Finance 1 – Tutorial 5

10.2 vTwo common measures of the risk of a probability

The following table shows the
one-year return distribution of
distribution:
Startup, Inc. a) The expected return:
Probability 40% 20% 20% 10% 10% 𝔼 𝑅 = $ 𝑝! ×𝑅!
Return -120% -85% -40% -30% 1000% !
= 0.4× −1.2 + 0.2× −0.85 + 0.2× −0.4
Calculate: +0.1×(−0.3) + 0.1× 10
a) The expected return. = 0.24
a) The standard deviation of the return:
b) The standard deviation of " "
𝑉𝑎𝑟 𝑅 = 𝐸[ 𝑅 − 𝐸 𝑅 ] = $ 𝑝! × 𝑅! − 𝔼 𝑅
the return. !
= 0.4× −1.2 − 0.24 + 0.2× −0.85 − 0.24 "
"

+0.2× −0.4 − 0.24 " + 0.1× −0.3 − 0.24 "

+0.1× 10 − 0.24 " = 10.70

𝑆𝐷 𝑅 = 𝑉𝑎𝑟 𝑅 = 10.70 = 3.27 = 327%

 10.7 a) The average annual return:
The last four years of returns $"%
for a stock are as follows: 1
𝑅! = & 𝑅!
𝑇
!"#
Year 1 2 3 4 1
= −0.044 + 0.278 + 0.116 + 0.039 = 0.0973
Return -4.40% 27.80% 11.60% 3.90% 4
a) What is the average
annual return?
b) The variance of the stock’s return (variance estimate):
$"%
1
b) What is the variance of !
𝑉𝑎𝑟 (𝑅) = , 𝑅! − 𝑅- &
𝑇−1
the stock’s returns? !"#
1 −0.044 − 0.0973 + 0.278 − 0.0973 &
&

4 − 1 + 0.116 − 0.0973 & + 0.039 − 0.0973 &

c) What is the standard = 0.0188
deviation of the stock’s
returns?
c) Standard deviation of annual returns:
8 = 𝑉𝑎𝑟
𝑆𝐷 8 = 0.0188 = 0.1371
10.16
How does the relationship
between the average return
and the historical volatility of
individual stocks differ from
the relationship between the
average return and the
historical volatility of large,
well-diversified portfolios?

vFor large portfolios there is a relationship between returns and

volatility—portfolios with higher returns have higher volatilities. For
stocks, no clear relation exists.

