coefficient of variation=CVY= = = =1.45

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