Solutions Manual

CHAPTER 22

ESTI
MATI
NG RI
SK AND

RETURN ON ASSETS

SUGGESTED ANSWERS TO THE R EVIEW
EVIEW QUESTIONS AND PROBLEMS

I. Questions

1.  Risk  is
 is the variability of an asset’s future
future returns. When only one return is
 possible, there is no risk. When more than one return is possible, the
asset is risky.
2. An objective probability distribution  is generally based on past outcomes
of similar events while a  subjective probability distribution is based on
probability distribution
opinions or “educated guesses about the likelihood that an event will
have a particular future outcome.
!. A discrete probability
probability distribution is an arrangement of the probabilities
associated with the values of a variable that can assume a limited or 
fini
finite
te numb
numberer of valu
values
es "out
"outco
come
mes#s# whil
whilee a continuous probability
probability
distribution is an arrangement of probabilities associated with the values
of a variable that can assume an infinite number of possible values
"outcomes#.
$. %he accura
accuracy
cy of foreca
forecaste
stedd returns
returns general
generally
ly decreas
decreaseses as the length
length of 
the pro&ect being forecast increases. %his increases the variability of an
asset’s returns and therefore risk.
'. %he expected value of return  of a single asset is the weighted average of 
the returns, with the weights being the probabilities of each return.
(. %he
%he risk
risk of a sing
single
le asset
asset is meas
measurured
ed by its
its stan
standa
dard
rd devia
deviati
tion
on or 
coefficient of variation. %he  standard deviation  measures the variability
of outcomes around the e)pected value and is an absolute measure of 
risk.
risk. %he coefficient of variation  is the ratio of the standard deviation to
the e)pected value and is a relative measure of risk.
*. %he
%he char
charac
acte
teri
rist
stic
ic of
of a normal curve  is a bell+shaped distribution that is
dependent upon the mean and the standard deviation of the population
under investigation. ince the normal distribution is a continuous rather 
than a discrete distribution, it is not possible to speak of the probability

22-1
Chat!" ##  Estimating Risk and Return on Assets

of a point but only of the probability of falling within some specified

range of values. %hus, the area under the curve between any two points
must
must then
then also
also depe
depend
nd upon
upon the
the valu
values
es of the
the mean
mean andand stan
standa
dard
rd
deviation. -owever, it is possible to standardie any normal distribution
so that it has a mean of ero and a standard deviation of one.
/. 0ecisi
0ecision
on makers
makers may be classi
classifie
fiedd into three
three catego
categorie
riess accordin
accordingg to
their risk preferences risk-averse, risk-neutral and risk-taker . inancial
theory assumes that decision makers are risk+averse.
3.  Portfolio risk is measured by the portfolio standard deviation. 4ortfolio
risk is influenced by diversification. 5isk reduction is achieved through
diversification whenever the returns of the assets combined in a portfolio
are not perfectly positively correlated. 6orrelation measures the tendency
of two variables to move together.
17. 8o to both 9uestions.
9uestions. %he portfolio
portfolio e)pected return is a weighted
weighted average
of the asset returns, so it must be less than the largest asset return and
greater than the smallest asset return.
11. alse. %he variance ofof the individual assets
assets is a measure of the
the total risk.
%he variance on a well+diversified portfolio is a function of systematic
risk only.
12. :es,
es, the standard
standard deviation
deviation can be less than that of every asset
asset in the
 portfolio. -owever, β p cannot be less than the smallest beta because β p is
a weighted average of the individual asset betas.

II.  Multiple Choice Questions

Questions

1. ; !. 0 '. ; *. A
2. 6 $. A (. ;

III. Problems
III. Problems

P"o$l!% &
"a# %he bar charts for tock A and tock ; are
are shown in the
the ne)t page.
"b# tock A’
A’s probability
probability distribu
distribution
tion is skewed to the left and tock ;’s
 probability distribution
distribution is symmetrical.
symmetrical.
"c# tock A’
A’s range of returns
returns is 2$ percentage
percentage points "2' < 1# and tock ;’s
;’s
range of returns is 27 points "!7 < 17#.

