Chapter 5

Risk and Return: Portfolio Theory and Asset Pricing Models

ANSWERS T EN!"#"C$APTER %&EST'NS
5-1 a. A portfolio is made up of a group of individual assets held in combination. An asset
that would be relatively risky if held in isolation may have little, or even no risk if held
in a well-diversified portfolio.
The feasible, or attainable, set represents all portfolios that can be constructed from a
given set of stocks. This set is only efficient for part of its combinations.
An efficient portfolio is that portfolio which provides the highest expected return for
any degree of risk. Alternatively, the efficient portfolio is that which provides the
lowest degree of risk for any expected return.
The efficient frontier is the set of efficient portfolios out of the full set of potential
portfolios. n a graph, the efficient frontier constitutes the boundary line of the set of
potential portfolios.
b. An indifference curve is the risk!return trade-off function for a particular investor and
reflects that investor"s attitude toward risk. The indifference curve specifies an
investor"s re#uired rate of return for a given level of risk. The greater the slope of the
indifference curve, the greater is the investor"s risk aversion.
The optimal portfolio for an investor is the point at which the efficient set of
portfolios--the efficient frontier--is $ust tangent to the investor"s indifference curve.
This point marks the highest level of satisfaction an investor can attain given the set of
potential portfolios.
c. The %apital Asset &ricing 'odel (%A&') is a general e#uilibrium market model
developed to analy*e the relationship between risk and re#uired rates of return on
assets when they are held in well-diversified portfolios. The +', is part of the
%A&'.
The %apital 'arket ,ine (%',) specifies the efficient set of portfolios an investor can
attain by combining a risk-free asset and the risky market portfolio '. The %',
states that the expected return on any efficient portfolio is e#ual to the riskless rate
plus a risk premium, and thus describes a linear relationship between expected return
and risk.
d. The characteristic line for a particular stock is obtained by regressing the historical
returns on that stock against the historical returns on the general stock market. The
Answers and Solutions:
slope of the characteristic line is the stock"s beta, which measures the amount by which
the stock"s expected return increases for a given increase in the expected return on the
market.
The beta coefficient (b) is a measure of a stock"s market risk. -t measures the stock"s
volatility relative to an average stock, which has a beta of 1...
e. Arbitrage &ricing Theory (A&T) is an approach to measuring the e#uilibrium
risk!return relationship for a given stock as a function of multiple factors, rather than
the single factor (the market return) used by the %A&'. The A&T is based on
complex mathematical and statistical theory, but can account for several factors (such
as /0& and the level of inflation) in determining the re#uired return for a particular
stock.
The 1ama-1rench 2-factor model has one factor for the excess market return (the
market return minus the risk free rate), a second factor for si*e (defined as the return
on a portfolio of small firms minus the return on a portfolio of big firms), and a third
factor for the book-to-market effect (defined as the return on a portfolio of firms with
a high book-to-market ratio minus the return on a portfolio of firms with a low book-
to-market ratio).
'ost people don3t behave rationally in all aspects of their personal lives, and
behavioral finance assume that investors have the same types of psychological
behaviors in their financial lives as in their personal lives.
5-4 +ecurity A is less risky if held in a diversified portfolio because of its lower beta and
negative correlation with other stocks. -n a single-asset portfolio, +ecurity A would be
more risky because 5A 6 57 and %8A 6 %87.
Answers and Solutions: 5 " (
5-1 a. A plot of the approximate regression line is shown in the following figure9
:sing ;xcel, the regression e#uation estimates are9 7eta < ..5=> -ntercept < ...2?> @
4
< ..A=.
b. The arithmetic average return for +tock B is calculated as follows9
C. = . 1.
?
) 4 . 1D ... . . 42 . . 1E (
r Avg =
+ + +
=
The arithmetic average rate of return on the market portfolio, determined similarly, is
14.1C.
1or +tock B, the estimated standard deviation is 12.1 percent9
C. 1 . 12
1 ?
) = . 1. 4 . 1D ( ... ) = . 1. . . 42 ( ) = . 1. . . 1E (
4 4 4
B
=

