## CHAPTER 7

### Introduction to Risk, Return, and the Opportunity Cost of Capital

1.                  Recall from Chapter 3 that:

(1 + rnominal) = (1 + rreal) ´ (1 + inflation rate)

Therefore:

rreal = (1 + rnominal)/(1 + inflation rate) - 1

a.                  The real return on the S&P 500 in each year was:

 1996: 19.2% 1997: 31.2% 1998: 26.6% 1999: 17.8% 2000: -12.1%

b.                  From the results for Part (a), the average real return was 16.5 percent.

c.         The risk premium for each year was:

 1996: 17.9% 1997: 28.1% 1998: 23.7% 1999: 16.3% 2000: -15.0%

d.         From the results for Part (c), the average risk premium was 14.2 percent.

e.                  The standard deviation (s) of the risk premium is calculated as follows:

2.                  Internet exercise; answers will vary.

3.         a.         A long-term United States government bond is always absolutely safe in terms of the dollars received.  However, the price of the bond fluctuates as interest rates change and the rate at which coupon payments can be invested also changes as interest rates change.  And, of course, the payments are all in nominal dollars, so inflation risk must also be considered.

b.         It is true that stocks offer higher long-run rates of return than bonds, but it is also true that stocks have a higher standard deviation of return.  So, which investment is preferable depends on the amount of risk one is willing to tolerate.  This is a complicated issue and depends on numerous factors, one of which is the investment time horizon.  If the investor has a short time horizon, then stocks are generally not preferred.

c.                  Unfortunately, 10 years is not generally considered a sufficient amount of time for estimating average rates of return.  Thus, using a 10-year average is likely to be misleading.

4.                  If the distribution of returns is symmetric, it makes no difference whether we look at the total spread of returns or simply the spread of unexpectedly low returns.  Thus, the speaker does not have a valid point as long as the distribution of returns is symmetric.

5.                  The risk to Hippique shareholders depends on the market risk, or beta, of the investment in the black stallion.  The information given in the problem suggests that the horse has very high unique risk, but we have no information regarding the horse’s market risk.  So, the best estimate is that this horse has a market risk about equal to that of other racehorses, and thus this investment is not a particularly risky one for Hippique shareholders.

6.                  In the context of a well-diversified portfolio, the only risk characteristic of a single security that matters is the security’s contribution to the overall portfolio risk.  This contribution is measured by beta.  Lonesome Gulch is the safer investment for a diversified investor because its beta (+0.10) is lower than the beta of Amalgamated Copper (+0.66).  For a diversified investor, the standard deviations are irrelevant.

7.         a.         To the extent that the investor is interested in the variation of possible future outcomes, risk is indeed variability.  If returns are random, then the greater the period-by-period variability, the greater the variation of possible future outcomes.  Also, the comment seems to imply that any rise to \$20 or fall to \$10 will inevitably be reversed; this is not true.

b.                  A stock’s variability may be due to many uncertainties, such as unexpected changes in demand, plant manager mortality or changes in costs.  However, the risks that are not measured by beta are the risks that can be diversified away by the investor so that they are not relevant for investment decisions.  This is discussed more fully in later chapters of the text.

c.                  Given the expected return, the probability of loss increases with the standard deviation.  Therefore, portfolios that minimize the standard deviation for any level of expected return also minimize the probability of loss.

d.                  Beta is the sensitivity of an investment’s returns to market returns.  In order to estimate beta, it is often helpful to analyze past returns.  When we do this, we are indeed assuming betas do not change.  If they are liable to change, we must allow for this in our estimation.  But this does not affect the idea that some risks cannot be diversified away.

8.         xI = 0.60                                                                                                      sI = 0.10

xJ = 0.40                                                                                                     sJ = 0.20

a.

b.

c.

