CHAPTER 7

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

Answers to Practice Questions
1. Recall from Chapter 3 that:
(1 + rnominal) = (1 + rreal) (1 + inflation rate)
Therefore:
rreal = (1 + rnominal)/(1 + inflation rate) - 1
a. The real return on the S&P !! in each "ear #a$:
1%%&: 1%.'(
1%%): 31.'(
1%%*: '&.&(
1%%%: 1).*(
'!!!: -1'.1(
+. ,rom the re$ult$ for Part (a)- the a.era/e real return #a$ 1&. percent.
c. The ri$0 premium for each "ear #a$:
1%%&: 1).%(
1%%): '*.1(
1%%*: '3.)(
1%%%: 1&.3(
'!!!: -1.!(
1. ,rom the re$ult$ for Part (c)- the a.era/e ri$0 premium #a$ 12.' percent.
e. The $tan1ar1 1e.iation () of the ri$0 premium i$ calculate1 a$ follo#$:
' ' ' '
!.12') (!.'3) !.12') (!.'*1 !.12') (!.1)% 3
1
1
4 + +

=
5 !.12') !.1! ( !.12') (!.1&3
' '
+ +
'. 6nternet e7erci$e8 an$#er$ #ill .ar".
&1
!.!'**& 5 !.112'! 3
2
1
4
'
=

=
1).!( !.1)! 4 = =
3. a. 9 lon/-term :nite1 State$ /o.ernment +on1 i$ al#a"$ a+$olutel" $afe in
term$ of the 1ollar$ recei.e1. ;o#e.er- the price of the +on1 fluctuate$ a$
intere$t rate$ chan/e an1 the rate at #hich coupon pa"ment$ can +e
in.e$te1 al$o chan/e$ a$ intere$t rate$ chan/e. 9n1- of cour$e- the
pa"ment$ are all in nominal 1ollar$- $o inflation ri$0 mu$t al$o +e
con$i1ere1.
+. 6t i$ true that $toc0$ offer hi/her lon/-run rate$ of return than +on1$- +ut it
i$ al$o true that $toc0$ ha.e a hi/her $tan1ar1 1e.iation of return. So-
#hich in.e$tment i$ prefera+le 1epen1$ on the amount of ri$0 one i$
#illin/ to tolerate. Thi$ i$ a complicate1 i$$ue an1 1epen1$ on numerou$
factor$- one of #hich i$ the in.e$tment time hori<on. 6f the in.e$tor ha$ a
$hort time hori<on- then $toc0$ are /enerall" not preferre1.
c. :nfortunatel"- 1! "ear$ i$ not /enerall" con$i1ere1 a $ufficient amount of
time for e$timatin/ a.era/e rate$ of return. Thu$- u$in/ a 1!-"ear a.era/e
i$ li0el" to +e mi$lea1in/.
2. 6f the 1i$tri+ution of return$ i$ $"mmetric- it ma0e$ no 1ifference #hether #e loo0
at the total $prea1 of return$ or $impl" the $prea1 of une7pecte1l" lo# return$.
Thu$- the $pea0er 1oe$ not ha.e a .ali1 point a$ lon/ a$ the 1i$tri+ution of
return$ i$ $"mmetric.
. The ri$0 to ;ippi=ue $harehol1er$ 1epen1$ on the mar0et ri$0- or +eta- of the
in.e$tment in the +lac0 $tallion. The information /i.en in the pro+lem $u//e$t$
that the hor$e ha$ .er" hi/h uni=ue ri$0- +ut #e ha.e no information re/ar1in/
the hor$e>$ mar0et ri$0. So- the +e$t e$timate i$ that thi$ hor$e ha$ a mar0et ri$0
a+out e=ual to that of other racehor$e$- an1 thu$ thi$ in.e$tment i$ not a
particularl" ri$0" one for ;ippi=ue $harehol1er$.
&. 6n the conte7t of a #ell-1i.er$ifie1 portfolio- the onl" ri$0 characteri$tic of a $in/le
$ecurit" that matter$ i$ the $ecurit">$ contri+ution to the o.erall portfolio ri$0. Thi$
contri+ution i$ mea$ure1 +" +eta. ?one$ome @ulch i$ the $afer in.e$tment for a
1i.er$ifie1 in.e$tor +ecau$e it$ +eta (+!.1!) i$ lo#er than the +eta of
9mal/amate1 Copper (+!.&&). ,or a 1i.er$ifie1 in.e$tor- the $tan1ar1 1e.iation$
are irrele.ant.
