Ushtrime te zgjidhura Tema 7

CHAPTER 7
introduction to Risk, Return, and the Opportunity Cost of Capital

Answers to Practice Questions 2 . R e c a l l f r o m C h a p t e r

t h a t :

Therefore:

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

b.From the results for Part (a), the average real return was 16.5 percent. c . T h e r i s k p r e m i u m ex e r ci se ; f o r e a c h y e a r w a s :

3 . I n t e r ne t 3 .

a n sw ers

w i l l

va r y.

a .A l o ng - t e rm U ni t e d S ta t es g ov e r nme n t b o n d i s a l w a y s a b s o l u t e l y s a f e i n terms of the dollars received. However, the price of the bond fluctuates asinterest rates change and the rate at which coupon payments can beinvested also changes as interest rates change. And, of course, thepayments are all in nominal dollars, so inflation risk must also beconsidered. b.It is true that stocks offer higher long-run rates of return than b o n d s , b u t i t is also true that stocks have a higher standard deviation of return. So,which investment is preferable depends on the amount of risk one iswilling to tolerate. This is a complicated issue and depends on numerousfactors, one of which is the investment time horizon. If the investor has ashort time horizon, then stocks are generally not preferred.c . U n f o r t u n a t e l y , 1 0 y e a r s i s

n o t g e n e r a l l y c o n s i d e r e d a s u f f i c i e n t a m o u n t o f time for estimating average rates of return. Thus, using a 10-year averageis likely to be misleading .4 . I f t h e d i s t r i b u t i o n o f r e t u r n s i s s y m m e t r i c , i t m a k e s n o d i f f e r e n c e w h e t h e r w e l o o k 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 b e t a , o f t h e investment in the black stallion. The information given in the problem suggeststhat the horse has very high unique risk, but we have no information regardingthe horse s market risk. So, the best estimate is that this horse has a market riskabout equal to that of other racehorses, and thus this investment is not aparticularly risky one for Hippique shareholders. 6.In the context of a well-diversified portfolio, the only risk characteristic of a s i n g l e security that matters is the security s contribution to the overall portfolio risk. Thiscontribution is measured by beta. Lonesome Gulch is the safer investment for adiversified investor because its beta (+0.10) is lower than the beta of Amalgamated Copper (+0.66). For a diversified investor, the standard deviationsare irrelevant.

7.a.To t he ext ent t hat t he invest or is int erested i n t h e v a r i a t i o n o f p o s s i b l e future outcomes, risk is indeed variability. If returns are random, then thegreater the period-by-period variability, the greater the variation of possible future outcomes. Also, the comment seems to imply that any riseto $20 or fall to $10 will inevitably be reversed; this is not true.56

b.A stocks variabilit y may be due to many uncertainties, s u c h a s unexpected changes in demand, plant manager mortality or changes incosts. However, the risks that are not measured by beta are the risks thatcan be diversified away by the investor so that they are not relevant for investment decisions. This is discussed more fully in later chapters of thetext. c. G ive n t he e xpe ct ed r et ur n, t he pr o ba b ilit y o f lo s s inc r e a se s w it h t h e standard deviation. Therefore, portfolios that minimize the standarddeviation for any level of expected return also minimize the probability of loss.d . B e t a i s t h e s e n s i t i v i t y o f a n i n v e s t m e n t s r e t u r n s t o m a r k e t r e t u r n s . I n order to estimate beta, it is often helpful to analyze past returns. When wedo this, we are indeed assuming betas do not change. If they are liable tochange, we must allow for this in our estimation. But this does not affectthe idea that some risks cannot be diversified away.

8.

9.a.Refer to Figure 7.10 in t he text. Wit h 100 s e c u r i t i e s , t h e b o x i s 1 0 0 b y 100. The variance terms are the diagonal terms, and thus there are 100variance terms. The rest are the covariance terms. Because the box has(100 times 100) terms altogether, the number of covariance terms is:1002 - 100 = 9,900Half 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. W i t h 5 0 stocks, all with the same standard deviation (0.30), the same weight in theportfolio (0.02), and all pairs having the same correlation coefficient (0.4),the portfolio variance is:

c.For a completely diversified portfolio, portfolio variance equals the a v e r a g e covariance:

10.a.Refer to Figure 7.10 in the text. For each d i f f e r e n t p o r t f o l i o , t h e r e l a t i v e weight of each share is [one divided by the number of shares (n) in theportfolio], the standard deviation of each share is 0.40, and the correlationbetween pairs is 0.30. Thus, for each portfolio, the diagonal terms are thesame, and the off-diagonal terms are the same. There are n diagonalterms and (n2

 n) off-diagonal terms. In general, we have:

The results are summarized in the second and third columns of the tableon the next page b.(Graphs are on the next page.) The underlying market risk that can n o t b e diversified away is the second term in the formula for variance above:

c.This is the same as Part (a), except that all the off-diagonal terms a r e n o w equal to zero. The results are summarized in the fourth and fifth columnsof the table below.