vBut, we can see that larger stocks have lower volatility overall.
Besides, even the largest stocks are typically more volatile than a
portfolio of large stocks, the S&P 500.
10.20 vThe role of diversification:
Consider two local banks. Bank A
has 100 loans outstanding, each The expected payoffs are the same, but bank A is less risky.
for $1 million, that it expects will
be repaid today. Each loan has a
5% probability of default, in which 𝑉𝑎𝑟 𝑜𝑣𝑒𝑟𝑎𝑙𝑙 𝑝𝑎𝑦𝑜𝑓𝑓 𝑜𝑓 𝑏𝑎𝑛𝑘 𝑗 = $ 𝑉𝑎𝑟 𝑝𝑎𝑦𝑜𝑓𝑓 𝑜𝑓 𝑒𝑎𝑐ℎ 𝑙𝑜𝑎𝑛 𝑖
case the bank is not repaid !
"
anything. The chance of default
=$ $ 𝑅!,# − 𝔼 𝑅! ×𝑝#
is independent across all the
loans. Bank B has only one loan ! #${&,(}
of $100 million outstanding, vBank A:
which it also expects will be 𝑉𝑎𝑟 𝑅* = 100× $1 − $0.95 " ×0.95 + $0 − $0.95 " ×0.05
repaid today. It also has a 5% = 100×0.0475 = 4.75
probability of not being repaid.
Explain the difference between 𝑆𝐷 𝑅* = 𝑉𝑎𝑟 𝑅* = 4.75 = 2.179
the type of risk each bank faces.
Which bank faces less risk?
vBank B:
Why? 𝑉𝑎𝑟 𝑅+ = 1× $100 − $95 " ×0.95 + $0 − $95 " ×0.05
= 475
𝑆𝐷 𝑅+ = 𝑉𝑎𝑟 𝑅+ = 475 = 21.79
10.23 vFirst, calculate the statistics for an individual firm:
Consider an economy with 𝔼 𝑅 = 0.6×0.15 + 0.4×−0.10 = 0.05
two types of firms, S and I. S 𝑉𝑎𝑟 𝑅 = 0.6× 0.15 − 0.05 ! + 0.4× −0.10 − 0.05 !
= 0.015
𝑆𝐷 𝑅 = 𝑉𝑎𝑟(𝑅) = 0.015 = 0.1225
firms all move together. I
firms move independently. vPortfolio return with equal weights is defined as:
1
For both types of firms, there 𝑅" = ; 𝑅#
20
is a 60% probability that the
firms will have a 15% return
and a 40% probability that a) Calculating the volatility of a portfolio of S firms:
the firms will have a -10% Since the stocks move together, all the 𝑅# equal each other. The portfolio will be:
return. What is the volatility 𝑅" =
1
; 𝑅# =
1
×20×𝑅# = 𝑅#
(standard deviation) of a 20 20
portfolio that consists of an 𝑆𝐷 𝑅" = 𝑆𝐷 𝑅# = 0.1225
equal investment in 20 firms Which means that the portfolio has the same outcome as the underlying stock,
of: with the same volatility. There is no diversification benefit. So the standard
deviation of the portfolio is the same as the standard deviation of the stocks.
b) In the case that all the stocks are independent (IID), we can use Eq. 10.8:

a) type S?
1 1
𝑆𝐷 𝑅" = 𝑉𝑎𝑟(𝑅" ) = ×𝑆𝐷 𝑅# = ×0.1225 = 0.0274
b) type I? 20 20
10.33 vBeta measures the sensitivity of a security to market-wide risk factors.
Suppose the market portfolio is
vThe systematic risk of the strength of the economy produces a 30%-(-
equally likely to increase by 30% 10%)=40% change in the return of the market portfolio.
or decrease by 10%.
a) Calculate the beta of a firm a) Calculating beta:
that goes up on average by Δ𝑆𝑡𝑜𝑐𝑘 0.43 − (−0.17)
43% when the market goes 𝛽= = = 1.5
Δ𝑀𝑎𝑟𝑘𝑒𝑡 0.30 − (−0.10)
up and goes down by 17%
when the market goes down.
This means that each 1% change in the return of the market portfolio leads to a
b) Calculate the beta of a firm 1.5% change in the firm’s return on average.
that goes up on average by b) Calculating beta:
18% when the market goes Δ𝑆𝑡𝑜𝑐𝑘 −0.22 − 0.18
𝛽= = = −1.0
down and goes down by 22% Δ𝑀𝑎𝑟𝑘𝑒𝑡 0.30 − (−0.10)
when the market goes up.
This means that each 1% decrease in the return of the market portfolio leads to a
c) Calculate the beta of a firm 1.0% increase in the firm’s return on average.
that is expected to go up by
4% independently of the c) Calculating beta:
market. 𝛽=0
A firm that moves independently has no systematic risk, so its sensitivity to the
market movements is zero.
10.35
Suppose the market risk
premium is 5% and the risk-free
interest rate is 4%. Using the
data in Table 10.6, calculate the
expected return of investing in
a) Starbucks’ stock (Beta=0.80).

b) Hershey’s stock (Beta=0.33).