). a. To the e7tent that the in.e$tor i$ intere$te1 in the .ariation of po$$i+le
future outcome$- ri$0 i$ in1ee1 .aria+ilit". 6f return$ are ran1om- then the
/reater the perio1-+"-perio1 .aria+ilit"- the /reater the .ariation of
po$$i+le future outcome$. 9l$o- the comment $eem$ to impl" that an" ri$e
to A'! or fall to A1! #ill ine.ita+l" +e re.er$e18 thi$ i$ not true.
&'
+. 9 $toc0>$ .aria+ilit" ma" +e 1ue to man" uncertaintie$- $uch a$
une7pecte1 chan/e$ in 1eman1- plant mana/er mortalit" or chan/e$ in
co$t$. ;o#e.er- the ri$0$ that are not mea$ure1 +" +eta are the ri$0$ that
can +e 1i.er$ifie1 a#a" +" the in.e$tor $o that the" are not rele.ant for
in.e$tment 1eci$ion$. Thi$ i$ 1i$cu$$e1 more full" in later chapter$ of the
te7t.
c. @i.en the e7pecte1 return- the pro+a+ilit" of lo$$ increa$e$ #ith the
$tan1ar1 1e.iation. Therefore- portfolio$ that minimi<e the $tan1ar1
1e.iation for an" le.el of e7pecte1 return al$o minimi<e the pro+a+ilit" of
lo$$.
1. Beta i$ the $en$iti.it" of an in.e$tment>$ return$ to mar0et return$. 6n
or1er to estimate +eta- it i$ often helpful to anal"<e pa$t return$. Chen #e
1o thi$- #e are in1ee1 a$$umin/ +eta$ 1o not chan/e. 6f the" are lia+le to
chan/e- #e mu$t allo# for thi$ in our e$timation. But thi$ 1oe$ not affect
the idea that $ome ri$0$ cannot +e 1i.er$ifie1 a#a".
*. 76 = !.&! 6 = !.1!
7D = !.2! D = !.'!
a.
+.
c.
%. a. Refer to ,i/ure ).1! in the te7t. Cith 1!! $ecuritie$- the +o7 i$ 1!! +"
1!!. The .ariance term$ are the 1ia/onal term$- an1 thu$ there are 1!!
.ariance term$. The re$t are the co.ariance term$. Becau$e the +o7 ha$
(1!! time$ 1!!) term$ alto/ether- the num+er of co.ariance term$ i$:
1!!
'
- 1!! = %-%!!
;alf of the$e term$ (i.e.- 2-%!) are 1ifferent.
&3
1 E
6D
=
)5 4 4 E 7 '(7 4 7 4 7 3 4
D 6 6D D 6
'
D
'
D
'
6
'
6
'
p
+ + =
!.!1%& 5 !)(!.'!) 2!)(1)(!.1 '(!.&!)(!. (!.'!) !.2!) ( (!.1!) (!.&!) 3
' ' ' '
= + + =
! E
iF
=
!.!12* 5 ) !.1!)(!.'! 2!)(!.!)( '(!.&!)(!. (!.'!) !.2!) ( (!.1!) (!.&!) 3
' ' ' '
= + + =
!.! E
6D
=
!.!1!! 5 !)(!.'!) 2!)(!)(!.1 '(!.&!)(!. (!.'!) !.2!) ( (!.1!) (!.&!) 3
' ' ' '
= + + =
)5 4 4 E 7 '(7 4 7 4 7 3 4
D 6 6D D 6
'
D
'
D
'
6
'
6
'
p
+ + =
)5 4 4 E 7 '(7 4 7 4 7 3 4
D 6 6D D 6
'
D
'
D
'
6
'
6
'
p
+ + =
+. Gnce a/ain- it i$ ea$ie$t to thin0 of thi$ in term$ of ,i/ure ).1!. Cith !
$toc0$- all #ith the $ame $tan1ar1 1e.iation (!.3!)- the $ame #ei/ht in the
portfolio (!.!')- an1 all pair$ ha.in/ the $ame correlation coefficient (!.2)-
the portfolio .ariance i$:
Hariance = !(!.!')
'
(!.3!)
'
+ 3(!)
'
- !5(!.!')
'
(!.2)(!.3!)
