FINM 2412 Financial Management for Business
Tutorial 8 Answers
1. Three stocks have the following risk-return characteristics:
Stock Expected Return Standard Deviation
A 20% 38%
B 12% 15%
C 15% 28%
(a) If there is no risk-free asset, do any of these three stocks clearly dominate any other
in terms of risk and return?
Now assume there is a risk-free asset with a guaranteed return of 5% p.a. You can now
form a portfolio consisting of one risky asset plus the risk-free asset. You are willing to bear
a standard deviation of 25% p.a. for your portfolio.
(b) For a portfolio comprising Stock A and the risk-free asset, what weights will you
assign to each in order to get the desired level of risk? What is the expected return
on this portfolio? Repeat this for Stock B, then Stock C.
(c) Which of the three portfolios from part (b) is dominant? (Hint: There is a clear
winner.)
COMMENTARY:
This question illustrates how the introduction of a risk-free asset enables us to
clearly identify the dominant asset. We could not do this in part (a) when there was
no risk-free asset.
The answers do not depend on my desired level of risk (standard deviation of 25%
p.a. above). If you re-do the entire question with a desired level of risk of 10% p.a.
standard deviation, you'll still get the same dominant asset.
To see why one asset dominates, plot the risk-return characteristics of the three
assets on the usual graph. Draw a line connecting each asset with the risk-free
asset. The dominant asset is the one with the steepest slope.
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(a)
No stock dominates any other in terms of both risk and return. B has the lowest risk (standard
deviation) and the lowest expected return. A has the highest expected return but also the highest
risk. See the following figure:
Risk and Return
25%
20% A
Expected Return
15% C
B
10%
5%
0%
10% 15% 20% 25% 30% 35% 40%
Standard Deviation
If I said “Stock D has expected return of 18% and standard deviation of 40%”, then we could
unambiguously state that A dominates D – A has higher return and lower risk than D. But of the
three stocks given (A, B and C), there is no clear dominance.
(b)
Here, we use our formula for the variance of a two-asset portfolio. In this case, we invest some
proportion of our wealth, w , in Stock A and the balance, (1−w), in the risk-free asset. We know
what the risk of the portfolio must be (standard deviation of 25%), and can therefore solve for the
required weight in each asset.
This is a relatively simple task since σ rf =0 :
2 2 2 2 2
σ p=w σ A + ( 1−w ) σ r +2 w ( 1−w ) ρ A ,r σ A σ r ( 0.25 )2 =w2 ( 0.38 )20.25=w (0.38)w=0.6579
f f f
That is, we invest 65.79% of our wealth in Stock A and the balance, 34.21%, in the risk-free
asset. To find the expected return, we again use our formula for a two-asset portfolio:
E ( r p ) =wE ( r A ) + ( 1−w ) r f ¿ 0.6579 ( 0.20 ) + 0.3421 ( 0.05 )¿ 14.87 % p . a .
For a portfolio of Stock B and the risk-free asset, we have:
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2 2 2 2 2
σ p=w σ B + ( 1−w ) σ r +2 w (1−w ) ρ B ,r σ B σ r ( 0.25 )2 =w2 ( 0.15 )2
f f f
in which case w=1.67 . That is, we invest 167% of our wealth in Stock B and we invest –67% in
the riskless asset. Suppose we have $100 to invest. We borrow another $67 at the risk-free rate
and invest the total of $167 in Stock B.
The expected return of this portfolio is:
E ( r p ) =wE ( r B ) + ( 1−w ) r f ¿ 1.67 ( 0.12 ) +(−0.67) ( 0.05 )¿ 16.69 % p . a .
For a portfolio of Stock C and the risk-free asset, we have:
2 2 2 2 2
σ p=w σ C + ( 1−w ) σ r +2 w ( 1−w ) ρC ,r σ C σ r ( 0.25 )2 =w2 ( 0.28 )2
f f f
in which case w=0.8929 . That is, we invest 89.29% of our wealth in Stock C and 10.71% (the
balance) in the risk-free asset.
The expected return of this portfolio is:
E ( r p ) =wE ( r C ) + (1−w ) r f ¿ 0.8929 ( 0.15 ) +0.1071 ( 0.05 )¿ 13.93 % p . a .
(c)
We have created three portfolios, all with the same risk (standard deviation of 25%). Since the
portfolio of the risk-free asset plus Stock B generates the highest return, that is the portfolio that
we would prefer.
This is all summarised in the following figure:
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Risk and Return
25%
20%
A
Expected Return
15% B
C
10%
5%
0%
0% 5% 10% 15% 20% 25% 30% 35% 40%
Standard Deviation
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2. Consider the following information for Stocks 1 and 2:
Stock Expected Return Standard Deviation
1 20% 40%
2 12% 20%
The correlation between the returns of these two stocks is 0.3.
(a) How will you divide your money between Stocks 1 and 2 if your aim is to achieve a
portfolio with an expected return of 18% p.a.? That is, what are the weights assigned
to each stock? Also, take note of the risk (i.e., standard deviation) of this portfolio.
Now assume that in addition to the two risky stocks, there is a risk-free investment with a
guaranteed return of 5% p.a. This gives you the opportunity to use the risk-free asset in
your portfolio.
(b) You create a portfolio with 79.65% of your funds invested in Stock 1 and 20.35%
invested in the risk-free asset. Calculate the expected return and standard deviation
of this portfolio.
(c) How does the portfolio in part (b) compare to the portfolio in part (a)? Which portfolio
do you prefer? Why?
