Risk & Return- Refresher

1. Unicom is a regulated entity serving Northern Illinois. The following table lists the stock prices (beginning of the year) and dividends (during the year) of Unicom from 1989 to 1997.
Year Price ($) Dividend ($) 1989 36.1 3 1990 33.6 3 1991 37.8 3 1992 30.9 2.3 1993 26.8 1.6 1994 24.8 1.6 1995 31.6 1.6 1996 28.5 1.6 1997 24.25 1.6

i. ii.

Estimate the average annual return you would have made on your investment at beginning of 1989. If you were investing in Unicom today, would you expect the historical standard deviations and variances to hold? Explain.

2. Suppose shares of ABC ltd and XYZ ltd trade at the same price today. Over the next 3 years, returns on the common stock of ABC ltd and XYZ ltd show the following trends: Returns/Year ABC (%) XYZ (%) i. ii. Year 1 25 10 Year 2 -20 -15 Year 3 10 20

Would the share prices of ABC and XYZ be same after 3 years? Calculate the CAGR for ABC and XYZ.

3. The economy of a country may experience rapid growth or moderate growth or recession. The following table illustrates the probability of the three outcomes along with the respective stock market returns. State of economy Rapid growth Moderate growth Recession i. Probability 0.2 0.6 0.2 Stock market return (%) 25 15 -15

Calculate the expected stock market returns and the standard deviation of returns.

4. Suppose the returns of the Moonshine Company Ltd are normally distributed. The mean return is 20% and the standard deviation of the return is 10%. Determine the range of returns in which about 2/3 of the Companys returns fall. 5. You have been asked to analyze the standard deviation of a portfolio composed of the following three assets:

Investment Sony Corporation Tesoro Petroleum Storage Technology

Expected return (%) 11 9 16

Standard deviation (%) 23 27 50

You have also been provided with the correlations across the three investments. Investment Sony Tesoro Storage Tech Sony 1 -0.15 0.2 Tesoro -0.15 1 -0.25 Storage Tech 0.2 -0.25 1

Estimate the variance of the portfolio, equally weighted across all assets. 6. Consider a Markowitz portfolio across a universe of 1250 assets. How many covariances would you need to compute in order to obtain Markowitz portfolios? 7. Consider a portfolio of equally weighted securities in which the average variance of return for each security is 50 while its average covariance with any other security in the portfolio remains constant at 10. What is the expected variance of a portfolio of 20, 50, and 100 securities? How many securities need to be held before the risk of the portfolio is only 10% more than the minimum? 8. Tim Anderson owns a combination of the optimal risky market portfolio and a riskfree asset. If the standard deviation of the optimal risky market portfolio is 20% and the expected return on the portfolio is 10%. Consider the following situations to advise Tim on his portfolio composition. (Proportion of wealth invested between the market portfolio and the risk-free asset.) i. If Tim desires a portfolio with no standard deviation. ii. If Tim desires a portfolio with no more than 20% standard deviation. iii. If Tim desires a portfolio with a standard deviation of 10%.

9. John Nelson intends to borrow a sum equivalent to 20% of his portfolio to be invested in a risky portfolio that lies on the Capital Market Line (CML). If the slope of the CML is 0.48 and the return of the optimal risky market portfolio is 20% with a standard deviation of 25%, calculate the returns derived by John if the borrowing cost exceeds the risk free lending rate by 2%. 10. A security that lies on the Security Market Line (SML) is represented by the coordinates (0.25, 0.11) represented in the standard (x, y) convention. If the market returns are 20%, determine the slope and the Y-intercept of the SML.

11. Gamma Natural Resources (GNR), an iron ore miner, buys a large but privately held iron ore miner in Australia. As a result of the cross-border acquisition of a private company, GNRs standard deviation of returns is reduced from 50% to 30% and its correlation with the market falls from 0.95 to 0.75. Assume that the standard deviation and return of the market remain unchanged at 25% and 10%, respectively and that the risk-free rate is 3%. i. Calculate the beta of GNR stock and its expected return before the acquisition. ii. Calculate the expected return after the acquisition. 12. You invest 20% of your money in the risk-free asset, 30% in the market portfolio and 50% in Green Apple, a British firm that has a beta of 1.5. Given that the risk-free rate is 3% and the market return is 15%, calculate the portfolio beta and expected return. 13. A French pension fund has employed three investment managers, each of whom is responsible for investing in one-third of all asset classes so that the pension fund has a well-diversified portfolio. Consider the following information about the managers.

Manager A B C Risk-free rate

Return (%) 10 11 12 3

Alpha 0.2 0.1 0.25

Beta 1.1 0.7 0.6

Calculate: i. Expected return ii. Sharpe ratio* iii. Treynor ratio* iv. Jensens alpha Optional. Not in the curriculum. 14. A British investor is holding FTSE 100 index, which is her version of the market. She thinks that three stocks, X, Y, and Z, which are not part of the FTSE 100 index, are undervalued and should form a part of her portfolio. She has the following information about the stocks, the FTSE 100 index and the risk-free rate. Stocks/Index X Y Z FTSE 100 Risk-free rate i. ii. iii. Expected return (%) 15 18 16 12 2 Standard deviation (%) 30 25 23 18 0 Beta 1.5 1.2 1.1 1 0

Calculate Jensen alpha for X, Y, and Z. Nonsystematic variance for X, Y, and Z. Should any of the three stocks be included in the portfolio? If so, which stock should have the highest weight in the portfolio?