BFF2631

FINANCIAL MANAGEMENT

TUTORIAL SET 09 - SOLUTIONS

RISK AND RETURN
Question One

a) Total risk can be decomposed into systematic risk and unsystematic risk. Explain each
component of risk, and how each is affected by increasing the number of securities in the
portfolio.

SOLUTION

Systematic risk is the risk attributable to the market and is variously described as market,
systematic and non-diversifiable risk. This risk will prevail even if the investor holds the
market portfolio.

Risk that is company specific is known as unique, non-systematic or diversifiable risk

and
the process of diversification will reduce the amount of unique risk in a portfolio.

Therefore, increasing the number of stocks in a portfolio will reduce (non-systematic)

unique risk. Diversification will not eliminate (systematic) market risk.

Ratio of the 1.2

portfolio
standard
deviation to 1
that of the
typical
0.8
individual
share As more shares are added to the portfolio, the
0.6 portfolio's risk declines, eventually leveling off

0.4

0.2

0
1 6 11 16 21 26 31 36
Number of shares in the portfolio
  As more shares are added, each new share has a smaller risk-reducing impact
 p falls very slowly after about 12-16 shares are included (Fama, 1976)
 By forming portfolios, we can eliminate about half the riskiness of individual shares
 However, there is a minimum level of risk that cannot be diversified away and that is
systematic portion
 Systematic risk exists as most assets returns are positively correlated with one
another. Systematic risk is the average covariance of the assets in the portfolio.
Diversification will exist for assets with correlations <1.

Number of Stocks in a Portfolio and the

Standard Deviation of Portfolio Return

Standard Deviation of Return

Unsystematic
(diversifiable)
Risk
Total
Risk

Systematic Risk

Number of Stocks in the Portfolio

47

b) The table gives information on two risky assets A and B:

Asset Expected Standard deviation Correlations

return (%) of return (%) A B
A 12.5 40 1.00 0.20
B 16 45 0.20 1.00

There is also a risk free asset F whose expected return is 8%.

(i) Portfolio 1 consists of 40 per cent asset A and 60 per cent Asset B. Calculate its
expected return and standard deviation.
(ii) Portfolio 2 consists of 40 per cent Asset A and 60 per cent in the risk free asset.
Calculate its expected return and standard deviation. Compare your answers to (i) and
comment.

SOLUTION

[1] Expected Return

40% A, 60% B,
so k p = (0.4)(0.125) + (0.6)(0.16) = 0.146, or 14.6%
 Standard Deviation
40% A, 60% B,
2P = (A2wA2)+ (B2wB2)+2ABwAwB rAB
= (0.402×0.402)+(0.452×0.602) + 2×0.40×0.45×0.40×0.60×0.20
= 0.11578
P = 0.11578 =34%

[2] Expected Return

40% A, 60% risk-free,
so k p = (0.4)(0.125) + (0.6)(0.08) = 0.098, or 9.8%

Standard Deviation
40% A, 60% risk-free,

2P = (A2wA2)+ (RF2wRF2)+2ARFwAwRF rARF

= (0.402×0.402) + (0.02×0.602) + 2×0.40×0.0×0.40×0.60×?
= 0.0256
P = 0.0256 =16%

Question Two

The following table provides a sample of the last six monthly percentage price changes for
two market indexes. You are encouraged to make use of the statistical functionality available
with your calculator when answering this question.

Month Nikkei Russell_2000

1 0.08 0.12
2 0.15 0.09
3 -0.12 -0.07
4 0.11 0.13
5 0.09 0.04
6 -0.06 -0.14

Calculate the following:

a) The expected monthly rate of return and standard deviation for each series
b) The covariance between the rates of return for Nikkei–Russell_2000
c) The correlation coefficient for Nikkei-Russell_2000
Sharp El 735S / SHARP EL-738 Business Financial Calculator
Step One: place the calculator in Stats mode for linear calculation: [MODE] [1] [1]
Procedure Key Operation Display
Enter calculator into STATS [MODE] [1] [1] Stat 1
mode 0.00
Step Two: enter the data as follows;
Procedure Key Operation Display
Enter cash flow data 0.08 (x,y) 0.12 [ENT] DATA SET =
1.00
0.15 (x,y) 0.09 [ENT] DATA SET =
2.00
0.12 [+/-] (x,y) DATA SET =
0.07 [+/-] [ENT] 3.00
0.11 (x,y) 0.13 [ENT] DATA SET =
4.00
0.09 (x,y) 0.04 [ENT] DATA SET =
5.00
0.06 [+/-] (x,y) DATA SET =
0.14 [+/-] [ENT] 6.00
Compute expected return [RCL] [4] –
for Nikkei X= 0.0417
Compute expected return [RCL] [7] –
for Russell_2000 Y= 0.0283
Compute std. deviation for [RCL] [5] SX =
Nikkei 0.1065
Compute std. deviation for [RCL] [8] SY =
Russell_2000 0.1102
Compute correlation for [RCL] [(]r r=
Nikkei-Russell_2000 0.8647
Compute covariance for [RCL] [(]r [×] r×Sx×Sy =
Nikkei-Russell_2000 [RCL] [5] [×]
[RCL] [8] 0.0101

a)
n
 ki
0.08  0.15  (0.12)  0.11  0.09  (0.06)
k NIKKEI  i 1   0.0417 or 4.17%
n 6
n
 k i2
 
n
k RUSSELL  ki i1k  0.12  0.09  (0.07)  0.13  0.04  (0.14)  0.0283 or 2.83%
 i 1
2 n 6
 NIKKEI
n 1
(.08  .0417)  (.15  .0417) 2  (.12  .0417) 2  (.11  .0417) 2  (.09  .0417) 2  (.06  .0417) 2
2
  0.011337
6 1

