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Case 3

Question 1

The T-bond return does not depend on the state of the economy because the interest payments will be made and the bond will be redeemed by the federal
government, barring global disaster.
The T-bond, since its return is independent of the state of the economy, is risk-free, but only in the nominal sense. An investor is “guaranteed” an 8.0
percent nominal return. However, the real realized return will depend on inflation over the next year. Thus, the real return, which counts most, is uncertain. Also, if
interest rates rise, the bond’s price will decline (slightly, for a l-year bond, and if you must sell it to raise cash, you would suffer a slight loss (a large loss on a long-
term bond).

Question 2

Expected kTECO = 0.1 (-8.0%) + 0.2(.0$) + 0.4(14.0%) + 0.(25.0%) + 0.1(33.0%)

= 13.5%.
Expected kT-bond = 8.0%.
Expected kGH = 8.8%.
Expected kT-S$P 500 = 15.0%.

Looking solely at expected rates of return, the S$P 500 looks best with a return of 15.0% while the T-bonds, at 8.0 percent, look the worst.

Question 3

n
VarianceTECO =  P1 (ki - k)2
i 1
= 0.1(-8 - 13.5) 2 + 0.2(2 - 13.5) 2
+ 0.4(14 - 13.5) 2 + 0.2(25 - 13.5) 2 + 0.1(33 - 13.5) 2 = 137.3.
 TECO = var = 137.3 = 11.7%
CV =  /Expected value = 11.7%/13.5% = 0.87.
 T-BOND = 0.0%.
CV T-BOND = 0.00.
 GH = 9.1%
CV GH = 1.03.
 S&P 50 = 16.4%.
CV S&P 50 = 1.10.

Standard deviation and coefficient of variation are measures of dispersion about the mean, and hence measure total risk. Total risk is the relevant measure of risk
only for assets held in isolation.
Of the two total risk measures, coefficient of variation is the better one because it relates risk to the expected rate of return; that is, it
standardizes the measure. (Note that a measure such as semivariance, which measures only downside risk, may be a better total risk measure than either standard
deviation or coefficient of variation. However, if return distributions are approximately symmetric, then semivariance offers no advantages over variance and  ,
and it is harder to calculate.)
Here is a risk/return comparison of the four alternatives:
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Alternative CV ^
T-bonds
TECO
0.00
0.87
k
8.0%
Gold Hill 1.03 13.5
S$P 500 1.10 8.8
15.0

For three of the four investments, the higher the risk as measured by the coefficient of variation, the higher the expected rate of return. However, Gold Hill offers a
lower return than TECO, but it has greater total risk. (Of course, investors are looking at Gold Hill’s market risk when setting required rates of return, and this
causes the apparent anomaly.)

Question 4

a. Here is the returns distribution of a 50/50 mix portfolio created from TECO and
Gold Hill :
State of the Estimated Return

Economy Prob. TECO Gold Hill Portfolio

Recession 0.1 -8.0% 18.0% 5.0%
Below average 0.2 2.0 23.0 12.5
Average 0.4 14.0 7.0 10.5
Above average 0.2 25.0 -3.0 11.0
Boom 0.1 33.0 2.0 17.5
Mean 13.5% 8.8% 11.15%
 11.7% 9.1% 2.9%
CV 0.87 1.03 0.26

The estimated portfolio return in each state of the economy is 0.5(TECO k) + 0.5 (GH k). For example, for the recession state, 0.5(-8.0%) +
0.5(18.0%) = 5.0%.

^
The expected rate of return on the portfolio, , is 11.15 percent :
k p

^
= 0.1 (5.0%) + 0.2(12.5%) + 0.4(10.5%) + 0.2(11.0%) + 0.1(17.5%)
k p

= 11.15%.
Note that the expected rate of return can also be calculated as the weighted average of the expected returns of the portfolio components:
^
= 0.5(13.5%) + 0.5(8.8%) = 11.15%.
k p

The portfolio’s variance is 8.4, its standard deviation is 2.9 percent, and its coefficient of variation is 0.26. Thus, the riskiness of the portfolio, as
measured by standard deviation or coefficient of variation, is significantly less than the riskiness of either component held in isolation.
The characteristic of the two stocks which makes risk reduction possible is the fact that their returns are not perfectly positively correlated. The
correlation coefficient here is -0.88, with the minus sign indicating that , in general, when TECO’s returns increase, GoldmHill’s decrease. If the two stocks were
perfectly negatively correlated (Coefficient = -1.0), then a riskless portfolio could be created. But, with the TECO and Gold Hill distributions, the least risky
portfolio has a standard deviation of 2.6 percent,which occurs at a mix of 42 percent TECO and 58 percent Gold Hill.
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OPTIONAL :
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Actually, the condition necessary for a two-stock portfolio to be less risky than the least risky of the two stocks is that the correlation coefficient must be less than
the ratio of the standard deviations:
rAB <  A/  B, where  A  B