22-2
  Estimating Risk and Return on Assets Chat!" ##

"d# tock
tock A is riskier
riskier than tock
tock ; becaus
becausee tock
tock A has a wider
wider range of 
returns and a flatter probability distribution.
distribution.
Stock A

0.60

0.50

   i 0.40
  o  a
   l
  r    i   y
   b    t
   P    b

0.30

0.20

0.10

- 40 0 5 10 15 20 25 30 35 40
10 -5
Return (%)

Stock B

0.60

0.50

0.40
   b  y
  o    t
  r   a
   i
   l
   P
   b   i

0.30

0.20

0.10

- -5 0 5 10 15 20 25 30 35 40
10 -5
Return
22-3 (%)
Chat!" ##  Estimating Risk and Return on Assets

P"o$l!% #

%he e)pected value of the returns for each stock is

 Stock A
ȓA = "7.7'# "7.71# > "7.27# "7.7'# > "7.2'#
"7.2'# "7.17# > "7.!'# "7.1'# > "7.1'# "7.2'#
= 7.12'' or 12.''?
12.''?
 Stock B
ȓ; = "7.17# "7.17# > "7.27# "7.1'# > "7.$7#
"7.$7# "7.27# > "7.27#
"7.27# "7.2'# > "7.17#
"7.17# "7.!7#
= 7.27 or 27?
27?

P"o$l!% '

"a# %he calculatio

calculationn of the e)pected
e)pected value can be set
set up in tabular
tabular form.
i i "i ()
 ()* i "i ()*
1 7.1 7 7
2 7.2 17 2.7
! 7.$ 27 /.7
$ 7.2 !7 (.7
' 7.1 $7 $.7
ȓ = 27.7?

"b# %he calculatio

calculationn of the standard
standard deviation
deviation can also
also be set up in tabular 
form. %he s9uare root of the variance, @ 2, of 127 percent is 17.3' percent
"rounded#.
i "i ()
 ()* ȓ ()* "i ()* + ȓ ()* ""i + ȓ* # ()
 ()* i i ""i + ȓ* # ()*

1 7 27 + 27 $77 7.1 $7.7

2 17 27 + 17 177 7.2 27.7
! 2277 27 7 7 7.$ 7
$ !7 27 17 177 7.2 27.7
' $7 27 27 $77 7.1 $7.7
 @ 2 = 127.7

22-4
  Estimating Risk and Return on Assets Chat!" ##

  127.7 = 17.3'?

"c# %he coefficien

coefficientt variati
variation
on is
is
17.3'
6F = 27.77 = 7.''

A coefficient
coefficient of variation of 7.'' means that there is 7.'' percent risk for 
every 1 percent of return.

P"o$l!% ,

"a#
"a# 4ro&
4ro&ec
ectt : is risk
riskie
ierr than
than 4ro&
4ro&ec
ectt B when
when rank
ranked
ed by thei
theirr stan
standa
dard
rd
deviations. -owever, the two pro&ects are e9ually risky when ranked by
their coefficients of variation.
"b# Cn this situation,
situation, the coefficient
coefficient variation
variation is the more appropriate
appropriate risk 
measure because the pro&ects have different net investments and e)pected
values. %hus, a relative measure of risk "coefficient of variation# is
needed rather than an absolute measure "standard deviation#.

P"o$l!% -

"a# %he ranges

ranges for 4ro&ec
4ro&ectt B are shown
shown below
below
 Standard 
 Expected   Deiation
Value !"#$###% Range
4177,777 D1 4/7,777 E 4127,777
4177,777 D2 4(7,777 E 41$7,777

"b# Appro)im
Appro)imately
ately (/ percent
percent of the returns should
should lie between
between D 1 standard
standard
deviation of the e)pected value and about 3' percent within D 2 standard
deviations.

P"o$l!% 

"a# 6alculatin
6alculatingg the probabil
probability
ity that the return will e)ceed 41!7,777
41!7,777 re9uires
re9uires
three steps
irst, compute the  z  value
 value as follows
22-5
Chat!" ##  Estimating Risk and Return on Assets