c) Autodesk’s stock
(Beta=1.72).
10.35
Suppose the market risk 𝐸 𝑅! = 𝑟! = 𝑟" + 𝛽!,$ × 𝐸[𝑅$ ] − 𝑟"
premium is 5% and the risk-free
interest rate is 4%. Using the a) Expected return:
data in Table 10.6, calculate the 𝔼 𝑅% = 0.04 + 0.8×0.05 = 0.08
expected return of investing in
a) Starbucks’ stock (Beta=0.80).
b) Expected return:
b) Hershey’s stock (Beta=0.33).
𝔼 𝑅& = 0.04 + 0.33×0.05 = 0.057

c) Autodesk’s stock c) Expected return:

(Beta=1.72).
𝔼 𝑅' = 0.04 + 1.72×0.05 = 0.126
11.2 a) Portfolio weights:
You own three stocks: 600 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑖 𝑃G ×𝑁G
shares of Apple Computer, 𝑥G = =
10,000 shares of Cisco Systems, 𝑇𝑜𝑡𝑎𝑙 v𝑎𝑙𝑢𝑒 of the portfolio ∑G 𝑃G ×𝑁G
and 5000 shares of Colgate-
Palmolive. The current share 600×$511
prices and expected returns of 𝑥HIIJK = = 0.3222
Apple, Cisco, and Colgate- 600×$511 + 10000×$16 + 5000×$97
Palmolive are, respectively, $511,
$16, $97 and 12%, 10%, 8%. 10000×$16
𝑥LGMNO = = 0.1681
a) What are the portfolio 600×$511 + 10000×$16 + 5000×$97
weights of the three stocks in
your portfolio? 5000×$97
𝑥LOJPQ!K = = 0.5097
600×$511 + 10000×$16 + 5000×$97
b) What is the expected return
of your portfolio?
b) Expected portfolio return:
𝔼 R R = , 𝑥G ×𝐸 R G
G
= 0.3222×0.12 + 0.1681×0.1 + 0.5097×0.08 = 0.0963
11.2 c) Portfolio weights:
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑠𝑡𝑜𝑐𝑘 𝑖 𝑃G ×𝑁G
You own three stocks: 600 𝑥G = =
shares of Apple Computer, 𝑇𝑜𝑡𝑎𝑙 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜 𝑉𝑎𝑙𝑢𝑒 ∑G 𝑃G ×𝑁G
10,000 shares of Cisco Systems, 600×$538
and 5000 shares of Colgate- 𝑥HIIJK = = 0.3335
600×$538 + 10000×$21 + 5000×$87
Palmolive. The current share
prices and expected returns of
Apple, Cisco, and Colgate- 10000×$21
Palmolive are, respectively, $511, 𝑥LGMNO = = 0.2170
600×$538 + 10000×$21 + 5000×$87
$16, $97 and 12%, 10%, 8%.
c) Suppose the price of Apple
stock goes up by $27, Cisco
5000×$87
𝑥LOJPQ!K = = 0.4495
rises by $5, and Colgate- 600×$538 + 10000×$21 + 5000×$87
Palmolive falls by $10. What
are the new portfolio
weights? d) Expected portfolio return:
d) Assuming the stocks’
expected returns remain the 𝔼 R R = , 𝑥G ×𝐸 R G
same, what is the expected G
return of the portfolio at the = 0.3335×0.12 + 0.2170×0.1 + 0.4495×0.08 = 0.0977
new prices?
11.5 v Calculate results by using definitions:
a) Average returns:
Using the data in the 1
𝑅h# = ; 𝑅$
following table, estimate 𝑇
$
1
𝑅% = × −0.1 + 0.2 + 0.05 − 0.05 + 0.02 + 0.09 = 0.035
6
1
𝑅& = × 0.21 + 0.07 + 0.3 − 0.03 − 0.08 + 0.25 = 0.12
6

v Variances:
1 !
(a) The average return and 𝑉𝑎𝑟 𝑅# = ; 𝑅#,$ − 𝑅h#
𝑇−1
volatility for each stock 1 −0.1 − 0.035 !
$
+ 0.2 − 0.035 ! + 0.05 − 0.035 !
𝑉𝑎𝑟 𝑅% = × !
6−1 −0.05 − 0.035 + 0.02 − 0.035 ! + 0.09 − 0.035 !
= 0.01123
(b) The covariance between
the stocks. 1 0.21 − 0.12 ! + 0.07 − 0.12 ! + 0.3 − 0.12 !
𝑉𝑎𝑟 𝑅& = ×
6−1 −0.03 − 0.12 ! + −0.08 − 0.12 ! + 0.25 − 0.12 !

