Unit II Supplemental Practice Problems

1. The following are the weekly prices of Coca-Cola stock over a five-week period
Date Price
July 10 42.65
July 17 43.90
July 24 44.52
July 31 43.85
August 7 43.76

a. Find the arithmetic mean return.

b. Find the geometric mean return.
c. Find the standard deviation of the return.
d. Using the approximation we studied that applies when returns are normally
distributed, find the estimated geometric mean return using the arithmetic mean
and the standard deviation. How good is the approximation?
e. Find the sequence of continuously compounded returns.
f. Given your answer in d., show that their arithmetic average is the log of one plus
the geometric mean return.

2. Find the expected return, standard deviation, covariance and correlation of the returns
on two stocks, X and Y, given the following information.
Market outcome Return on X Return on Y Probability
Good year 0.12 0.09 0.30
Average year 0.05 0.02 0.30
Bad year -0.10 -0.05 0.40

3. Given the following information on three securities (J, K, and L), find the expected
return and standard deviation of a portfolio consisting of 40% invested in J, 35%
invested in K, and 25% invested in L.
Stock Expected return Standard deviation
J 0.12 0.28
K 0.22 0.65
L 0.09 0.15
Correlation between J and K: 0.44
Correlation between J and L: 0.70
Correlation between K and L: 0.52

4. Consider a portfolio with 50 stocks in which the average variance is 0.04 and the
average covariance is 0.08.
a. How many variance terms are there in the formula for the portfolio variance?
b. How many covariance terms are there in the formula for the portfolio variance?
c. Using the average variance and covariance, calculate the portfolio variance.

Unit II Supplemental Practice Problems p. 1 of 5 Version: January 3, 2011

5. Consider a combination of a portfolio, called A, with expected return of 20% and
standard deviation of 40% combined with the risk-free asset, which has expected
return of 4%. Assume 60% of the money is invested in A and 40% is invested in the
risk-free asset.
a. Find the expected return.
b. Find the standard deviation.

6. Find the expected returns of the following portfolios if the risk-free rate is 6% and the
expected return on the market is 20%.
a. A portfolio with beta of 1.3
b. A portfolio with beta of 0.75
c. A portfolio with beta of 1.0

7. The risk-free rate is 4%. Use the information given below to find the expected return
on the market.
Stock Expected return Beta
A 0.25 1.5
B 0.1240 0.60

Unit II Supplemental Practice Problems p. 2 of 5 Version: January 3, 2011

 Solutions

1. First find the rates of return:

43.90
− 1 = 0.0293
42.65
44.52
− 1 = 0.0141
43.90
43.85
− 1 = −0.0150
44.52
43.76
− 1 = −0.0021
43.85
a. The arithmetic mean is just the simple average return:
0.0293 + 0.0141 − 0.0150 − 0.0021
R= = 0.0066
4
b. The geometric mean is as follows:
43.76
G=4 − 1 = 0.0064
42.65
c. The standard deviation is found as follows:

(0.0293 − 0.0066) 2 + (0.0141 − 0.0066) 2 + (−0.0150 − 0.0066) 2 + (−0.0021 − 0.0066) 2

σ2 =
3
= 0.0004
σ = 0.0004 = 0.0193

d. The approximation is as follows and it is almost exact:

G  R − (1/ 2)σ 2
= 0.0066 − (1/ 2)(0.0004) = 0.0064

e. The continuously compounded return is just the natural log of one plus the price
relative.
⎛ 43.90 ⎞
ln ⎜ ⎟ = 0.0289
⎝ 42.65 ⎠
⎛ 44.52 ⎞
ln ⎜ ⎟ = 0.0140
⎝ 43.90 ⎠
⎛ 43.85 ⎞
ln ⎜ ⎟ = −0.0152
⎝ 44.52 ⎠
⎛ 43.76 ⎞
ln ⎜ ⎟ = −0.0021
⎝ 43.85 ⎠
f. The result is as follows:

Unit II Supplemental Practice Problems p. 3 of 5 Version: January 3, 2011

 0.0289 + 0.0140 − 0.0152 − 0.0021
= 0.0064
4
ln (1 + G ) = ln(1.0064) = 0.0064
There is considerable round-off error here and the numbers are all close to zero
making it harder to see any differences, but the result is correct.