9.         a.         Refer to Figure 7.10 in the text.  With 100 securities, the box is 100 by 100.  The variance terms are the diagonal terms, and thus there are 100 variance terms.  The rest are the covariance terms.  Because the box has (100 times 100) terms altogether, the number of covariance terms is:

1002 - 100 = 9,900

Half of these terms (i.e., 4,950) are different.

b.                  Once again, it is easiest to think of this in terms of Figure 7.10.  With 50 stocks, all with the same standard deviation (0.30), the same weight in the portfolio (0.02), and all pairs having the same correlation coefficient (0.4), the portfolio variance is:

Variance = 50(0.02)2(0.30)2 + [(50)2 - 50](0.02)2(0.4)(0.30)2 =0.0371

Standard deviation = 0.193 = 19.3%

c.                  For a completely diversified portfolio, portfolio variance equals the average covariance:

Variance = (0.30)(0.30)(0.40) = 0.036

Standard deviation = 0.190 = 19.0%

10.       a.         Refer to Figure 7.10 in the text.  For each different portfolio, the relative weight of each share is [one divided by the number of shares (n) in the portfolio], the standard deviation of each share is 0.40, and the correlation between pairs is 0.30.  Thus, for each portfolio, the diagonal terms are the same, and the off-diagonal terms are the same.  There are n diagonal terms and (n2 – n) off-diagonal terms.  In general, we have:

Variance = n(1/n)2(0.4)2 + (n2 - n)(1/n)2(0.3)(0.4)(0.4)

For one share: Variance = 1(1)2(0.4)2 + 0 = 0.160000

For two shares:

Variance = 2(0.5)2(0.4)2 + 2(0.5)2(0.3) (0.4)(0.4) = 0.104000

The results are summarized in the second and third columns of the table on the next page.

b.                  (Graphs are on the next page.)  The underlying market risk that can not be diversified away is the second term in the formula for variance above:

Underlying market risk = (n2 - n)(1/n)2(0.3)(0.4)(0.4)

As n increases, [(n2 - n)(1/n)2] = [(n-1)/n] becomes close to 1, so that the underlying market risk is: [(0.3)(0.4)(0.4)] = 0.048

c.                  This is the same as Part (a), except that all the off-diagonal terms are now equal to zero.  The results are summarized in the fourth and fifth columns of the table below.

 (a) (a) (c) (c) No. of Standard Standard Shares Variance Deviation Variance Deviation 1 .160000 .400 .160000 .400 2 .104000 .322 .080000 .283 3 .085333 .292 .053333 .231 4 .076000 .276 .040000 .200 5 .070400 .265 .032000 .179 6 .066667 .258 .026667 .163 7 .064000 .253 .022857 .151 8 .062000 .249 .020000 .141 9 .060444 .246 .017778 .133 10 .059200 .243 .016000 .126

Graphs for Part (a):

Graphs for Part (c):

11.             Internet exercise; answers will vary depending on time period.

12.             xBP = 0.4

xKLM = 0.4

xN = 0.2

13.       Internet exercise; answers will vary depending on time period.

14.             “Safest” means lowest risk; in a portfolio context, this means lowest variance of return.  Half of the portfolio is invested in Alcan stock, and half of the portfolio must be invested in one of the other securities listed.  Thus, we calculate the portfolio variance for six different portfolios to see which is the lowest.  The safest attainable portfolio is comprised of Alcan and Nestle.

 Stocks Portfolio Variance Alcan & BP 0.057852 Alcan & Deutsche 0.082431 Alcan & KLM 0.082871 Alcan & LVMH 0.095842 Alcan & Nestle 0.041666 Alcan & Sony 0.096994

15.       a.         In general, we expect a stock’s price to change by an amount equal to (beta ´ change in the market).  Beta equal to -0.25 implies that, if the market rises by an extra 5 percent, the expected change is -1.25 percent.  If the market declines an extra 5 percent, then the expected change is +1.25 percent.

b.                  “Safest” implies lowest risk.  Assuming the well-diversified portfolio is invested in typical securities, the portfolio beta is approximately one.  The largest reduction in beta is achieved by investing the \$20,000 in a stock with a negative beta.  Answer (iii) is correct.

16.       a.         If the standard deviation of the market portfolio’s return is 20 percent, then the variance of the market portfolio’s return is 20 squared, or 400.  Further, we know that a stock’s beta is equal to: the covariance of the stock’s returns with the market divided by the variance of the market return.  Thus:

bZ = 800/400 = 2.0

b.                  For a fully diversified portfolio, the standard deviation of portfolio return is equal to the portfolio beta times the market portfolio standard deviation:

Standard deviation = 2 ´ 20% = 40%

c.                  By definition, the average beta of all stocks is one.

d.                  The extra return we would expect is equal to (beta ´ the extra return on the market portfolio):

Extra return = 2 ´ 5% = 10%

17.             Diversification by corporations does not benefit shareholders because shareholders can easily diversify their portfolios by buying stock in many different companies.

