Solutions to Chapter 10

Introduction to Risk, Return, and the Opportunity Cost of Capital

1. return =

= = .15 = 15%

dividend yield = dividend / initial price = 2/40 = .05 = 5%

capital gains yield = capital gains / initial price

= 4/40 = .10 = 10%

2. dividend yield = 2/40 = .05 = 5%. The dividend yield is unaffected; it is based on the initial
price, not the final price.

capital gain = $36 – $40 = $4

capital gains yield = –4/40 = –.10 = – 10%

3. a. Rate of return =

= =0

Real rate =  1 =  1 = –.0476 = –4.76%

b. Rate of return = = .05 = 5%

Real rate =  1 =  1 = 0

c. Rate of return = = .10 = 10%

Real rate =  1 =  1 = .0476 = 4.76%

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4. Real return =  1

Costaguana: Real return =  1 = .0833 = 8.33%

Canada: Real return =  1 = .1067 = 10.67%

Canada provides the higher real return despite the lower nominal return. Notice that the
approximation

real rate  nominal rate – inflation rate

would incorrectly suggest that the Costaguanan real rate was higher than the Canadian
real rate. The approximation is valid only for low rates.

5. We use the relationship (with all rates expressed as decimals) that:

Real rate =  1

Asset class Nominal Return Inflation Real Rate

Treasury bills 4.7% 3% 1.65%
Treasury bonds 6.4 3 3.3
Common stocks 11.4 3 8.16

6. The nominal interest rate cannot be negative. If it were, investors would choose to
hold cash (which pays a return of zero) rather than buy a bill providing a negative
return. On the other hand, the real expected rate of return is negative if the inflation
rate exceeds the nominal return.

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7.
%
Average % change Total change % change
price of % change Equal in Equal Market in total Value in Value
stocks in in average Weighted Weighted value of market Weighted Weighted
Week market stock price Index Indexa stocks value Indexb Index
1 85.90 100 571,400 100
2 85.00 -1.05% 98.95 -1.05% 552,950 -3.23% 96.77 -3.23%
3 84.80 -0.24% 98.72 -0.24% 540,300 -2.29% 94.56 -2.29%
4 85.70 1.06% 99.77 1.06% 536,900 -0.63% 93.96 -0.63%
5 88.60 3.38% 103.14 3.38% 552,050 2.82% 96.61 2.82%
6 86.00 -2.93% 100.12 -2.93% 546,550 -1.00% 95.65 -1.00%
7 85.20 -0.93% 99.19 -0.93% 553,900 1.34% 96.94 1.34%
8 83.60 -1.88% 97.32 -1.88% 548,750 -0.93% 96.04 -0.93%
9 78.60 -5.98% 91.50 -5.98% 511,050 -6.87% 89.44 -6.87%

Notes:
a. The value of the portfolio for the equal weighted index is the simple average of
the prices of the stocks in the index. For any week, the value of the index is the
current simple average price of the stocks in the index divided by the average
stock price for the first week of the index, multiplied by an arbitrary starting value
for the index. Here we start the index at 100. A second way to calculate the new
value of the index is to multiply the previous value by 1 plus the percentage
change in average stock price for that week. You can see this by noting that the
weekly percentage change in the simple average stock price is identical to the
percentage change in the equal weighted index.

NOTE: the values above have been calculated with Excel and more decimal
places were used than are shown. If you use the rounded values in the table, your
answers will differ slightly than the ones above.

b. The market value index tracks the value of a portfolio that holds shares in each
firm in proportion to the number of outstanding shares. The composition of the
value-weighted portfolio is identical to that of the entire market. Therefore, the
new value of the index equals the previous index value increased (or decreased)
by the percentage change in the total value of stocks in the market. The market
value index can also be calculated as the current market value of the stocks in the
index divided by the market value of the stocks in the index for the first week of
the index, multiplied by an arbitrary starting value for the index. Again we start
the index at 100. Note that the weekly percentage change in the total market
value of the stocks is identical to the percentage change in the value weighted
index.

