A B AXB C AXC

Problem 7: Stock A Stock B

State of Economy Probability Return Expected Variance Return Expected Variance
Recession 0.1 0.02 0.002 0.0008464 -0.3 -0.030 0.0234256
Normal 0.5 0.10 0.050 7.2E-05 0.18 0.090 0.0000080
Boom 0.4 0.15 0.060 0.0005776 0.31 0.124 0.0063504
Total 11.20% 0.1496% 18.40% 2.98%
Standard Deviation 3.8678% 17.26%

Problem 8: A B AXB For problem 9

Stock Proportion Return Expected Boom ERp Bust
G 20% 9.2% 0.01840 Stock A 1/3 0.15 0.0500 0.03
J 35% 11.1% 0.03885 Stock B 1/3 0.02 0.0067 0.16
K 45% 13.8% 0.06210 Stock C 1/3 0.34 0.1133 -0.08
Expected Return of Portfolio 11.94% 0.1700

A B C D E AxE
Problem 9: Proportion 1/3 1/3 1/3 Portfolio
Probability Stock A Stock B Stock C Return Expected
Boom 0.6 0.1500 0.02 0.340000 0.17000 0.1020
Bust 0.4 0.0300 0.16 -0.080000 0.03667 0.0147
Expected 11.67%
A B AXB
Proportion 20% 20% 60% Portfolio A X (B - ERp)^2
Probability Stock A Stock B Stock C Return Expected Variance
Boom 0.6 0.1500 0.02 0.340000 0.23800 0.1428 0.00590438
Bust 0.4 0.0300 0.16 -0.080000 -0.01000 -0.0040 0.00885658
Total ERp-----> 13.88% 0.01476096
Standard Deviation 12.15%

Problem 10 Proportion 25% 50% 25% Portfolio

State of Economy Probability Stock A Stock B Stock C Return Expected Variance
Boom 0.15 0.35 0.45 0.33 39.50% 5.925% 0.01279
Good 0.50 0.12 0.1 0.17 12.25% 6.125% 0.00019
Poor 0.25 0.01 0.02 -0.05 0.00% 0.000% 0.00265
Bust 0.10 -0.11 -0.25 -0.09 -17.50% -1.750% 0.00773
Expected Return / Variance 10.300% 0.02336
Std Deviation 0.15284
Problem 10 Equally Portfolio
State of Economy Probability Stock A Stock B Stock C Return Expected Variance
Boom 0.15 0.35 0.45 0.33 37.67% 5.650% 0.01123
Good 0.50 0.12 0.1 0.17 13.00% 6.500% 0.00036
Poor 0.25 0.01 0.02 -0.05 -0.67% -0.167% 0.00301
Bust 0.10 -0.11 -0.25 -0.09 -15.00% -1.500% 0.00640
 Expected Return / Variance 10.483% 0.02101
Std Deviation 0.14493

Capital Asset Pricing Model in computing Expected Return (ER)

ER = Rf + (MR - Rf) X B: Where ER = Expected Return; Rf = Risk Free; MR = Return on Market; B = Beta
Problem 16
ER = Rf + (MR - Rf) X B
10.7% = Rf + (11.5% - Rf) X .91
Rf = 2.61%

Problem 17:
a) ER = (11.7% + 3.5%)/2
ER = 7.60%
b)
We need to find the portfolio weights that result in a portfolio with a b of .7. We know the b of
the risk-free asset is zero. We also know the weight of the risk-free asset is one minus the
weight of the stock since the portfolio weights must sum to one, or 100 percent. So:

Bp = [(Bs X Ws) + (BRf X WRf):

Where Bp = Beta of the Portfolio
Bs = Beta of the Stock
Ws = Weight of the Stock
BRf = Beta of the Portfolio = 0
WRf = Weight of the Risk Free Asset = (1 - Ws)

Bp = .70 = Ws(1.23) + (1 – Ws)(0)

.70 = 1.23Ws + 0 – 0Ws
WS = .70 / 1.23
WS = .5691
The weight of the risk-free asset is:
WRf = 1 – .5691
WRf = .4309
c.
We need to find the portfolio weights that result in a portfolio with an expected return of 9
percent. We also know the weight of the risk-free asset is one minus the weight of the stock
since the portfolio weights must sum to one, or 100 percent. So:
ERp = .09 = .117Ws + .035(1 – Ws)
.09 = .117Ws + .035 – .035Ws
Ws = .6707

So, the B of the portfolio will be:

Bp = .6707(1.23) + (1 – .6707)(0)
Bp = .825

d. Solving for the B of the portfolio as similar to part a:

 Bp = 2.46 = Ws(1.23) + (1 – Ws)(0)
Ws = 2.46 / 1.23
Ws = 2

WRf = 1 – 2
WRf = –1
The portfolio is invested 200% in the stock and –100% in the risk-free asset. This represents
borrowing at the risk-free rate to buy more of the stock.