= 0.02448
(c) The correlation between
these two stocks. v Volatilities:
𝑆𝐷 𝑅% = 0.001123 = 0.1060
𝑆𝐷 𝑅& = 0.02448 = 0.1565
11.5-cont b) Covariance:
1
Using the data in the 𝐶𝑜𝑣 𝑅& , 𝑅' = 6 𝑅&! − 𝑅& 𝑅'! − 𝑅7'
𝑇−1
!
following table, estimate
−0.1 − 0.035 × 0.21 − 0.12 +
0.2 − 0.035 × 0.07 − 0.12 +
1 0.05 − 0.035 × 0.3 − 0.12 +
𝐶𝑜𝑣 𝑅( , 𝑅) = ×
6−1 −0.05 − 0.035 × −0.03 − 0.12 +
0.02 − 0.035 × −0.08 − 0.12 +
0.09 − 0.035 × 0.25 − 0.12
(a) The average return and = 0.00104
volatility for each stock

c) Correlation:
(b) The covariance between 𝐶𝑜𝑣 𝑅( , 𝑅) 0.00104
𝐶𝑜𝑟𝑟 𝑅( , 𝑅) = = = 0.0627
the stocks. 𝑆𝐷 𝑅( ×𝑆𝐷 𝑅) 0.1060×0.1565

(c) The correlation between

these two stocks.
11.6 a) Portfolio Returns:
𝑅* = 0.5×𝑅( + 0.5×𝑅)
Use the data in Problem 5,
consider a portfolio that Year 2010 2011 2012 2013 2014 2015
maintains a 50% weight on Stock A -0.1 0.2 0.05 -0.05 0.02 0.09
stock A and a 50% weight on Stock B 0.21 0.07 0.3 -0.03 -0.08 0.25
stock B. Portfolio 0.055 0.135 0.175 -0.04 -0.03 0.17
a) What is the return each
year of this portfolio?
b) Portfolio average return and volatility:

b) Based on your results 1

𝑅* = × 0.055 + 0.135 + 0.175 − 0.04 − 0.03 + 0.17 = 0.0775
from part a, compute the 6
average return and
volatility of the portfolio. 𝑉𝑎𝑟 𝑅*
1
=
6−1
0.055 − 0.0775 + + 0.135 − 0.0775 + + 0.175 − 0.0775 +
×
−0.04 − 0.0775 + + −0.03 − 0.0775 + + 0.17 − 0.0775 +