NOTE: The values above have been calculated with Excel and more decimal
places were used than are shown. If you use the rounded values in the table, your
answers will differ slightly than the ones above.

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8.
Weekly Rates of Return on Stocks
Week Tonsil Prochnik Krosno Exbud Kable Average
1
2 -0.1000 -0.0893 -0.1008 0.1007 0.0000 -0.0379
3 -0.0980 -0.0980 -0.0841 0.0976 0.0000 -0.0365
4 -0.0942 -0.0978 -0.0408 0.1000 -0.0062 -0.0278
5 -0.0960 -0.0843 0.0957 0.0960 0.0063 0.0035
6 -0.0088 0.0921 0.0971 -0.0968 0.0000 0.0167
7 0.0982 0.0964 0.0973 -0.0969 0.0000 0.0390
8 0.0976 0.0989 -0.0323 -0.0960 0.0063 0.0149
9 -0.0963 -0.0900 -0.1000 0.0000 -0.0994 -0.0771
Average rate of
return -0.0372 -0.0215 -0.0085 0.0131 -0.0116 -0.0132
Standard
deviation of
return 0.0888 0.0973 0.0906 0.0967 0.0357 0.0381

The average of the individual stocks’ standard deviation, is .0818 or 8.18%. The
standard deviation of the equal-weighted portfolio, shown in the table is 3.81%. This
is striking evidence of the benefits of diversification.

Note: Since the question works with observed data, the sample standard deviations
are calculated. Thus for each stock the average rate of return is calculated. Then, for
each week, the squared difference between the week’s return and the average rate of
return for all weeks is calculated. The squared deviations are summed and dividend
by 8 (the number of weeks minus 1). This gives the sample variance. The sample
standard deviation is the square root of the sample variance.

9. a.

TSX risk Long bond

TSX T-Bill Long Bond premium risk premium
2000 7.41 5.63 13.64 1.78 8.01
2001 -12.57 4.14 3.92 -16.71 -0.22
2002 -12.44 2.55 10.09 -14.99 7.54
2003 26.72 2.93 8.06 23.79 5.13
2004 11.53 2.28 8.82 9.25 6.54

average 4.13 3.50 8.91 0.63 5.40

Std. Dev. 16.80 1.39 3.51 17.01 3.33

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 b. The average TSX risk premium was 0.63 %. The average long bond risk
premium was 5.4% for these five years. These results are largely due to the
very poor performance of the TSX in 2001 and 2002. No investor expected
to lose 12% each year on their stock portfolio!

c. A fast way to calculate standard deviation of a sample of data is using a

spreadsheet, such as Excel. In Excel, use the STDEV function. Alternatively,
the standard deviation can be calculated by hand. First, calculate the sample
variance, then take the square root. The sample variance is the sum of the
squared deviations from the mean, divided by the number of observations
minus 1. We illustrate with the TSX risk premium:

Variance of TSX risk premium

= [1/(5-1)] × [(1.78 - .63)2 + (-16.71 - .63)2 + (-14.99 - .63)2
+ (23.79 - .63)2 + (9.25 - .63)2
= 289.21
Standard deviation of TSX risk premium = = 17.01%

We would expect that the risk premium standard deviation would be higher
for the TSX than for the Long Bond portfolio. This is what we find: the TSX
risk premium has a 14.2% standard deviation and the Long Bond risk
premium has a 3.33% standard deviation. There is a lot more variation in the
TSX risk premium because there is a lot more variation in the TSX return
than for the Long Bond portfolio.

10. In early 2000, the Dow was more than three times its 1990 level. Therefore a 40-
point movement was far less significant in percentage terms than in 1990. We would
expect to see more 40-point days even if market risk as measured by percentage
returns is no higher than in 1990.

11. Investors would not have invested in bonds if they had expected to earn negative
average returns. Unanticipated events must have led to these results. For example,
inflation and nominal interest rates during this period rose to levels not seen for
decades. These increases, which resulted in large capital losses on long-term bonds,
were almost surely unanticipated by investors who bought those bonds in prior
years.