12.

15.a.In general, we expect a sto cks price to c h a n g e b y a n a m o u n t e q u a l t o (beta change in the market). Beta equal to -0.25 implies that, if themarket 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 i s invested in typical securities, the portfolio beta is approximately one. Thelargest reduction in beta is achieved by investing the $20,000 in a stockwith a negative beta. Answer (iii) is correct.

16.a.If the standard deviation of the market portfolio s r e t u r n i s 2 0 p e r c e n t , t h e n 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 thestock s returns with the market divided by the variance of the marketreturn. Thus:

b.For a fully diversified portfolio, the standard deviation of portfolio r e t u r n i s equal to the portfolio beta times the market portfolio standard deviation:

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 onthe market portfolio):

17.Diversifi cation by corporations does not benefit shareholders b e c a u s e shareholders can easily diversify their portfolios by buying stock in many differentcompanies.

Challenge Questions 1 a . I

b.We can think of this in terms of Figure 7.10 in the text, with t h r e e securities. One of these securities, T-bills, has zero risk and, hence, zerostandard deviation. Thus

Another way to think of this portfolio is that it is comprised of one-thirdT-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:

c.With 50 percent margin, the investor invests twice as much money i n t h e 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:

d. Wit h 100 st o ck s, t he po r t fo lio is we ll d ive r s if ie d, a nd he nc e t he p o r t f o l i o standard deviation depends almost entirely on the average covariance of the securities in the portfolio (measured by beta) and on the standarddeviation of the market portfolio. Thus, for a portfolio made up of 100stocks, each with beta = 2.21, the portfolio standard deviation isapproximately: (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:

If security one is Treasury bills and security two is the market portfolio, then 1 is zero, 2 is 20 percent. Therefore:

3.a.From the text, we know that the standard deviation of a well-diversified p o r t f o l i o 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.

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

The first measure provides an estimate of the amount of risk that can still bediversified away. With a fully diversified portfolio, the ratio is approximately one.Unfortunately, the use of average historical data does not necessarily reflectcurrent or expected conditions The second measure indicates the potential reduction in the number of securitiesin a portfolio while retaining the current portfolio s risk. However, this measuredoes not indicate the amount of risk that can yet be diversified away.

Kapitulli 8
Risk and Return Answers to Practice Questions

.In the following solution, security one is Coca-Cola and security two is Reebok. Then:

Further, we know that for a two-security portfolio

Therefore, we have the following results

b. S e e t he f ig ur e be lo w. T he s et o f po r t fo lio s is r epr es e nt ed b y t he c u r v e d l i n e . T h e five points are the three portfolios from Part (a) plus the two following two portfolios: one consists of 100% invested in X and the other consists of 100%invested in Y. c . S e e t h e f i g u r e b e lo w . T he b e s t o p po r t u n it i e s l i e a lo n g t he s t r a i g ht l i n e . F r o m t h e d i a g r a m , t he o p t i m a l p o r t fo l i o o f r i s k yassets is portfolio 1, and so Mr. Harrywitz should invest 50 percent in X and 50 percent in Y.-+

4.a.Expect ed return 15) + (0.4 20) = 17%Variance = (0.6) 2 (20) 2 + (0.4) 2

= (0.6

(22) 2 + 2(0.6)(0.4)(0.5)(20)(22) = 327Standard deviation = (327) (1/2) = 18.1% b . C o r r e l a t i o n c o e f f i c i e n t Standard deviation = 14.9%Correlation coefficient = -0.5

Standard deviation = 10.8%c . H i s p o r t f o l i o i s b e t t e r . T h e p o r t f o l i o h a s a higher expected return and a lower standard deviation

b . M a r k e t r i s k p r e m i u m = r m -r f = 0.12 - 0.04 = 0.08 = 8.0%c . U s e t h e s e c u r i t y

m a r k e t

l i n e :

d. Fo r a n y in ve st me nt , w e c a n f ind t he o ppo r t u nit y co st o f c ap it a l u s i n g t h e security market line. With = 0.8, the opportunity cost of capital is:

