Chapter 3

Investment Risk and Return

1. Stocks M and N have the following probability distribution of expected future returns:
Rate of Return
Probability Stock M Stock N
0.10 (25%) (40%)
0.20 5 0
0.40 15 16
0.20 30 40
0.10 45 66
a. Calculate the expected rate of return for stock M and N.
b. Calculate the standard deviation and coefficient of variation of expected returns for stock M and N.
c. Which stock is riskier?
2. You have estimated the following probability distribution of expected future returns for stocks X and Y:
Stock X Stock Y
Probability Return Probability Return
0.1 – 10% 0.2 2%
0.2 10 0.2 7
0.4 15 0.3 12
0.2 20 0.2 15
0.1 40 0.1 18
a. What is the expected rate and standard deviation of returns for stock X? Stock Y?
b. Which stock would you consider to be riskier? Why?
3. Stock X and Y have the following probability distributions of expected future returns:
Probability X Y
0.1 -10 – 35%
0.2 5 0
0.4 12 20
0.2 20 25
0.1 28 45
a. Calculate the expected rate of return, for stock Y. (That for stock X is 11.6 percent).
b. Calculate the standard deviation of expected returns for stock X. (That for stock Y is 20.35 percent). Now
calculate the coefficient of variation for stock Y. Is it possible that most investors might regard stock Y as being
less risky than stock X? Explain.
4. The Star Nepal Inc. has following historical rates of return on project A and B
Year Project A’s return Project B’s return
2001 0.10 (0.20)
2002 0.15 0.25
2003 0.20 0.25
2004 0.25 0.20
2005 0.30 0.30
a. Calculate the average return, variance and standard deviation for each project.
b. What is the correlation coefficient between the projects’ return?
c. Interpret your result in relation to correlation coefficient.
5. Stocks P and Q have the following probability distribution of expected future returns:
State of Rate of Return
economy Probability Stock P Stock Q
Recession 0.3 - 5% 5%
Average 0.4 10 15
Boom 0.3 25 35
a. Which stock is more profitable?
b. Which stock is riskier in absolute term?
c. Which stock is riskier in relative term?
d. Which stock would you prefer?
6. Year-end dividend per share and year-end market price per share of Mechi Tea Company are as follows:
Year Year-end dividend Year-end market
per share price per share
2003 - Rs. 200
2004 Rs. 10 210
2005 11.5 230
2006 26 250
2007 0 225
2008 7.5 240
Calculate:
a. Annual rate of return.
b. Average rate of return
c. Standard deviation of annual return
d. Coefficient of variation
7. On 31st December, 2008 stock M had market price Rs 100 per share. There are three possible states of economy for
2009. State of economy, their probability, expected dividend on Stock M and year-end price of stock M are as follows:
State of Expected
Year-end Price
economy Probability dividend
Recession 0.3 Rs. 0 Rs. 95
Average 0.4 5 105
Boom 0.3 10 115
Calculate:
a. Rate of return for each state of economy
b. Expected rate of return
c. Standard deviation
d. Coefficient of variation
8. Following are the probability distribution of rates of return associated with stocks X and Y.
Probability Return on stock X Return on stock Y
0.3 - 20% 5%
0.3 30 25
0.4 40 30
a. What are the expected returns and standard deviation of each stock?
b. Which stock investment would you prefer? Why?
c. What is the covariance of return between stocks X and Y?
d. What is the correlation coefficient between returns from stocks X and Y?
e. Would you think that forming a portfolio of these two stocks reduces the risk? Why or Why not? Explain.
9. Stocks T and U have the following historical returns:
Year Return on stock T Return on stock U
2002 -10% -10%
2003 12 20
2005 15 -5
2005 20 10
2006 18 15
a. Calculate the average rate of return and standard deviation for each stock during the period 2002 through 2006.
b. What is the correlation coefficient between returns on the two stocks?
c. How do you interpret the value of the correlation calculated in part b? Is it possible to reduce the risk by forming
a portfolio of these two stocks? Why?
10. Two common stock, Uniliver Nepal and Bottlers Nepal, have the following expected return and standard deviation of
return over the next year.
Common stock Expected rate of return Standard deviation
Uniliver Nepal 12% 6%
Bottlers Nepal 20 15