= 0.009448
𝑆𝐷 𝑅* = 𝑉 𝑅* = 0.0972
11.6 c) Alternative calculation:
Use the data in Problem 5,
consider a portfolio that 𝑅, = 0.5×𝑅* + 0.5×𝑅+ = 0.5×0.035 + 0.5×0.12 = 0.0775
maintains a 50% weight on
stock A and a 50% weight on 𝑉𝑎𝑟 𝑅, = 𝑥-" 𝑉𝑎𝑟 𝑅- + 𝑥"" 𝑉𝑎𝑟 𝑅" + 2𝑥- 𝑥" 𝐶𝑜𝑣 𝑅- , 𝑅"
stock B. = 0.5" ×0.01123 + 0.5" ×0.02448 + 2×0.5×0.5×0.00104
c) Show that (i) the average = 0.009448
return of the portfolio is
equal to the average of 𝑆𝐷 𝑅, = 𝑉 𝑅, = 0.0972
the average returns of the
two stocks, and (ii) the
volatility of the portfolio d) The volatility is lower since some of the idiosyncratic risk of
equals the same result as the stocks in the portfolio is diversified away.
from the calculation in Eq.
11.9.
d) Explain why the portfolio
has a lower volatility than
the average volatility of
the two stocks.
11.19 vMarginal contribution to risk:
Stock A has a volatility of 29% 𝑆𝐷 𝑅g ×𝐶𝑜𝑟𝑟 𝑅g , 𝑅h
and a correlation of 29% with
your current portfolio. Stock B
has a volatility of 44% and a
correlation of 33% with your vFor A: 0.29×0.29 = 0.0841
current portfolio. You currently
hold both stocks. Which will vFor B: 0.44×0.33 = 0.1452
increase the volatility of your
portfolio:
i. selling a small amount of vVolatility increases if we sell a small amount
stock B and investing the
proceeds in stock A. of stock A and invest the proceeds in stock
or B.
ii. selling a small amount of
stock A and investing the
proceeds in stock B?
11.22 a) Using the definition of variance (risk) of a
Suppose Intel’s stock has an portfolio:
𝑉𝑎𝑟 𝑅*
expected return of 20% and a
= 𝑥,+ 𝑆𝐷 𝑅, + 𝑥-+ 𝑆𝐷
+ +
𝑅- + 2𝑥, 𝑥- 𝑆𝐷 𝑅, 𝑆𝐷 𝑅- 𝐶𝑜𝑟𝑟 𝑅, , 𝑅-
volatility of 30%, while Coca-
= 𝑥,+ 𝑆𝐷 𝑅, + + 𝑥-+ 𝑆𝐷 𝑅- + − 2𝑥, 𝑥- 𝑆𝐷 𝑅, 𝑆𝐷 𝑅-
Cola’s has an expected +
return of 7% and volatility of = 𝑥, 𝑆𝐷 𝑅, − 𝑥- 𝑆𝐷 𝑅-
30%. If these two stocks v We need to solve:
"..0. "..0.
were perfectly negatively
correlated (i.e., their 𝑥, 𝑆𝐷 𝑅, − 𝑥- 𝑆𝐷 𝑅- = 0
correlation coefficient is −1) 𝑥, − 𝑥- = 0
v We also know that: 𝑥, + 𝑥- = 1, so the solution is:
a) Calculate the portfolio 1 1
weights that remove all 𝑥, = , 𝑥- =
2 2
risk.
b) The portfolio in (a), reduces the variance to 0
b) If there are no arbitrage
(risk of the portfolio is zero). Therefore, we
opportunities, what is the
risk-free rate of interest in created a risk-free asset. Its return must be:
1 1
this economy? 𝑟1 = 𝑥, ×𝐸 𝑅, + 𝑥- ×𝐸 𝑅- = ×0.20 + ×0.07 = 0.1350
2 2
11.36 v To answer the question, we need to calculate the Sharpe
Ratios (SR) of the funds:
Assume the risk-free rate is 𝔼 𝑅! − 𝑟.
4%. You are a financial 𝑆𝑅! =
advisor, and must choose 𝑆𝐷 𝑅!
one of the funds below to
recommend to each of your
0.10 − 0.04
clients. Whichever fund you 𝑆𝑅* = = 1.5
recommend, your clients will 0.04
then combine it with risk-free 0.13 − 0.04
borrowing and lending 𝑆𝑅+ = = 0.5
0.18
depending on their desired
level of risk. 0.07 − 0.04
𝑆𝑅/ = = 0.75
0.04
Expected
Return Volatility
Fund A 10% 4% v Fund A gives the highest Sharpe ratio. It is the best choice
Fund B 13% 18% no matter what your clients’ risk preferences are.
Fund C 7% 4%
11.40 a) To answer the question, we need to calculate the Sharpe Ratios (SR)
of the funds:
The Optima Mutual Fund has 𝔼 𝑅! − 𝑟"
𝑆𝑅! =
an expected return of 19.1% 𝑆𝐷 𝑅!
and a volatility of 21.5%.
Optima claims that no other 0.191 − 0.047
𝑆𝑅#$ = = 0.67
0.215
portfolio offers a higher
Sharpe ratio. Suppose this
claim is true, and the risk-free b) In equilibrium, we should have the following relationship (Eq. 11.18):
𝐸 𝑅% − 𝑟"
interest rate is 4.7%. 𝐸 𝑅! − 𝑟" = 𝑆𝐷 𝑅! ×𝐶𝑜𝑟𝑟 𝑅! , 𝑅% ×
𝑆𝐷 𝑅%
𝐸 𝑅! − 𝑟" 𝐸 𝑅% − 𝑟"
⇒ = 𝐶𝑜𝑟𝑟 𝑅! , 𝑅% ×
a) What is Optima’s Sharpe 𝑆𝐷 𝑅! 𝑆𝐷 𝑅%
Ratio? ⇒ 𝑆𝑅! = 𝐶𝑜𝑟𝑟 𝑅! , 𝑅% ×𝑆𝑅%