The results from this period demonstrate the perils of attempting to measure “normal”
maturity (or risk) premiums from historical data. While experience over long periods
may be a reasonable guide to normal premiums, the realized premium over short
periods may contain little information about expectations of future premiums.

12. If investors become less willing to bear investment risk, they will require a higher
risk premium for holding risky assets. Security prices will fall until the expected rates
of return on those securities rise to the now-higher required rates of return.

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13. Based on the historical risk premium of the TSX (7.0 percent), and the current level
of the risk-free rate (about 2.75 percent), one would predict an expected rate of
return of 9.75 percent. If the stock has the same systematic risk, it also should
provide this expected return. Therefore, the stock price equals the present value of
cash flows for a one-year horizon.

2  50
P0 = 1.0975 = $47.38

14. Boom = 122.22%

Normal = 13.33%

Recession = –100%

Expected return = .3  122.22 + .5  13.33 + .2  (100)= 23.33%

Variance = .3  (122.22  23.33)2 + .5  (13.3323.33)2 + .2  (10023.33)2 = 6025.8

Standard deviation = = 77.63%

15. The bankruptcy lawyer does well when the rest of the economy is floundering, but
does poorly when the rest of the economy is flourishing and the number of
bankruptcies is down. Therefore, the Tower of Pita is a good hedge. When the
economy does well and the lawyer’s bankruptcy business suffers, the stock return is
excellent, thereby stabilizing total income. The owner of the gambling casino
probably does well when the economy is flourishing and less well when it is doing
poorly. For the casino owner, holding Tower of Pita stock will not stabilize total
income as much as it does for the bankruptcy lawyer.

16. Rate of Return

Boom = –28%

Normal = 8%

Recession = 48%

Expected return = .3  (28%) + .5  8% + .2  48% = 5.2%

Variance = .3  (28 – 5.2)2 + .5  (8 – 5.2)2 + .2  (48 – 5.2)2 = 700.96

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 Standard deviation = = 26.5%

Portfolio Rate of Return

Boom (28 + 122.22)/2 = 47.11%
Normal (8 + 13.33)/2 = 10.665%
Recession (48 –100)/2 = –26.0%

Expected return = .3  47.11% + .5  10.665% + .2  (-26.0%) = 14.27%

Variance = .3  (47.11 – 14.27)2 + .5  (10.665 – 14.27)2 + .2  (-26.0 – 14.27)2
= 654.4

Standard deviation = = 25.6%

Standard deviation is lower than for either firm individually because the variations in
the returns of the two firms serve to offset each other. When one firm does poorly,
the other does well, which reduces the risk of the combination of the two.

17. a. Interest rates tend to fall at the outset of a recession and rise during boom
periods. Because bond prices move inversely with interest rates, bonds will
provide higher returns during recessions when interest rates fall.

b. rstock = .2  (5%) + .6  15% + .2  25% = 13%

rbonds = .2  14% + .6  8% + .2  4% = 8.4%

Variance(stocks) = .2  (513)2 + .6  (1513)2 + .2  (25 – 13)2 = 96

Standard deviation = = 9.80%

Variance(bonds) = .2  (148.4)2 + .6  (88.4)2 + .2  (48.4)2 = 10.24

Standard deviation = = 3.20%

c. Stocks have higher expected return and higher volatility. More risk averse
investors will choose bonds, while others will choose stocks.