In the TECO-Gold Hill portfolio,  A /  B = 9.1%/11.7% = 0.78, and the correlation coefficient is -0.88, which, because of the minus sign, is
less than 0.78.
We see then that the risk-lowering properties of a two-asset portfolio depends on both the correlation coefficient and the relative standard
deviation.
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b. For a portfolio containing 75% Gold Hill and 25% TECO, the expected rate of
return would be 10.01%, and the standard deviation would be 4.5%. For a portfolio containing 25% Gold Hill and 75% TECO, the expected rate of
return would be 12.36% and the standard deviation would be 6.9%.
The expected returns and standard deviations for portfolio mixes containing from 0% TECO up to 100% TECO are as follows :
TECO $ GOLD HILL

Percent TECO Expected Return Standard Deviation

0% 8.8% 9.1%
10 9.3 7.2
20 9.7 5.3
30 10.2 3.7
40 10.7 2.6
50 11.2 2.9
60 11.6 4.2
70 12.1 6.0
80 12.6 7.8
90 13.0 9.8
100 13.5 11.7

Note that the expected rate of return is merely a linear combination (weighted average) of the expected returns on the two stocks. The standard
deviation, however, is not a weighted average—it depends on the standard deviations of the two stocks and their correlation coefficients.

Question 5

Because TECO’s and the S$P 500’s returns are not perfectly positively correlated, risk reduction may be possible.
TECO & S&P
Percent TECO Expected Return Standard Deviation
0% 15.0% 16.4%
10 14.9 16.0
20 14.7 15.5
30 14.6 15.0
40 14.4 14.5
50 14.3 14.1
60 14.1 13.6
70 14.0 13.1
80 13.8 12.7
90 13.7 12.2
100 13.5 11.7

Note here that the standard deviation of the portfolio never falls below TECO’s standard deviation. Since TECO and the S&P 500 are highly positively correlated,
diversification has little impact on risk. (See previous optional note.)
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Question 6

a. See Figure 1. As more and more stocks are added, the standard deviation is
reduced. However, since most stocks are positively correlated (average correlation coefficient of about 0.5 to 0.7), it is not possible to remove all risk.
The average standard deviation of a single stock portfolio is about 28 percent, while a portfolio made up of all stocks on the NYSE has a standard
deviation of about 15 percent. Thus, much of the riskiness inherent in single stocks can be eliminated by holding diversified portfolios. In practice, a
random portfolio of about 40 stocks eliminates just about as much risk as holding all the NYSE index stocks.

b. The implications for investors are clear. First, investors should hold well-
diversified portfolios to minimize risk. Second, total risk measured such as standard deviation are not appropriate risk measures for well-diversified
investors. Thus, each stock’s risk must be measured by the contribution of the stock to the riskiness of a well-diversified portfolio.

c. Total risk is the riskiness of an asset held in isolation. Diversifiable risk is that
portion of total risk that is eliminated by diversification, while market risk is the risk that remains. Here is the situation:
Total risk = Market risk + Diversifiable risk.
 i2 = b i2  m2 +  ei2
d. If you own only one stock, you must bear the total risk of the stock. However, most investors are rational, and hence hold well-diversified portfolios.
Diversified investors, who dominate the market, have eliminated the diversifiable risk, and thus they must bear only the market risk of each stock.
Since prices and returns will reflect only market risk, and not total risk, you cannot expect to be compensated for the riskiness of the stock held in
isolation. The moral here is simple—diversify if you are risk averse.

Question 7

See Figure 2. The plots of returns on individual stocks versus returns on the market are called “characteristic lines.” The horizontal plot is the T-bond’s
characteristic line, the upward sloping line is TECO’s characteristic line, and the downward sloping line is Gold Hill’s characteristic line. The slope of
each line follows: The slope is a measure of the volatility of the stock vis-a-vis the market. Positive slopes mean that the stock goes up when the
market goes up, and the greater the slope, the greater the movement of the stock price in response to a given movement in the market. A zero slope
indicates that returns on the security are independent of returns on the market, while a negative slope indicates a negative correlation. The slope of the
characteristic line is the security’s beta coefficient, which is the measure of its market risk and the key input in the Security Market Line.
The distance of the points from the regression line indicates the security’s diversifiable risk—the farther the points from the line, the
greater the diversifiable risk. Thus, the T-bonds have no diversifiable risk, TECO’s stock has some diversifiable risk, and Gold Hill’s stock has a great
deal of such risk.