41!7,777 < 4177,777

 = 427,777 = 1.'7
 8e)t, find 4r "7 G  z   G 1.'# which is 7.$!!2 or $!.!2 percent. %his
 probability is the chance of getting a return between the e)pected return
of 4177,777 and a return of 41!7,777.
inally, the probability of getting a return greater than 41!7,777 must be
calculated. 5emember that in a normal distribution, '7 percent of the
outcomes lies on each side of the e)pected value. %he probability of 
receiving a return of more than 41!7,777 is 7.7((/ "7.'777 E 7.$!!2# or 
(.(/ percent.
"b# 0eterm
0etermini
ining
ng the probabil
probability
ity of a return
return falling
falling betwee
betweenn 4'7,77
4'7,7777 and
41!7,777 re9uires several additional steps.
irst, determine the  z  value
 value for a return between 4'7,777 and 4177,777.
4'7,777 < 4177,777
 = 427,777 = E 2.'7

 8e)t, find 4r "+ 2.'7 G z  G

 G 7# which is 7.$3!/ or $3.!/ percent.
inally, the probability of a return between 4'7,777 and 41!7,777 is
obtained by adding the probability of a return between 4'7,777 and
4177,777, or 7.$3!/, and the probability of a return between 4177,777
and 41!7,777, or 7.$!!2. %his produces a probability of 7.32*7 "7.$3!/
> 7.$!!2# or 32.*7 percent chance of obtaining a return between 4'7,777
and 41!7,777.
P"o$l!% /

"a# %he e)pected

e)pected portfo
portfolio
lio return
return for each
each plan is
is
 Plan A Plan B
ȓ p = "7.(# "7.2$# > "7.$# "7.7/# ȓ p = "7.2
"7.2## "7.
"7.2$
2$## > "7./
"7./## "7.
"7.7/
7/##
= 7.1*( or 1*.(? = 7.112 or 11.2?
%he portfolio standard deviation for each plan is
 Plan A

@ p =  "7.(# 2 "7.1(# 2 > "7.$# 2 "7.72# 2 > "2# "7.(# "7.$# "7.'# "7.1(# "7.72#
=  7.77322 > 7.7777( > 7.777**
22-6
  Estimating Risk and Return on Assets Chat!" ##

=   7.7177'
= 7.1772' or 17.72'?
 Plan B

@ p =  "7.2# 2 "7.1(# 2 > "7./# 2 "7.72# 2 > "2# "7.2# "7./# "7.'# "7.1(# "7.72#
=  7.77172 > 7.7772( > 7.777'1
=   7.771*3
= 7.7$2!1 or $.2!1?

"b# As shown in 4lan

4lan ;, both
both the e)pecte
e)pectedd portf
portfoli
olioo return
return and portfo
portfolio
lio
standard deviation decrease as a greater proportion of the portfolio is
invested in Hega Falue ood tores. %hus, the influence of Iigabyte
6omputer’s higher e)pected risk and return are replaced in the portfolio
 by Hega Falu
Faluee ood tores’ lower e)pected risk and return.

P"o$l!% 0

%he e)pected returns are &ust the possible returns multiplied by the associated
 probabilities
J "5 A# = ".27 ) +.1'# > ".'7 ) .27# > ".!7 ) .(7# = 2'?
J "5 ;# = ".27 ).27# > ".'7
".'7 ) .!7# > ".!7
".!7 ) .$7# = !1?

%he variances are given by the sums of the s9uared deviations from the e)pected
returns multiplied by their probabilities
@2A = .27 ) "+.1' E .2'# 2 > .'7 ) ".27 E .2'# 2 > .!7 ) ".(7 E .2'# 2
= ".27 ) +.$72# > ".'7 ) +.7' 2# > ".!7 ) .!' 2#
= ".27 ) .1(# > ".'7 ) .772'# > ".!7 ) .122'#
= .7*77

@2; = .27 ) ".27 E .!1# 2 > .'7 ) ".!7 E .!1# 2 > .!7 ) ".$7 E .!1# 2
= ".27 ) +.112# > ".'7 ) +.71 2# > ".!7 ) .73 2#
= ".27 ) .7121# > ".'7 ) .7771# > ".!7 ) .77/1#

22-7
Chat!" ##  Estimating Risk and Return on Assets

= .7*$3

%he standard deviations are thus

@A =  .7*77 @; =  .77$3
= 2(.$(? = *?

P"o$l!% 1

%he portfolio weights are 41',777K27,777 = .*' and 4',777K27,777 = .2'. %he
e)pected return is thus
J "5 4# = .*' ) J "5 A# > .2' ) J "5 ;#
= ".*' ) 2'?# > ".2' ) !1?#
= 2(.'?