b) If eBay’s stock has a

volatility of 38.9% and an v Then we can get eBay’s correlation with the Optima fund:
𝑆𝑅&' 0.118
expected return of 9.3%, 𝐶𝑜𝑟𝑟 𝑅&' , 𝑅#$ = = = 0.176
𝑆𝑅#$ 0.67
what must be its
correlation with the
Optima Fund?
11.40 – cont. c) We know from b) that:
𝑆𝑅! = 𝐶𝑜𝑟𝑟 𝑅! , 𝑅0 ×𝑆𝑅0
The Optima Mutual Fund has
an expected return of 19.1%
and a volatility of 21.5%. So, we can easily calculate SubOptima’s SR with the given
Optima claims that no other information:
portfolio offers a higher 𝑆𝑅#1( = 𝐶𝑜𝑟𝑟 𝑅21( , 𝑅34 ×𝑆𝑅34 = 0.77×0.67 = 0.516
Sharpe ratio. Suppose this
claim is true, and the risk-free
interest rate is 4.7%.

c) If the SubOptima Fund

has a correlation of 77%
with the Optima Fund,
what is the Sharpe ratio of
the SubOptima Fund?
11.44
When the CAPM correctly
prices risk, the market
portfolio is an efficient
portfolio. Explain why.

v All investors will want to maximize their Sharpe ratios by picking

efficient portfolios – portfolios that yield the maximum expected return
for a given level of volatility.