'
=!.!3)1
Stan1ar1 1e.iation = !.1%3 = 1%.3(
c. ,or a completel" 1i.er$ifie1 portfolio- portfolio .ariance e=ual$ the a.era/e
co.ariance:
Hariance = (!.3!)(!.3!)(!.2!) = !.!3&
Stan1ar1 1e.iation = !.1%! = 1%.!(
1!. a. Refer to ,i/ure ).1! in the te7t. ,or each 1ifferent portfolio- the relati.e
#ei/ht of each $hare i$ 3one 1i.i1e1 +" the num+er of $hare$ (n) in the
portfolio5- the $tan1ar1 1e.iation of each $hare i$ !.2!- an1 the correlation
+et#een pair$ i$ !.3!. Thu$- for each portfolio- the 1ia/onal term$ are the
$ame- an1 the off-1ia/onal term$ are the $ame. There are n 1ia/onal
term$ an1 (n
'
I n) off-1ia/onal term$. 6n /eneral- #e ha.e:
Hariance = n(1/n)
'
(!.2)
'
+ (n
'
- n)(1/n)
'
(!.3)(!.2)(!.2)
,or one $hare: Hariance = 1(1)
'
(!.2)
'
+ ! = !.1&!!!!
,or t#o $hare$:
Hariance = '(!.)
'
(!.2)
'
+ '(!.)
'
(!.3) (!.2)(!.2) = !.1!2!!!
The re$ult$ are $ummari<e1 in the $econ1 an1 thir1 column$ of the ta+le
on the ne7t pa/e.
+. (@raph$ are on the ne7t pa/e.) The un1erl"in/ mar0et ri$0 that can not +e
1i.er$ifie1 a#a" i$ the $econ1 term in the formula for .ariance a+o.e:
:n1erl"in/ mar0et ri$0 = (n
'
- n)(1/n)
'
(!.3)(!.2)(!.2)
9$ n increa$e$- 3(n
'
- n)(1/n)
'
5 = 3(n-1)/n5 +ecome$ clo$e to 1- $o that the
un1erl"in/ mar0et ri$0 i$: 3(!.3)(!.2)(!.2)5 = !.!2*
&2
c. Thi$ i$ the $ame a$ Part (a)- e7cept that all the off-1ia/onal term$ are no#
e=ual to <ero. The re$ult$ are $ummari<e1 in the fourth an1 fifth column$
of the ta+le +elo#.
(a) (a) (c) (c)
Jo. of Stan1ar1 Stan1ar1
Share$ Hariance Ke.iation Hariance Ke.iation
1 .1&!!!! .2!! .1&!!!! .2!!
' .1!2!!! .3'' .!*!!!! .'*3
3 .!*333 .'%' .!3333 .'31
2 .!)&!!! .')& .!2!!!! .'!!
.!)!2!! .'& .!3'!!! .1)%
& .!&&&&) .'* .!'&&&) .1&3
) .!&2!!! .'3 .!''*) .11
* .!&'!!! .'2% .!'!!!! .121
% .!&!222 .'2& .!1)))* .133
1! .!%'!! .'23 .!1&!!! .1'&
@raph$ for Part (a):
@raph$ for Part (c):
&
Portfolio Hariance Portfolio Hariance
0
0.0
0.!
0.!
0."
0 " # $ % !0 !"
&u'(er of )ecurities
*
a
r
i
a
n
c
e
Portfolio Stan1ar1 Ke.iation Portfolio Stan1ar1 Ke.iation
0
0.!
0."
0.+
0.#
0.
0 " # $ % !0 !"
&u'(er of )ecurities
)
t
a
n
d
a
r
d

,
e
-
i
a
t
i
o
n
Portfolio Hariance Portfolio Hariance
0
0.0
0.!
0.!
0."
0 " # $ % !0 !"
&u'(er of )ecurities
*
a
r
i
a
n
c
e
Portfolio Stan1ar1 Ke.iation Portfolio Stan1ar1 Ke.iation
0
0.!
0."
0.+
0.#
0.
0 " # $ % !0 !"
&u'(er of )ecurities
)
t
a
n
d
a
r
d

,
e
-
i
a
t
i
o
n
11. 6nternet e7erci$e8 an$#er$ #ill .ar" 1epen1in/ on time perio1.
1'. 7BP = !.2
7L?M = !.2
7J = !.'
13. 6nternet e7erci$e8 an$#er$ #ill .ar" 1epen1in/ on time perio1.
12. NSafe$tO mean$ lo#e$t ri$08 in a portfolio conte7t- thi$ mean$ lo#e$t .ariance of
return. ;alf of the portfolio i$ in.e$te1 in 9lcan $toc0- an1 half of the portfolio
mu$t +e in.e$te1 in one of the other $ecuritie$ li$te1. Thu$- #e calculate the
portfolio .ariance for $i7 1ifferent portfolio$ to $ee #hich i$ the lo#e$t. The $afe$t
attaina+le portfolio i$ compri$e1 of 9lcan an1 Je$tle.