Alternatively,
Alternatively, we could calculate the portfolio’s return in each of the states
 Probabilit' )eighted 
 State o&  o& State o&   Port&olio Return i&  Returns
 Econom'  Econom'  State (ccurs !*%
5ecession .27 ".*' ) E.1'# > ".2' ) .27# = E.7(2' E 1.2'?
 8ormal .'7 ".*' ) .27# > ".2' ) .!7# = .22'7 11.2'?
;oom .!7 ".*' ) .(7# > ".2' ) .$7# = .''77 1(.'?
2(.'?

P"o$l!% &2

%he portfolio weight of an asset is total investment in that asset divided by the
total portfolio value. irst, we will find the portfolio value, which is

%otal
%otal value = 1/7 "4$'# > 1$7 "42*#
= 411,//7

%he portfolio weight for each stock is

WeightA = 1/7 "4$'# K 411,//7

= .(/1/

22-8
  Estimating Risk and Return on Assets Chat!" ##

Weight; = 1$7 "42*# K 411,//7

= .!1/2
P"o$l!% &&

%he e)pected return of a portfolio is the sum of the weight of each asset times the
e)pected return of each asset. %he total value of the portfolio is

%otal
%otal value = 42,3'7 > !,*77 = 4(,('7

o, the e)pected return of this portfolio is

J "5  p# = "42,3'7K4(,('7#"7.11# > "4!,*77K4(,('7#"7.1'#

"4!,*77K4(,('7#"7.1'# = .1!2!
. 1!2! or 1!.2!?

P"o$l!% &#

%he e)pected return of a portfolio is the sum of the weight of each asset times the
e)pected return of each asset. o, the e)pected return of the portfolio is

J "5  p# = .(7 ".73# > .2' ".1*# > .1'

. 1' ".1!# = .11(7 or 11.(7?

P"o$l!% &'

-ere, we are given the e)pected return of the portfolio and the e)pected return of 
each asset in the portfolio, and are asked to find the weight of each asset. We can
use the e9uation for the e)pected return of a portfolio to solve this problem.
ince the total weight of a portfolio must e9ual 1 "177?#, the weight of tock :
must be one minus the weight of tock B. Hathematically speaking, this means

J "5  p# = .12$ = .1$w B > .17'"1 < w B#

We can now solve this e9uation for the weight of tock B as

.12$ = .1$wB > .17' < .17'wB

.713 = .7!'wB
wB = 7.'$2/'*

o, the amount invested in tock B is the weight of tock B times the total
 portfolio value, or
or
Cnvestment in B = 7.'$2/'* "417,777# = 4',$2/.'*

22-9
Chat!" ##  Estimating Risk and Return on Assets

And the amount invested in tock : is

Cnvestment in : = "1 < 7.'$2/'*# "417,777# = 4$,'*$.$!
P"o$l!% &,

%he e)pected return of an asset is the sum of the probability of each return
occurring times the probability of that return occurring. o, the e)pected return of 
the asset is

J "5# = .2' "<.7/# > .*' ".21# = .1!*' or 1!.*'?

P"o$l!% &-

%he e)pected return of an asset is the sum of the probability of each return
occurring times the probability of that return occurring. o, the e)pected return of 
the asset is

J "5# = .27 "<.7'# > .'7 ".12# > .!7 ".2'#

".2'# = .12'7 or 12.'7?

P"o$l!% &

%he e)pected return of an asset is the sum of the probability of each return
occurring times the probability of that return occurring. o, the e)pected return of 
each stock asset is

J "5 A# = .1' ".7'#

".7'# > .(' ".7/# > .27 ".1!# = .7/'' or /.''?
/.''?

J "5 ;# = .1' "<.1*# > .(' ".12# > .27

.27 ".23#
".23# = .117' or 11.7'?
11.7'?

%o calculate the standard deviation, we first need to calculate the variance. %o

find the variance, we find the s9uared deviations from the e)pected return. We
then multiply each possible s9uared deviation by its probability, then add all of 
these up. %he result is the variance. o, the variance and standard deviation of 
each stock is

σA2 = .1'".7' < .7/''# 2 > .('".7/ < .7/''# 2 > .27".1! < .7/''# 2 = .777(7

σA  = ".777(7# 1K2 = .72$( or 2.$(?