Additionally, assume that the correlation coefficient of returns on the two securities is + 0.50 for portfolio consisting
of 75 percent of the fund invested in Uniliver and the remainder in Bottlers Nepal, determine the:
a. Expected rate of return on the portfolio.
b. Standard deviation of the rate of return on the portfolio.
11. Security A offers an expected return of 15 percent with a standard deviation of 7 percent. Security B offers an expected
return of 9 percent with a standard deviation of 4 percent. The correlation between the returns of A and B is + 0.6. If
an investor puts one-fourth of his wealth in A and three-fourth in B, what is the expected return and risk of this
portfolio?
12. The stock of Kathmandu Water Supply Inc., is expected to return 14 percent with a standard deviation of 5 percent.
United’s stock is expected to return 16 percent with a standard deviation of 9 percent.
a. If you invest 30 percent of your funds in Kathmandu Water Supply Inc.’s stock and 70 percent in United’s stock,
what is the expected return on your portfolio?
b. What is the risk of this portfolio if the returns for the two stocks have?
i. A perfect positive correlation (+1.0)?
ii. A slightly negative correlation (– 0.2)?
13. The Common stocks of companies A and B have the expected returns and standard deviations given below; the
correlation co-efficient between the two stock is – 0.35.
rJ σJ
Common stock A 0.10 0.05
Common stock B 0.06 0.04
Compute the risk and return for a portfolio comprised of 60 percent invested in the stock of company A and 40 percent
invested in the stock of company B.
14. Consider the probability distribution of alternative rates of return associated with stock X and Y given in the following
table
Probability Return from stock X Return from stock Y
0.1 0.15 -0.10
0.3 0.17 0.15
0.3 0.08 0.22
0.3 -0.02 -0.03
a. Calculate the expected return and standard deviation of stock X and Y.
b. What are the covariance and correlation coefficient between stock X and Y?
c. If you form a portfolio of stock X and Y comprising 80 percent wealth in stock X and the rest in Y, what are the
expected return, variance and standard deviation of your portfolio?
d. Which investment would you prefer? Stock X or Y or the portfolio? Why?
15. The expected returns for two firms S and L are as follows:
Rate of Returns
Probability S L
0.1 -5% -10%
0.4 10 15
0.3 25 10
0.2 30 18
Firm S has a total investment in assets of Rs. 75 million, three times the size of firm L. Assume that a new firm M
is formed through a merger between firm S and L. The share of S and L in the portfolio represented by the new firm
M is based on the ratio of their total assets, prior to the merger.
Calculate:
a. The expected return and standard deviation of firm S and L before the merger.
b. The covariance and correlation coefficient between the returns for firm S and L before the merger.
c. The expected return of firm M.
d. The standard deviations of the returns for firm M.
16. Stock A and B have the following historical returns:
Year Returns, rA Returns, rB
1991 8% 16%
1992 10 14
1993 12 12
1994 14 10
1995 16 8
a. Calculate the average rate of return for each during the period 1991 through 1995
b. Assume that someone held a portfolio consisting of 50 percent of stock A and 50 percent of stock B. What would
have been the realized rate of return on the portfolio in each year from 1991 through 1995? What would have
been the average return on the portfolio during this period?
c. Calculate the standard deviation of returns for each stock and for the portfolio.
d. Calculate the coefficient of variation for each stock and for the portfolio.
e. If you are a risk–averse investor, would you prefer to hold Stock A, Stock B, or the portfolio? Why?
17. You are planning to invest Rs. 100,000. Two securities, A and B, are available. The Portfolio risk and expected return
for A is 9 percent and its standard deviation is 4 percent. For B, the return expected return and standard deviations are
10 percent and 5 percent respectively. The correlation between the two assets is 0.5.
a. Construct a table giving the portfolio expected return and standard deviation for 100 percent, 75 percent, 50
percent, 25 percent and 0 percent in security A.
b. Use your calculated values of E(rP) and σ(rP) to graph the minimum variance portfolio opportunity set and the
efficient set.
18. Assume that you recently graduated with a major in finance, and you just joined as a financial planner with Golchha
Investment Inc., a large financial services corporation. Your assignment is to invest Rs 100,000 for a client. Because
your client needs funds at the end of 1 year, you have been instructed to plan for a 1year holding period. Further, your
boss has restricted you in the following investment alternatives with their outcomes and associated probabilities.
State of Probability Estimated rate of return on Alternative investment
Economy T-bills High-Tech Stock Manufacturing Stock Market Portfolio
Recession 0. 1 8.0% (22.0%) 10.0%* (13.0%)
Below average 0.2 8.0 (2.0) (10.0) 1.0
Average 0.4 8.0 20.0 7.0 15.0
Above average 0.2 8.0 35.0 45.0 29.0
Boom 0.1 8.0 50.0 30.0 43.0
* Note that the estimated returns of manufacturing sectors do not always move in the same direction as the overall
economy. For example, when the economy is below average, consumers purchase fewer than they would if the
economy was stronger. However, if the economy is in a flat-out recession, a large number of consumers choose to
wait and instead purchase new items for they currently own. Under these circumstances, we would expect
manufacturing sector’s stock price to be higher if there is a recession than if the economy was lust below average.
Golchha Investment Inc.’s economic forecasting staff has developed probability estimates for the state of economy
and its security analysts have developed a sophisticated computer program which was to estimate the rate of return on
each alternative under each state of the economy, The firm also maintains an “index of market return” with a market-
weighted fraction of all publicly traded stocks; you can invest in that fund, and the avenge stock market results. Given
the situation as described, answer the following questions.
a. Why is the T-bill’s return independent of the state of the economy? Do Tbills promise a completely risk-free
return? Why are High Tech’s returns expected to move with economy whereas manufacturing’s are expected to
move counter to the economy?
b. Calculate the expected rate of return on each alternative.
c. You should recognize that basing a decision solely on expected returns is only appropriate for risk-neutral
individuals. Because your client, like virtually everyone, is risk averse, riskiness of each alternative is an
important aspect of the decision. One possible measure risk is the standard deviation of returns. Calculate the
standard deviation for each alternative. What type of risk is measured by standard deviation?
d. Suppose you suddenly remembered that the coefficient of variation (CV) is generally as being a better measure
of risk than the standard deviation when alternatives being considered have widely differing expected returns.
Calculate the CVs. Does the CV produce same risk rankings as the standard deviation?
e. Suppose you created a 2-stock portfolio by investing Rs 50,000 in High Tech and Rs 50,000 in manufacturing.
Calculate the expected return, the standard deviation, and the coefficient of variation for this portfolio. How
does the risk of this 2-stock portfolio compare with the risk of the individual stocks if they were held in isolation?
f. Suppose an investor starts with a portfolio consisting of one randomly selected stock. What would happen (1)
to the risk and (2) to the expected return of the portfolio as more and more randomly selected stocks were added
to the portfolio? What is the implication for investors?