+ + +
=
Answers and Solutions:
S)&T'NS T EN!"#"C$APTER PR*)EMS
-4.
-15
-1.
-5
.
5
1.
15
4.
45
2.
-2. -4. -1. . 1. 4. 2. E. 5.
rB (C)
rF
The standard deviation of returns for the market portfolio is similarly determined to be
44.= percent. The results are summari*ed below9
+tock B 'arket &ortfolio
Average return, Avg r 1..=C 14.1C
+tandard deviation, 5 12.1 44.=
+everal points should be noted9 (1) 5' over this particular period is higher than the
historic average 5' of about 15 percent, indicating that the stock market was relatively
volatile during this period> (4) +tock B, with B < 12.1C, has much less total risk than
an average stock, with Avg < 44.=C> and (2) this example demonstrates that it is
possible for a very low-risk single stock to have less risk than a portfolio of average
stocks, since 5B G 5'.
c. +ince +tock B is in e#uilibrium and plots on the +ecurity 'arket ,ine (+',), and
given the further assumption that
B B r r

=
and
' ' r r =

--and this assumption often

does not hold--then this e#uation must hold9
. b ) r r ( r r
B @1 @1
B + =
This e#uation can be solved for the risk-free rate, r@1, which is the only unknown9
C. = . D EE . . ! D . 2 r
D . = = . 1. r EE . .
r 5= . . D . = r = . 1.
5= . . ) r 1 . 14 ( r = . 1.
@1
@1
@1 @1
@1 @1
= =
=
+ =
+ =
Answers and Solutions: 5 " +
d. The +', is plotted below. Hata on the risk-free security (b@1 < .,
r@1 < D.=C) and +ecurity B (bB < ..5=,
X r < 1..=C) provide the two points through
which the +', can be drawn. r' provides a third point.
e. -n theory, you would be indifferent between the two stocks. +ince they have the same
beta, their relevant risks are identical, and in e#uilibrium they should provide the same
returns. The two stocks would be represented by a single point on the +',. +tock F,
with the higher standard deviation, has more diversifiable risk, but this risk will be
eliminated in a well-diversified portfolio, so the market will compensate the investor
only for bearing market or relevant risk. -n practice, it is possible that +tock F would
have a slightly higher re#uired return, but this premium for diversifiable risk would be
small.
Answers and Solutions:
Beta
k(%)
20
10
1.0 2.0
= 8.6
k
X = 10.6%
k
M
= 12.1%
k
RF
r(%)
r
X
= 10.6%
r
RF
= 8.6%
5-4
a. The regression graph is shown above. :sing a speadsheet, we find b < ..=4.
b. 7ecause b < ..=4, +tock F is about =4 percent as volatile as the market> thus, its
relative risk is about =4 percent of that of an average firm.
c. 1. Total risk ) (
4
F
would be greater because the second term of the firm"s risk
e#uation,
4
eF
4
'
4
F
4
F
b + = , would be greater.
4. %A&' assumes that company-specific risk will be eliminated in a portfolio, so the
risk premium under the %A&' would not be affected.
d. 1. The stock"s variance would not change, but the risk of the stock to an investor
holding a diversified portfolio would be greatly reduced.
4. -t would now have a negative correlation with r'.
2. 7ecause of a relative scarcity of such stocks and the beneficial net effect on
portfolios that include it, its Irisk premiumI is likely to be very low or even
negative. Theoretically, it should be negative.
Answers and Solutions: 5 " ,
45
30
15
-15
-30 -15 15 30 45
k
M
(%)
k
y
(%)
r
S
(%)
r
M
(%)
5-2 a.
. ) r r ( r b ) r r ( r r
'
i i'
@1 ' @1 i @1 ' @1 i

+ = + =
b. %',9
.
r r
r r
p
'
@1
'
@1
p

+ =

+',9
. r
r r
r r
i i'
'
@1 '
@1 i

+ =
Jith some arranging, the similarities between the %', and +', are obvious. Jhen
in this form, both have the same market price of risk, or slope,(r' - r@1)!5'.
The measure of risk in the %', is 5p. +ince the %', applies only to efficient
portfolios, 5p not only represents the portfolio"s total risk, but also its market risk.
Kowever, the +', applies to all portfolios and individual securities. Thus, the
appropriate risk measure is not 5i, the total risk, but the market risk, which in this form
of the +', is ri'5i, and is less than for all assets except those which are perfectly
positively correlated with the market, and hence have ri' < L1...
5-E a. :sing the %A&'9
ri < r@1 L (r' - r@1)bi < ?C L (1.1)(=.5C) < 1E.15C
b. :sing the 2-factor model9
ri < r@1 L (r' M rrf)bi L (r+'7)ci L (rK',)di
< ?C L (1.1)(=.5C) L (5C)(..?) L (EC)(-..2) < 1=.E5C
Answers and Solutions:
Mini Case: 5 " -