(d) Calculate the weights in the risk-free asset and Stock 2 that are required to achieve
a portfolio with the same risk as in parts (a) and (b). How does its expected return
compare? (Hint: you will have to borrow at the risk-free rate and invest the proceeds
in Stock 2 to get the desired risk for this portfolio.)
(e) Finally, consider a third risky asset: Stock 3. Stock 3 has an expected return of 15%
p.a. and standard deviation of 25% p.a. Does the combination of the risk-free asset
and Stock 3 dominate the combinations previously examined?
(a)
Here we use our formula for the expected return of a two-asset portfolio. In this case, we invest
some proportion of our wealth, w , in Stock 1 and the balance (1 – w) in Stock 2.
E ( r p ) =wE ( r 1 ) + ( 1−w ) E ( r 2 )0.18=w ( 0.20 )+ ( 1−w )( 0.12 )w=0.75
That is, we invest 75% of our wealth in Stock 1 and 25% in Stock 2. To find the standard
deviation of this portfolio, we begin with our formula for the variance of a two-asset portfolio:
2 2 2 2 2
σ p=w σ 1+ (1−w ) σ 2+ 2 w (1−w ) ρ1 , 2 σ 1 σ 2
2 2 2 2
¿ ( 0.75 ) ( 0.40 ) + ( 0.25 ) ( 0.20 ) +2 ( 0.75 ) ( 0.25 ) ( 0.3 ) ( 0.40 ) ( 0.20 ) ¿ 0.1015
The standard deviation is therefore:
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σ p=31.86 % p . a .
(b)
The expected return of this portfolio is:
E ( r p ) =wE ( r 1 ) + ( 1−w ) r f ¿ 0.7968 ( 0.20 )+ 0.2035 ( 0.05 )¿ 16.95 % p . a .
The variance is:
2 2 2 2 2
σ p=w σ 1+ (1−w ) σ r +2 w ( 1−w ) ρ1 ,r σ 1 σ r ¿ ( 0.7965 )2 ( 0.40 )2 +0+ 0¿ 0.1015
f f f
The standard deviation is therefore:
σ p=31.86 % p . a .
Note that we have a simple expression for the variance of this portfolio. That is because the
second asset is risk-free, and generates a constant return, with no variance. The last two terms
in our formula for the variance of a two-asset portfolio are therefore equal to zero in this case.
(c)
We prefer the portfolio in (a). The portfolios in (a) and (b) both have the same risk (standard
deviation) but the portfolio in (a) has the higher return.
(d)
Here, we use our formula for the variance of a two-asset portfolio. Again, we have a simple
expression for the variance of this portfolio because one of the assets is risk-free.
2 2 2 2 2
σ p=w σ 2+ (1−w ) σ r +2 w ( 1−w ) ρ2 ,r σ 2 σ r ( 0.3186 )2=w 2 ( 0.20 )2 +0+ 0w=1.593
f f f
Thus, we invest 159.30% of our wealth in Stock 2 and –59.3% in the risk-free asset. Suppose we
have $100 to invest. We borrow another $59.30 at the risk-free rate and invest the total of
$159.30 in Stock 2. The expected return of this portfolio is:
E ( r p ) =wE ( r 2 ) + ( 1−w ) r f ¿ 1.593 ( 0.12 ) + (−0.593 )( 0.05 )¿ 16.15 % p . a .
This combination of Stock 2 and the risk-free asset produces an expected return lower than the
combination of Stock 1 and the risk-free (16.95%).
(e)
In this case, we have
2 2 2
σ p=w σ 3( 0.3186 )2=w 2 ( 0.25 )2 w=1.2744
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That is, we invest 127.44% of our wealth in Stock 3 and borrow 27.44% of our original wealth at
the risk-free rate. The expected return of this portfolio is:
E ( r p ) =wE ( r 3 ) + (1−w ) r f ¿ 1.2744 ( 0.12 ) + (−0.2744 ) ( 0.05 ) ¿ 17.74 % p . a .
This combination of Stock 3 and the risk-free asset dominates the combination of Stock 1 and
the risk-free (part b), and Stock 2 and risk-free (part d). However, it is still inferior to the
combination of Stock 1 and Stock 2 in part a.
In this problem, we have constructed the following portfolios:
Part Expected Return Standard Deviation
(a) 18.00% p.a. 31.86% p.a.
(b) 16.95% p.a. 31.86% p.a.
(d) 16.15% p.a. 31.86% p.a.
(e) 17.74% p.a. 31.86% p.a.
Since all the portfolios have the same risk, we would choose the portfolio in (a) since it has the
highest expected return.
3. Assume the following data:
the expected return on the market is 13% p.a.,
the variance of the return on the market is 0.14, and
the risk-free rate is 6% p.a.
Your task is to determine a discount rate appropriate for a single company, BHP. If the
variance of BHP’s return is 0.30 and its beta is 1.20, what is the expected return of BHP?
The CAPM is a formula that dictates the appropriate discount rate given the firm’s (systematic)
risk. We will need the firm’s beta, and also need the expected return on the market and risk-free
rate as inputs.
E ( r BHP )=r f + β BHP [ E ( r m ) −r f ]¿ 0.06+1.20 [ 0.13−0.06 ]¿ 0.144=14.4 % p .a .
Note that the variance (or standard deviation) of BHP’s return is irrelevant when determining the
expected return. Under the CAPM, an asset’s risk is measured by its beta (i.e. systematic risk)
and this is what generates returns.