Question 8

See Figure 3 for a plot of the SML. From Table 1 in the case, we see that the risk-free rate is 8.0 percent and the required return on the market is 15.0 percent.
Using Value Line’s beta estimate of 0.6, we find that TECO’s required tate of return is 12.2 percent:
kTECO = kRF+ (kM - kRF) b = 8.0% + (15.0% - 8.0%) 0.6 = 8.0\\5 + (7.0%) 0.6 = 12.2%.

Note that TECO’s required rate of return based on this analysis is 12.2 percent, but its expected return is 13.5 percent. Thus, TECO appears to offer a return that is
1.3 percentage points in excess of that required by its risk, and hence the stock appears to be a bargain.

Question 9

If the inflation estimate increased by 3 percentage points, then both k RF and kM would also increase by 3 percentage points. Assuming no change in investors risk
aversion, TECO’s required rate of return would increase to 15.2 percent:

kTECO = 11.0%5 + (18.0% - 11.0%) 0.6 = 11.0% + (7.0%)0.6 = 15.20%.

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Now, if the market risk premium increased to 8 percentage points, and assuming no change in inflation expectations, TECO’s required rate of return
would increase to 12.8 percent:
kTECO = 8.0% + (8.0%) 0.6 = 12.8%.

If TECO’s beta increased from 0.6 to 1.0, then the required rate of return would
increase from 12.2% to 15%:

kTECO = 8% + (7.0%)(1.0) = 15%.

Question 10

The Efficient Markets Hypothesis (EMH) states that capital markets in the United States are informationally efficient in the sense that current prices reflect all
known information. Actually, the EMH postulates three forms of efficiency:

(1) The weak form states that all information contained in historical price
movements is embedded in current prices.
(2) The semistrong form states that security prices embody all publicly-know information, and hence that stock price movements reflect the impact of
new events and information as they become known.
(3) The strong form states that security prices reflect all information; whether publicly or privately held.

Most people think that the weak and semistrong forms of the EMH are correct. However, the fact that insiders can make millions of dollars by illegally trading on
private information refutes the strong form. Of course, some analysts are better at ferreting out and then acting on developing events, but even these analysts have a
tough time staying at the “top of the class.” Thus, to the extent that the EMH indicates security analysts cannot outperform a “buy-and-hold” strategy, it is
questionable how much additional “expertise” that Jake Taylor acquires with each additional analyst added to his staff.
If the market is semistrong-form efficient, then investors should conclude that securities are priced such that expected returns are just sufficient to
compensate investors for the relevant (market) risks involved. It is likely that securities plot on the SML, and unless you have inside information, deviations
represent mis-estimates of risk and/or expected return rather than disequilibrium.
Although security markets in the United States are generally recognized as efficient, the market for real assets (plant, equipment, and the like) is not.
Some firms are better at producing information and acting on it than others. Thus, while investments in securities can be thought of as zero NPV transactions,
firms try to identify and implement capital projects that have positive NPV s.
Financial managers must make decisions regarding security prices when they plan new issues or repurchases. Unless financial managers have private
information that is unknown to the markets, it is reasonable to assume that a firm’s securities are fairly priced; that is, they are neither undervalued nor overvalued.
However, managers often do have information—for example, R&D results and back orders—that the public does not have, and they would take this information
into account for such purposes as timing new security issues.

Question 11

Value Line’s beta, ad are most beta estimates, is based on 5 years of historical returns. Thus, TECO’s beta reflects the stock’s past market risk. If TECO’s
inherent business risk is changing by virtue of its further diversification into nonregulaated lines of business, then its historical beta is not a good estimator of the
firm’s future risk, and future risk is what is relevant to an investor today, Many analysts would claim that almost amy line of business is riskier than TECO’s
current regulated business, and hence that TECO’s business risk in the future will be greater than in the past.

Question 12

If TECO’s use of debt financing were decreasing, and this trend were projected to continue, then TECO’s financial risk would also be decreasing’ All else the same,
decreasing financial risk means lower market risk and hence a lower beta and required rate of return. As with the changing nature of the business, this change in
risk would probably not be fully captured by a historical beta.