Stoc0$ Portfolio Hariance
9lcan & BP !.!)*'
9lcan & Keut$che !.!*'231
9lcan & L?M !.!*'*)1
9lcan & ?HM; !.!%*2'
9lcan & Je$tle !.!21&&&
9lcan & Son" !.!%&%%2
1. a. 6n /eneral- #e e7pect a $toc0>$ price to chan/e +" an amount e=ual to
(+eta chan/e in the mar0et). Beta e=ual to -!.' implie$ that- if the
mar0et ri$e$ +" an e7tra percent- the e7pecte1 chan/e i$ -1.' percent.
6f the mar0et 1ecline$ an e7tra percent- then the e7pecte1 chan/e i$
+1.' percent.
&&
+ + + =
'
J
'
J
'
L?M
'
L?M
'
BP
'
BP
4 7 4 7 4 7
2
p
] ) 4 4 E 7 7 4 4 E 7 7 4 4 E 7 '3(7
J L?M J L?M- J L?M J BP J BP- J BP L?M BP L?M BP- L?M BP
+ +
+ + + =
' ' ' ' ' '
(!.1%)) (!.') (!.3%&) (!.2) (!.'2*) (!.2)
+ + 2*)(!.1%)) (!.'3)(!.' (!.2)(!.') ) '2*)(!.3%& 2)(!.')(!. '3(!.2)(!.
!.!2*&1 5 %&)(!.1%)) (!.3')(!.3 (!.2)(!.') =
!.''! 4
p
=
+. NSafe$tO implie$ lo#e$t ri$0. 9$$umin/ the #ell-1i.er$ifie1 portfolio i$
in.e$te1 in t"pical $ecuritie$- the portfolio +eta i$ appro7imatel" one. The
lar/e$t re1uction in +eta i$ achie.e1 +" in.e$tin/ the A'!-!!! in a $toc0
#ith a ne/ati.e +eta. 9n$#er (iii) i$ correct.
1&. a. 6f the $tan1ar1 1e.iation of the mar0et portfolio>$ return i$ '! percent- then
the .ariance of the mar0et portfolio>$ return i$ '! $=uare1- or 2!!.
,urther- #e 0no# that a $toc0>$ +eta i$ e=ual to: the co.ariance of the
$toc0>$ return$ #ith the mar0et 1i.i1e1 +" the .ariance of the mar0et
return. Thu$:
P = *!!/2!! = '.!
+. ,or a full" 1i.er$ifie1 portfolio- the $tan1ar1 1e.iation of portfolio return i$
e=ual to the portfolio +eta time$ the mar0et portfolio $tan1ar1 1e.iation:
Stan1ar1 1e.iation = ' '!( = 2!(
c. B" 1efinition- the a.era/e +eta of all $toc0$ i$ one.
1. The e7tra return #e #oul1 e7pect i$ e=ual to (+eta the e7tra return on
the mar0et portfolio):
Q7tra return = ' ( = 1!(
1). Ki.er$ification +" corporation$ 1oe$ not +enefit $harehol1er$ +ecau$e
$harehol1er$ can ea$il" 1i.er$if" their portfolio$ +" +u"in/ $toc0 in man" 1ifferent
companie$.
&)
Challenge Questions
1. a. 6n /eneral:
Portfolio .ariance = P
'
= 71
'
1
'
+ 7'
'
'
'
+ '717'1'1'
Thu$:
P
'
= (!.
'
)(!.&')
'
)+(!.
'
)(!.!)
'
)+'(!.)(!.)(!.&&)(!.&'))(!.!))
P
'
= !.'&)2
Stan1ar1 1e.iation = P = !.1) = 1.)(
+. Ce can thin0 of thi$ in term$ of ,i/ure ).1! in the te7t- #ith three
$ecuritie$. Gne of the$e $ecuritie$- T-+ill$- ha$ <ero ri$0 an1- hence- <ero
$tan1ar1 1e.iation. Thu$:
P
'
= (1/3)
'
(!.&')
'
)+(1/3)
'
(!.!)
'
)+'(1/3)(1/3)(!.&&)(!.&'))(!.!))
P
'
= !.11**)
Stan1ar1 1e.iation = P = !.32 = 32.(
9nother #a" to thin0 of thi$ portfolio i$ that it i$ compri$e1 of one-thir1
T-Bill$ an1 t#o-thir1$ a portfolio #hich i$ half Kell an1 half Micro$oft.