σ;2 = .1'"<.1* < .117'# 2 > .('".12 < .117'#2 > .27".23 < .117'# 2 = .71/!7

22-10
  Estimating Risk and Return on Assets Chat!" ##

σ;  = ".71/!7# 1K2 = .1!'! or 1!.'!?

P"o$l!% &/

%he e)pected return of a portfolio is the sum of the weight of each asset times the
e)pected return of each asset. o, the e)pected return of the portfolio is
J "5  p# = .2'".7/# > .''".1'# > .27".2$#
= .1'7' or 1'.7'?
Cf we own this portfolio, we would e)pect to get a return of 1'.7' percent.
P"o$l!% &0

"a# %o find
find the e)pected
e)pected return
return of the portfolio,
portfolio, we need to find the return of the
 portfolio in each state of the economy. %his portfolio is a special case since
all three assets have the same weight. %o find the e)pected return in an
e9ually weighted portfolio, we can sum the returns of each asset and divide
 by the number of assets, so the e)pected return of the portfolio in each state
of the economy is
;oom J "5  p# = ".7* > .1' > .!!#K! = .1/!! or 1/.!!?
5ecession J "5  p# = ".1! > .7! −.7(#K! = .7!!! or !.!!?
%o find the e)pected return of the portfolio, we multiply the return in each
state of the economy by the probability of that state occurring, and then sum.
0oing this, we find
J "5  p# = .!'".1/!!# > .('".7!!!#
= .7/'/ or /.'/?
"b# %his portfoli
portfolioo does not have an e9ual weight
weight in each asset.
asset. We still
still need to
find the return of the portfolio in each state of the economy. %o do this, we
will multiply the return of each asset by its portfolio weight and then sum the
 products to get the portfolio return in each state of the economy.
economy. 0oing so,
we get
;oom J "5  p# = .27".7*# >.27".1'# > .(7".!!# =.2$27 or 2$.27?
5ecession J "5  p# = .27".1!# >.27".7!# > .(7" −.7(# = <.77$7 or <7.$7?

22-11
Chat!" ##  Estimating Risk and Return on Assets

And the e)pected return of the portfolio is

J "5  p# = .!'".2$27# > .('" −.77$#
= .7/21 or /.21?
%o find the variance, we find the s9uared deviations from the e)pected return.
We then multiply each possible s9uared deviation by its probability,
probability, than add
all of these up. %he result is the variance. o, the variance and standard
deviation of the portfolio is
σ p2 = .!'".2$27 < .7/21# 2 > .('"−.77$7 < .7/21# 2

= .71!*(*
= 11.*!?
P"o$l!% &1
"a# %his portfolio
portfolio does
does not have an e9ual weight
weight in each asset. WeWe first need to
find the return of the portfolio in each state of the economy. %o do this, we
will multiply the return of each asset by its portfolio weight and then sum the
 products to get the portfolio return in each state of the economy.
economy. 0oing so,
we get

;oom J "5 p # = .!7".!# > .$7".$'# > .!7".!!# = .!(37 or !(.37?

Iood J "5  p# = .!7".12# > .$7".17# > .!7".1'# = .1217 or 12.17?
4oor J "5 p # = .!7".71# > .$7"<.1'# > .!7"<.7'# = <.7*27 or <*.27?
5ece
5ecess
ssio
ion
n J "5 
 p# = .!7"<.7(# > .$7"<.!7# > .!7"<.73# = <.1('7 or <1(.'7?

And the e)pected return of the portfolio is

J "5  p# = .1'".!(37# > .$'".1217#
.$'".1217# > .!'"<.7*27#
.!'"<.7*27# > .7'"<.1('7#
= .7*($ or *.($?

"b# %o calculate the standard deviation,

deviation, we first need to calculate the variance. %o
%o
find the variance, we find the s9uared deviations from the e)pected return.
We then multiply each possible s9uared deviation by its probability,
probability, than add
all of these up. %he result is the variance. o, the variance and standard
deviation of the portfolio is

σ p2 = .1'".!(37 < .7*($# 2 > .$'".1217 < .7*($# 2 > .!'"<.7*27 < .7*($# 2 >
.7'"<.1('7 < .7*($# 2

22-12
  Estimating Risk and Return on Assets Chat!" ##

σp2 = .02436

σ p = .72$!(
= .1'(1 or 1'.(1?

22-13