v When a riskless asset exists, this means that all investors (with
homogeneous expectations) will pick the same efficient portfolio, and
because the sum of all investors’ portfolios is the market portfolio this
efficient portfolio must be the market portfolio.
11.46 a) Under the CAPM assumptions, the market is efficient; that is, a leveraged
position in the market has the highest expected return of any portfolio for a
given volatility and the lowest volatility for a given expected return (highest
Your investment portfolio consists Sharpe Ratio).
of $13,000 invested in only one v By holding a leveraged position (𝑋) in the market portfolio, you can achieve
stock—Amazon. Suppose the risk- an expected return of:
free rate is 6%, Amazon stock has
an expected return of 11% and a 𝐸 𝑅 = 6% + 𝑋 10% – 6%
volatility of 39%, and the market
portfolio has an expected return of
10% and a volatility of 16%. Under v Setting this equal to 11% (Amazon’s expected return) gives
11% = 6% + 𝑋 (10% – 6%)
the CAPM assumptions,
11 = 6 + 10𝑋 – 6𝑋
a) What alternative investment 11 − 6 = 4𝑋
has the lowest possible 5 = 4𝑋
volatility while having the same 5
𝑋 = = 1.25
expected return as Amazon? 4
What is the volatility of this
investment? v So the portfolio with the lowest volatility that has the same return as Amazon
has a position of $13,000×1.25 = $16,250 in the market portfolio, and
b) What investment has the borrows : $16,250 – $13,000 = $3,250 in the risk-free asset. (a short position
highest possible expected in the risk-free asset of $-3,250)
return while having the same 𝑆𝐷 𝑅𝑝 = 1.25×16% = 20%
volatility as Amazon? What is
the expected return of this v Note that this is considerably lower than Amazon’s volatility.
investment?
11.46 – cont. b) A leveraged portion (𝑋) in the market has volatility equal to
𝑆𝐷 𝑅𝑝 = 𝑋 ×16%
Your investment portfolio consists
of $13,000 invested in only one
stock—Amazon. Suppose the risk-
free rate is 6%, Amazon stock has v Setting this equal to the volatility of Amazon gives:
an expected return of 11% and a 39% = 𝑋 ×16%,
volatility of 39%, and the market 𝑋 = 2.4375
portfolio has an expected return of
10% and a volatility of 16%. Under v So the portfolio with the highest expected return that has
the CAPM assumptions, the same volatility as Amazon has $13,000× 2.4375 =
a) What alternative investment $31,687.5 in the market portfolio, and borrows
has the lowest possible $31,687.5 – $13,000 = $18,687.5, that is $– 18,687.5 in the
volatility while having the same risk-free asset.
expected return as Amazon?
What is the volatility of this
investment?
v Then, we have:
b) What investment has the 𝐸 𝑅𝑝 = 6% + 2.4375×(10% – 6%) = 15.75%
highest possible expected
return while having the same
volatility as Amazon? What is
the expected return of this
investment?
11.49
Consider a portfolio consisting of
the three stocks on the right:
The volatility of the market portfolio
is 10% and it has an expected
return of 8%. The risk-free a) Beta of investment i with portfolio M (Eq. 11.19): 𝐵𝑒𝑡𝑎!,) =
*+ ,!
𝐶𝑜𝑟𝑟 𝑅! , 𝑅) ×
rate is 3%. *+ ,"
0.13
a) Compute the beta and 𝛽-,) = 0.42× = 0.546
0.10
expected return of each stock. 0.20
𝛽.,) = 0.68× = 1.36
b) Using your answer from part a, 0.10
0.12
calculate the expected return of 𝛽/,) = 0.54× = 0.648
the portfolio. 0.10

c) What is the beta of the

portfolio? v The CAPM Equation for the Expected Return (Eq. 11.22): 𝐸 𝑅! = 𝑟" +
𝛽!,) × 𝐸 𝑅) − 𝑟"
d) Using your answer from part c, 𝐸(𝑅- ) = 0.03 + 0.546× 0.08 − 0.03 = 0.0573
calculate the expected return of 𝐸 𝑅. = 0.03 + 1.36× 0.08 − 0.03 = 0.098
the portfolio and verify that it 𝐸 𝑅/ = 0.03 + 0.546× 0.08 − 0.03 = 0.0624
matches your answer to part b.

b) 𝐸 𝑅$ = ∑! 𝑥! 𝐸(𝑅! ) = x0 E R 0 + x1 E R 1 + x2 𝐸 𝑅/
𝐸 𝑅$ = 0.21×0.0573 + 0.31×0.098 + 0.48×0.0624=0.0724
11.49 – cont.
Consider a portfolio consisting of
the three stocks on the right:
The volatility of the market portfolio
is 10% and it has an expected
return of 8%. The risk-free c) 𝛽,,5 = ∑! 𝑥! 𝛽!,5 = x6 𝛽7,5 + x8 𝛽9,5 + x: 𝛽*,5
rate is 3%.
a) Compute the beta and 𝛽,,5 = 0.21×0.546 + 0.31×1.36 + 0.48×0.648 = 0.847
expected return of each stock.
b) Using your answer from part a,
calculate the expected return of d) 𝐸 𝑅, = 𝑟. + 𝛽,,5 × 𝐸 𝑅5 − 𝑟.
the portfolio.
c) What is the beta of the
𝐸 𝑅4 = 0.03 + 0.847× 0.08 − 0.03 = 0.0724
portfolio?
d) Using your answer from part c,
calculate the expected return of
the portfolio and verify that it
matches your answer to part b.