The opportunity cost of capital is 10.4 percent and the investment isexpected to earn 9.8 percent. Therefore, the investment has a negativeNPV. e .Ag ai n , w e us e t he s e c ur i ty m ar k e t l i n e :

10.a.Percivals current portfolio provides an expected r e t u r n o f 9 p e r c e n t w i t h an annual standard deviation of 10 percent. First we find the portfolioweights for a combination of Treasury bills (security 1: standard deviation= 0 percent) and the index fund (security 2: standard deviation = 16percent) such that portfolio standard deviation is 10 percent. In general,for a two security portfolio:

Therefore, he can improve his expected rate of return without changingthe risk of his portfolio. b.With equal amounts in the corporate bond portfolio (security 1) a n d t h e index fund (security 2), the expected return is:

Therefore, he can do even better by investing equal amounts in thecorporate bond portfolio and the index fund. His expected returnincreases to 11.5% and the standard deviation of his portfolio decreasesto 9.85% 11.No. Every stock has unique risk in addition to market risk. The unique risk reflectsuncertain events that are unrelated to the return on the market portfolio. TheCapital Asset Pricing Model does not predict these events. If the events arefavorable, the stock will do better than the model predicts. If the events areunfavorable, the stock will do worse.

1 u

2 e

. c .

a T

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T u

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u 69

13.a.True. By definition, the factors represent macroe c o n o m i c r i s k s t h a t cannot be eliminated by diversification.b . F a l s e . T h e A P T d o e s n o t s p e c i f y t h e f a c t o r s . c.True. Investors will not t a k e o n n o n d i v e r s i f i a b l e r i s k u n l e s s i t e n t a i l s a positive risk

premium.d . T r u e . D i f f e r e n t r e s e a r c h e r s h a v e p r o p o s e d a n d e m p i r i c a l l y i n v e s t i g a t e d different factors, but there is no widely accepted theory as to what thesefactors should be.e . T r u e . T o b e u s e f u l , w e m u s t b e a b l e t o e s t i m a t e t h e r e l e v a n t p a r a m e t e r s . If this is impossible, for whatever reason, the model itself will be of theoretical interest only.

Tema 9

The tota l ma rket va lue of outs ta nding debt is 300, 000 euros. The cost of debt capital is 8 percent. For the c o m m o n s t o c k , the outstanding market value is: (50 euros 10,000) = 500,000 euros. The cost of equity capital is 15 percent. Thus, Loreleis weightedaverage cost of capital is:

b . Be c a us e b u s i n e s s r i s k is u n c ha n g e d , t h e c o mp a n y s w e i g h t e d a ve ra g e c o s t o f c a p i t a l w i l l n o t c h a n ge . T he fi n a nc i a lstructure, however, has changed. Common stock is now worth 250,000 euros. Assuming that the market value of debt andthe cost of debt capital are unchanged, we can use the same equation as in Part (a) to calculate the new equity cost of capital, r equity

8 BN =r f +

BN (r m -r f ) = 0.035 + (0.64 0.08) = 0.0862 = 8.62%r IND =r f + IND (r m -r f ) = 0.035 + (0.50 0.08) = 0.075 = 7.50% b . N o , w e c a n n o t b e c o n fi d e n t t h a t B u r l i n g t o n s t r u e b e t a is n o t t h e i n d us t r y a ve ra g e . T h e d i f fe r e nc e b e t w e e n BN and IND (0.14) is less than one standard error (0.20), so we cannot reject the hypothesis that BN =

IND . c . B ur l i n g t o n s b e t a m i g h t b e d i f f e re n t fro m t h e in d us t r y b e t a fo r a v a r i e t y o f re a s o ns . Fo r e x a mp l e , B u r l i n g t o n s b us i n e s s might be more cyclical than is the case for the typical firm in the industry. Or Burlington might have more fixed operatingcosts, so that operating leverage is higher. Another possibility is that Burlington has more debt than is typical for theindustry so that it has higher financial leverage.d . C o m p a n y c o s t o f c a p i t a l = ( D / V ) ( r debt ) + (E/V)(r equity )Company cost of capital = (0.4 0.06) + (0.6 0.075) = 0.069 = 6.9%