Problem 25
State of Economy Probability Stock A Stock B Stock C Return Expected Variance
Boom 0.15 0.02 0.32 0.6 25.60% 3.840% 0.00351
Normal 0.60 0.1 0.12 0.2 12.80% 7.680% 0.00038
Bust 0.25 0.16 -0.11 -0.35 -5.00% -1.250% 0.00585
Expected Return / Variance 10.270% 0.00974
Std Deviation 9.87%

Risk Premium (RP) is the return difference of the risky and risk free asset. RP = ER - Rf
RP = 10.27% - 3.75% 6.52%

Problem 29 Stock A Stock B

State of Economy Probability Return Expected Variance Return Expected Variance
Bust 0.1 -0.12 -0.012 0.0064516 -0.05 -0.005 0.0054756
Normal 0.65 0.09 0.059 0.0003146 0.1 0.065 0.0045864
Boom 0.25 0.35 0.088 0.014161 0.21 0.053 0.0001690
Total 13.40% 2.0927% 11.25% 1.02%

We can use the expected returns we calculated to find the slope of the Security Market Line. We know that the beta of
Stock A is .25 greater than the beta of Stock B. Therefore, as beta increases by .25, the expected return on a security
increases by .0215 (= .1340 – .1125). The slope of the security market line (SML) equals:

SlopeSML = Rise / Run

SlopeSML = Increase in expected return / Increase in beta
SlopeSML = (.1340 – .1125) / .25
SlopeSML = .0860, or 8.60%

Since the market’s beta is 1 and the risk-free rate has a beta of zero, the slope of the Security Market Line equals the
expected market risk premium. So, the expected market risk premium must be 8.6 percent.

We could also solve this problem using CAPM. The equations for the expected returns of the two stocks are:

ERa = .1340 = Rf + (Bb + .25)(MRP) : ERa = Expected return of Security A; Bb = Beta of Security B ; MRP =
Market Risk Premium = MR - Rf
ERb = .1125 = Rf + Bb(MRP)
 We can rewrite the CAPM equation for Stock A as:

.1340 = Rf + bB(MRP) + .25(MRP)

Subtracting the CAPM equation for Stock B from this equation yields:

.0215 = .25MRP
MRP = .086, or 8.6%

which is the same answer as our previous result.

Problem 27
Stock Investment Beta
A 105,000.00 0.80 0.21 0.17
B 155,000.00 1.15 0.31 0.36
C 169,821.43 1.40 0.34
Risk Free 70,178.57 - -
Total 500,000.00 100%

WRf = 1 - Wa - Wb - Wc
Bp = 0.8Wa + 1.15Wb + 1.4Wc + 0x(1 - Wa - Wb - Wc)
Since the portfolio is equally risky as the market, the Beta of the Portfolio(Bp) is equal to 1
1 = 0.8(.21) + 1.15(.31) + 1.4Wc + 0x(1 - .21 - .31 - Wc)
1 = 0.168 + 0.3565 + 1.4Wc + 0 0.16800
1.4Wc = 1 - 0.5245 0.35650
Wc = 0.4755/1.4 0.52450
Wc = 0.33964
ERp
0.0100
0.0533
-0.0267
0.0367
 know that the beta of
d return on a security

Market Line equals the

Security B ; MRP =
Expected Return (ER) = [(P1 X R1) + (P2 X R2) + (P3 X R3) + …….]; Where P = Probability, and R = Rate of Return
Variance (V) = [(P1 X (R1 - ER)^2) + (P2 X (R2 - ER)^2) + (P3 X (R3 - ER)^2) + …..]
Std Deviation (SD) = Sqrt(V)

Expected Return of a Portfolio (ERp) = (Pr1 X R1) + (Pr2 X R2) + ……. Where Pr = Proportion of the specific
investment and R = return of a specific investment
Portfolio is a group of Investments.
Illustrative Problem (Problem 6) AXB
A B Expected
State of Economy Probability(P) Return ( R ) Return(ER) Variance
Recession 0.15 -0.09 -0.0135 0.00710 A X (B - ER)^2
Normal 0.60 0.11 0.0660 0.00018 A X (B - ER)^2
Boom 0.25 0.30 0.0750 0.00744 A X (B - ER)^2
Expected Return/Variance ER -----> 0.1275 0.01472 <------ Variance (V)
Standard Deviation 0.121321 Sqrt(V)
A B AXB
Problem 24: Portfolio Value of Rate of Expected
Stock No. of Shrs Price Investment Proportion Return Return(Erp)
W 645 43 27,735.00 20.47% 0.10 2.05%
X 830 29 24,070.00 17.77% 0.15 2.67%
Y 475 94 44,650.00 32.96% 0.11 3.63%
Z 765 51 39,015.00 28.80% 0.14 4.03%
135,470.00 ERp-------> 12.37%