18. a. Recession (5%  .6) + (14%  .4) = 2.6%

Normal (15%  .6) + ( 8%  .4) = 12.2%
Boom (25%  .6) + ( 4%  .4) = 16.6%

b. Expected return = .2  2.6% + .6  12.2% + .2  16.6% = 11.16%

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 Variance = .2  (2.6 – 11.16)2 + .6  (12.2 – 11.16)2 + .2  (16.6 – 11.16)2
= 21.22

Standard deviation = 21.22 = 4.61%

c. The investment opportunities have these characteristics:

Mean Return Standard Deviation

Stocks 13.0% 9.80%
Bonds 8.4 3.20
Portfolio 11.16 4.61

The best choice depends on the degree of your aversion to risk. Nevertheless,
we suspect most people would choose the portfolio over stocks since it gives
almost the same return with much lower volatility. This is the advantage of
diversification.

d. To calculate the correlation coefficient, rearrange the formula for the portfolio
standard deviation as we did in Check Point 9.6.

Correlation between bond and stock returns

= (σp2 – xs2 σs2 – xb2 σb2) / ( 2 xs xb σs σb)
= (.04612 – .62× .0982 – .42 × .0322) / ( 2 × .6 × .4 × .098 × .032) = -.995

The stocks and bonds are almost perfectly negatively correlated.

19. If we use historical averages to compute the “normal” risk premium, then our
estimate of “normal” returns and “normal” risk premiums will fall when we include a
year with a negative market return. This makes sense if we believe that each
additional year of data reveals new information about the “normal” behaviour of the
market portfolio. We should update our beliefs as additional observations about the
market become available.

20. Risk reduction is most pronounced when the stock returns vary against each other.
When one firm does poorly, the other will tend to do well, thereby stabilizing the
return of the overall portfolio. By contrast stock returns that move together provide
no risk reduction. If stock returns are independent, some risk reduction (variability
reduction) occurs but it is less than if the stock returns vary against each other.

21. a. General Steel ought to have more sensitivity to broad market movements.
Steel production is more sensitive to changes in the economy than is food
consumption.

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 b. Club Med sells a luxury good (expensive vacations) while General Cinema
sells movies, which are less sensitive to changes in the economy. Club Med
will have greater market risk.

22. a. Expected return = .5 × (-20%) + .5 × 30% = 5%

Standard deviation = [ .5 × (-20% - 5%)2 + .5 × (30% - .5%)2]1/2 = 25%
The expected rate of return on the stock is 5 percent. The standard deviation
is 25 percent.

b. Because the stock offers a risk premium of zero (its expected return is the
same as for Treasury bills), it must have no market risk. All the risk must be
diversifiable, and therefore of no concern to investors.

23. Sassafras is not a risky investment to a diversified investor. Its return is better when
the economy enters a recession. Therefore, the company risk offsets the risk of the
rest of the portfolio. It is a portfolio stabilizer despite the fact that there is a 90
percent chance of loss.

(Compare Sassafras to purchasing an insurance policy. Most of the time, you will
lose money on your insurance policy. But the policy will pay off big if you suffer
losses elsewhere — for example, if your house burns down. For this reason, we view
insurance as a risk-reducing hedge, not as speculation. Similarly, Sassafras may be
viewed as analogous to an insurance policy on the rest of your portfolio since it
tends to yield higher returns when the rest of the economy is faring poorly.)

In contrast, the Leaning Tower of Pita has returns that are positively correlated with
the rest of the economy. It does best in a boom and goes out of business in a
recession. For this reason, Leaning Tower would be a risky investment to a
diversified investor since it increases exposure to the macroeconomic or market risk
to which the investor is already exposed.

24. a. Portfolio expected return = .3 × 9% + .7 × 8% = 8.3%

Portfolio standard deviation = [.32 × .22 +.72 × .252 + 2 × .3 × .7 × .2 × .2 × .25] 1/2
= .196 = 19.6%

b. With correlation of .7, the portfolio standard deviation is

= [.32 × .22 +.72 × .252 + 2 × .3 × .7 × .7 × .2 × .25] 1/2
= .221 = 22.1%

c. The higher is the correlation between two variables, the less potential for
diversification. In (a), with correlation of only .2, the portfolio standard
deviation is less than the standard deviation of return of either of the two
stocks in the portfolio. However, with the higher correlation of .7, the stocks’
return move more closely together and forming a portfolio only somewhat

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 reduces total variability.

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