2. First we need the expected returns of each stock:

X : 0.12(0.30) + 0.05(0.30) − 0.10(0.40) = 0.0110
Y : 0.09(0.30) + 0.02(0.30) − 0.05(0.40) = 0.0130
Then we need the standard deviations of each stock:
X : (0.12 − 0.011) 2 (0.30) + (0.05 − 0.011) 2 (0.30) + (−0.10 − 0.011) 2 (0.40) = 0.0089
σ X = 0.0089 = 0.0946
Y : (0.09 − 0.013) 2 (0.30) + (0.02 − 0.013) 2 (0.30) + (−0.05 − 0.013) 2 (0.40) = 0.0034
σ Y = 0.0034 = 0.0581
The covariance is the probability-weighted average of the product of the deviation of
each stock’s return from its expected return:
(0.12 − 0.011)(0.09 − 0.013)(0.30) + (0.05 − 0.011)(0.02 − 0.013)(0.30)
+ (−0.10 − 0.011)(−0.05 − 0.013)(0.40) = 0.0054
The correlation is the covariance divided by the product of the standard deviations:
0.0054
= 0.9825
(0.0946)(0.0581)

3. The expected return is just a weighted-average of the expected returns on the

component securities. The variance is a weighted average of the variances and twice
all possible pairs of covariances. With three stocks, there are six pairs of covariances:
J and K, J and L, and K and L.

E = 0.12(0.40) + 0.22(0.35) + 0.09(0.25) = 0.1475

σ 2 = (0.40) 2 (0.28)2 + (0.35)2 (0.65)2 + (0.25) 2 (0.15)2
+2(0.40)(0.35)(0.44)(0.28)(0.65)
+2(0.40)(0.25)(0.70)(0.28)(0.15)
+2(0.35)(0.25)(0.52)(0.65)(0.15) = 0.1029
σ = 0.1029 = 0.3208

4. a. There will be one variance term for each stock, so there are 50 variance terms.
b. There will be N(N-1)/2 unique covariance terms (each appearing twice). So
50(49)/2 = 1,225 covariance terms, each twice.
c. As follows:
⎛ 1 ⎞ ⎛ 1 ⎞
⎜ ⎟ 0.04 + ⎜1 − ⎟ 0.08 = 0.0792
⎝ 50 ⎠ ⎝ 50 ⎠

Unit II Supplemental Practice Problems p. 4 of 5 Version: January 3, 2011

5.
a. The expected return is just a weighted-average of the expected returns on the two
component assets, portfolio A and the risk-free asset.
(0.60)0.20 + (0.40)0.04 = 0.1360
b. The variance comes from the formula for a two-asset portfolio (see problem 3,
which is the three-asset portfolio, for comparison). The second asset here is the
risk-free asset and its standard deviation and covariance are zero.

σ 2 = (0.6) 2 (0.40)2 + 0 + 0 = 0.0576

σ = 0.0576 = 0.24
6. All of these calculations are simple and based on the Capital Asset Pricing Model:
E ( R) = r + ( E ( Rm ) − r ) β
a. E ( R) = 0.06 + (0.20 − 0.06)1.3 = 0.242
b. E ( R ) = 0.06 + (0.20 − 0.06)0.75 = 0.165
c. E ( R) = 0.06 + (0.20 − 0.06)1 = 0.20
The last calculation was unnecessary, because knowing that the beta is 1, the stock
has the same beta as the market. Thus, its expected return must be the same as that of
the market.

7. Rearrange the CAPM:

E ( R) = r + ( E ( Rm ) − r ) β
E ( R) − r
= E ( Rm ) − r
β
E ( R) − r
+ r = E ( Rm )
β
Then make the appropriate substitutions into either set of results. In other words, you
do not have to do it for both stocks. The information from each stock must imply the
same expected return on the market.
E ( R) − r
+ r = E ( Rm )
β
0.25 − .04
A: + .04 = 0.18
1.5
0.1240 − 0.04
B: + 0.04 = 0.18
0.60

Unit II Supplemental Practice Problems p. 5 of 5 Version: January 3, 2011