 NIKKEI  0.011337  0.1065

 2
 
n
 ki  k
2
 RUSSELL  i 1
n 1
(.12  .0283)  (.09  .0283) 2  (.07  .0283) 2  (.13  .0283) 2  (.04  .0283) 2  (.14  .0283) 2
2
  0.012137
6 1

 RUSSELL  0.012137  0.1102

b)
  
n let i = Nikkei and j = Russell_2000
 k it  k i k jt  k j
 ij  t 1
n 10.0283  0.15  0.04170.09  0.0283  ......  0.06  0.0417 0.14  0.0283
0.08  0.04170.12
 ij   0.010143
6 1

c)  Nikkei , Russell 0.010143

rNikkei , Russell    0.8647
 Nikkei   Russell 0.1065  0.1102

Question Three

Mr. Henry can invest in Highbull stock and Slowbear stock. His projection of the returns on
these two stocks is as follows:

State of Probability of Return on Return on

Economy State Occurring Highbull Stock (%) Slowbear Stock (%)
Recession 0.25 -0.02 0.05
Normal 0.60 0.092 0.062
Boom 0.15 0.154 0.074

a) Calculate the expected return on each stock.

b) Calculate the standard deviation of returns on each stock.
c) Calculate the covariance and correlation between returns on the two stocks.
d) Create an equally weighted portfolio and calculate the expected return and standard
deviation for this portfolio.

SOLUTION

a. Expected ReturnHB = (0.25)(-0.02) + (0.60)(0.092) + (0.15)(0.154)

= 0.0733
= 7.33%

The expected return on Highbull’s stock is 7.33%.

 Expected ReturnSB = (0.25)(0.05) + (0.60)(0.062) + (0.15)(0.074)
= 0.0608
= 6.08%

The expected return on Slowbear’s stock is 6.08%.

b. VarianceA (HB2)
= (0.25)(-0.02 – 0.0733)2 + (0.60)(0.092 – 0.0733)2 + (0.15)(0.154 – 0.0733)2
= 0.003363

Standard DeviationA (HB) = (0.003363)1/2

= 0.0580
= 5.80%

The standard deviation of Highbear’s stock returns is 5.80%.

VarianceB (SB2) = (0.25)(0.05 – 0.0608)2 + (0.60)(0.062 – 0.0608)2 + (0.15)(0.074 – 0.0608)2

= 0.000056

Standard DeviationB (B) = (0.000056)1/2

= 0.0075
= 0.75%

The standard deviation of Slowbear’s stock returns is 0.75%.

c. Covariance(RHB, RSB)
σA,B = (0.25)(-0.02 – 0.0733)(0.05 – 0.0608) + (0.60)(0.092 – 0.0733)(0.062 –
0.0608) + (0.15)(0.154 – 0.0733)(0.074 – 0.0608)
= 0.000425

The covariance between the returns on Highbull’s stock and Slowbear’s stock is
0.000425.

Correlation

rA,B = Covariance(RA, RB) / (A * B)

= 0.000425 / (0.0580 * 0.0075)
= 0.9770

The correlation between the returns on Highbull’s stock and Slowbear’s stock is 0.9770.

d. Expected Return with 50% Highbull and 50% Slowbear,

so k p = (0.5)(0.0.733) + (0.5)(0.0608) = 0.06705 or 6.71%

Standard Deviation with 50% Highbull and 50% Slowbear

2P = (HB2wHB2)+ (SB2wSB2)+2HBSBwHBwSB rHB,SB
= (0.502×0.0582)+(0.502×0.00752) + 2×0.50×0.50×0.058×0.0075×0.9770
= 0.000841+0.0000140625+0.0002124975 = 0.00106756
P = 0.00106756 =3.27%
Additional Practice (2012 Semester one Final Exam)

2012 Semester One Final Exam

Question 3 Risk and Return (10 marks)

SOLUTION

A)

n
 ri
10  7  11  9  18
(rA) = r = i 1 = = 0.11 or 11.0%
n 5
n
 ri
12  12  11  9  10
(rB) = r = i 1 = = 0.108 or 10.8%
n 5
n
 ri
7  12  32  15  13
(rC) = r = i 1 = = 0.058 or 5.8%
n 5
n
 ri
 3  11  22  2  1
(rD) = r = i 1 = = 0.018 or 1.8%
n 5

B)
n 2
 (ri  r )
2 = i 1 = (10  11) 2  (7  112  (11  11) 2  (9  11) 2  (18  11)2
n 1 5 1

 =  2 = 4.18%
n 2
 (ri  r )
(12  10.8) 2  (12  10.8) 2  (11  10.8) 2  (9  10.8) 2  (10  10.8) 2
2 = i 1 =
n 1 5 1
6 .8
= = 1.7
4
 =  2 = 1.30%

n 2
 (ri  r )
(7  5.8) 2  (12  5.8) 2  (32  5.8) 2  (15  5.8) 2  (13  5.8) 2
C2 = i 1 =
n 1 5 1
1442.8
= = 360.7
4
C =  2 =18.99%
 n 2
 (ri  r )
(3  1.8) 2  (11  1.8) 2  (22  1.8) 2  (2  1.8) 2  (1  1.8) 2
D2 = i 1 =
n 1 5 1
602.8
= = 150.7
4
D =  2 = 12.28%

C)
Security Expected Return Standard Deviation Coefficient of Variation
A 11.0% 4.18% 0.38
B 10.8% 1.30% 0.12
C 5.8% 18.99% 3.27
D 1.8% 12.28% 6.82
E 10.8% 15.31% 1.42


Using the Coefficient of Variation = relative ranking can be obtained. Security B minimises the risk
r
per unit of returns and is therefore optimal for a rational investor.