Becau$e the ri$0 of T-+ill$ i$ <ero- the portfolio $tan1ar1 1e.iation i$ t#o-
thir1$ of the $tan1ar1 1e.iation compute1 in Part (a) a+o.e:
Stan1ar1 1e.iation = ('/3)(!.1)) = !.32 = 32.(
c. Cith ! percent mar/in- the in.e$tor in.e$t$ t#ice a$ much mone" in the
portfolio a$ he ha1 to +e/in #ith. Thu$- the ri$0 i$ t#ice that foun1 in Part
(a) #hen the in.e$tor i$ in.e$tin/ onl" hi$ o#n mone":
Stan1ar1 1e.iation = ' 1.)( = 1!3.2(
1. Cith 1!! $toc0$- the portfolio i$ #ell 1i.er$ifie1- an1 hence the portfolio
$tan1ar1 1e.iation 1epen1$ almo$t entirel" on the a.era/e co.ariance of
the $ecuritie$ in the portfolio (mea$ure1 +" +eta) an1 on the $tan1ar1
1e.iation of the mar0et portfolio. Thu$- for a portfolio ma1e up of 1!!
$toc0$- each #ith +eta = '.'1- the portfolio $tan1ar1 1e.iation i$
appro7imatel": ('.'1 1() = 33.1(. ,or $toc0$ li0e Micro$oft- it i$:
(1.*1 1() = ').1(.
&*
'. ,or a t#o-$ecurit" portfolio- the formula for portfolio ri$0 i$:
Portfolio .ariance = 71
'
1
'
+ 7'
'
'
'
+ '717'
1'1'
6f $ecurit" one i$ Trea$ur" +ill$ an1 $ecurit" t#o i$ the mar0et portfolio- then 1 i$
<ero- ' i$ '! percent. Therefore:
Portfolio .ariance = 7'
'
'
'
= 7'
'
(!.'!)
'
Stan1ar1 1e.iation = !.'! 7'
Portfolio e7pecte1 return = 71 (!.!&) + 7' (!.!& + !.*)
Portfolio e7pecte1 return = !.!&71 + !.127'
Portfolio R1 R' Q7p. Return St1. Ke.iation
1 1.! ! !.!&! !
' !.* !.' !.!)) !.!2!
3 !.& !.2 !.!%2 !.!*!
2 !.2 !.& !.111 !.1'!
!.' !.* !.1'* !.1&!
& ! 1.! !.12 !.'!!
&%
Portfolio Return & Ri$0
Portfolio Return & Ri$0
0
0.0
0.!
0.!
0."
)tandard ,e-iation
E
.
p
e
c
t
e
d

R
e
t
u
r
n
3. a. ,rom the te7t- #e 0no# that the $tan1ar1 1e.iation of a #ell-1i.er$ifie1 portfolio
of common $toc0$ (u$in/ hi$tor" a$ our /ui1e) i$ a+out '!.' percent.
;ence- the .ariance of portfolio return$ i$ !.'!' $=uare1- or !.!2!*!2 for
a #ell-1i.er$ifie1 portfolio.
The .ariance of our portfolio i$ /i.en +" ($ee ,i/ure ).1!):
Hariance = '3(!.')
'
(!.2)
'
5 + &3(!.1)
'
(!.2)
'
5
+ '3(!.')(!.')(!.3)(!.2)(!.2)5
+ '23(!.1)(!.')(!.3)(!.2)(!.2)5
+ 3!3(!.1)(!.1)(!.3)(!.2)(!.2)5 = !.!&3&*!
Thu$- the proportion i$ (!.!2!*!2/!.!&3&*!) = !.&21
+. 6n or1er to fin1 n- the num+er of $hare$ in a portfolio that ha$ the $ame
ri$0 a$ our portfolio- #ith e=ual in.e$tment$ in each t"pical $hare- #e mu$t
$ol.e the follo#in/ portfolio .ariance e=uation for n:
n(1/n)
'
(!.2)
'
+ (n
'
- n)(1/n)
'
(!.3)(!.2)(!.2) = !.!&3&*!
Sol.in/ thi$ e=uation- #e fin1 that n = ).12 $hare$.
The fir$t mea$ure pro.i1e$ an e$timate of the amount of ri$0 that can $till +e
1i.er$ifie1 a#a". Cith a full" 1i.er$ifie1 portfolio- the ratio i$ appro7imatel" one.
:nfortunatel"- the u$e of a.era/e hi$torical 1ata 1oe$ not nece$$aril" reflect
current or e7pecte1 con1ition$.
The $econ1 mea$ure in1icate$ the potential re1uction in the num+er of $ecuritie$
in a portfolio #hile retainin/ the current portfolio>$ ri$0. ;o#e.er- thi$ mea$ure
1oe$ not in1icate the amount of ri$0 that can "et +e 1i.er$ifie1 a#a".
2. 6nternet e7erci$e8 an$#er$ #ill .ar".
. 6nternet e7erci$e8 an$#er$ #ill .ar".
)!