Challenge Questions

1.                  a.         In general:

Portfolio variance = sP2 = x12s12 + x22s22 + 2x1x2r12s1s2

Thus:

sP2 = (0.52)(0.6272)+(0.52)(0.5072)+2(0.5)(0.5)(0.66)(0.627)(0.507)

sP2 = 0.26745

Standard deviation = sP = 0.517 = 51.7%

b.                  We can think of this in terms of Figure 7.10 in the text, with three securities.  One of these securities, T-bills, has zero risk and, hence, zero standard deviation.  Thus:

sP2 = (1/3)2(0.6272)+(1/3)2(0.5072)+2(1/3)(1/3)(0.66)(0.627)(0.507)

sP2 = 0.11887

Standard deviation = sP = 0.345 = 34.5%

Another way to think of this portfolio is that it is comprised of one-third T‑Bills and two-thirds a portfolio which is half Dell and half Microsoft.  Because the risk of T-bills is zero, the portfolio standard deviation is two-thirds of the standard deviation computed in Part (a) above:

Standard deviation = (2/3)(0.517) = 0.345 = 34.5%

c.                  With 50 percent margin, the investor invests twice as much money in the portfolio as he had to begin with.  Thus, the risk is twice that found in Part (a) when the investor is investing only his own money:

Standard deviation = 2 ´ 51.7% = 103.4%

d.                  With 100 stocks, the portfolio is well diversified, and hence the portfolio standard deviation depends almost entirely on the average covariance of the securities in the portfolio (measured by beta) and on the standard deviation of the market portfolio.  Thus, for a portfolio made up of 100 stocks, each with beta = 2.21, the portfolio standard deviation is approximately: (2.21 ´ 15%) = 33.15%.  For stocks like Microsoft, it is: (1.81 ´ 15%) = 27.15%.

2.                  For a two-security portfolio, the formula for portfolio risk is:

Portfolio variance = x12s12 + x22s22 + 2x1x2rr12s1s2

If security one is Treasury bills and security two is the market portfolio, then s1 is zero, s2 is 20 percent.  Therefore:

Portfolio variance = x22s22 = x22(0.20)2

Standard deviation = 0.20 x2

Portfolio expected return = x1 (0.06) + x2 (0.06 + 0.85)

Portfolio expected return = 0.06x1 + 0.145x2

 Portfolio X1 X2 Exp. Return Std. Deviation 1 1.0 0 0.060 0 2 0.8 0.2 0.077 0.040 3 0.6 0.4 0.094 0.080 4 0.4 0.6 0.111 0.120 5 0.2 0.8 0.128 0.160 6 0 1.0 0.145 0.200

3.                  a.         From the text, we know that the standard deviation of a well-diversified portfolio of common stocks (using history as our guide) is about 20.2 percent.  Hence, the variance of portfolio returns is 0.202 squared, or 0.040804 for a well-diversified portfolio.

The variance of our portfolio is given by (see Figure 7.10):

Variance = 2[(0.2)2(0.4)2] + 6[(0.1)2(0.4)2]

+ 2[(0.2)(0.2)(0.3)(0.4)(0.4)]

+ 24[(0.1)(0.2)(0.3)(0.4)(0.4)]

+ 30[(0.1)(0.1)(0.3)(0.4)(0.4)] = 0.063680

Thus, the proportion is (0.040804/0.063680) = 0.641

b.                  In order to find n, the number of shares in a portfolio that has the same risk as our portfolio, with equal investments in each typical share, we must solve the following portfolio variance equation for n:

n(1/n)2(0.4)2 + (n2 - n)(1/n)2(0.3)(0.4)(0.4) = 0.063680

Solving this equation, we find that n = 7.14 shares.

The first measure provides an estimate of the amount of risk that can still be diversified away.  With a fully diversified portfolio, the ratio is approximately one.  Unfortunately, the use of average historical data does not necessarily reflect current or expected conditions.

The second measure indicates the potential reduction in the number of securities in a portfolio while retaining the current portfolio’s risk.  However, this measure does not indicate the amount of risk that can yet be diversified away.

4.                  Internet exercise; answers will vary.

5.                  Internet exercise; answers will vary.