RISK AND RETURN

1. A stock earns the following returns over a five year period: R1 = 0.30, R2 = -0.20, R3
= -0.12, R4 = 0.38, R5 = 0.42, R6 = 0.36. Calculate the following: (a) arithmetic mean
return, (b) cumulative wealth index, and (c) geometric mean return.

Solution:

R1 = 0.30, R2 = - 0.20, R3 = - 0.12, R4 = 0.38, R5 = 0.42, R6 = 0.36

(a) Arithmetic mean

0.30 0.20 - 0.12 + 0.38 + 0.42+0.36

= = 0.19 or 19 %
6

(b) Cumulative wealth index

CWI5 = 1(1.30) (0.80) (0.88) (1.38) (1.42) (1.36) = 2.439

(c) Geometric Mean

= [(1.30) (0.80) (0.88) (1.38) (1.42) (1.36)]1/6 1 = 0.1602 or 16.02 %

2. A stock earns the following returns over a five year period: R1 = 10 %, R2 = 16%, R3
= 24 %, R4 = - 2 %, R5 = 12 %, R6 = 15%. Calculate the following: (a) arithmetic
mean return, (b) cumulative wealth index, and (c) geometric mean return.

Solution:

R1 = 10 %, R2 = 16%, R3 = 24 %, R4 = - 2 %, R5 = 12 %, R6 = 15 %

(a) Arithmetic mean

10 + 16 + 24 - 2 + 12 + 15
= = 12.5 %
6

(b) Cumulative wealth index

CWI5 = 1(1.10) (1.16) (1.24) (0.98) (1.12) (1.15) = 1.997

(c) Geometric Mean

= [(1.10) (1.16) (1.24) (0.98) (1.12) (1.15)]1/6 1 = 0.1222 or 12.22 %
3. What is the expected return and standard deviation of returns for the stock described
in 1?
Solution:

The expected return and standard deviation of returns is calculated below

Return in % Deviation Square of deviation

Period
Ri (Ri-R) (Ri-R)2
1 30 11 121
2 -20 -39 1521
3 -12 -31 961
4 38 19 361
5 42 23 529
6 36 17 289
19 SUM= 3782
R=

Expected return = 19 %
(Ri R)2 3782
Variance = = = 756.4
n1 61

Standard deviation = (756.4)1/2 = 27.50

4. What is the expected return and standard deviation of returns for the stock described in 2?

Solution:
The expected return and standard deviation of returns is calculated below.

Return in % Deviation Square of deviation

Period
Ri (Ri-R) (Ri-R)2
1 10 -2.5 6.25
2 16 3.5 12.25
3 24 11.5 132.25
4 -2 -14.5 210.25
5 12 -0.5 0.25
6 15 2.5 6.25
12.5 SUM= 367.5
R=

Expected return = 12.5 %

(Ri R)2 367.5
Variance = = = 73.5
n1 61

Standard deviation = (73.5)1/2 = 8.57

5. The probability distribution of the rate of return on a stock is given below:

State of the Economy Probability of Occurrence Rate of Return

Boom 0.20 30 %
Normal 0.50 18 %
Recession 0.30 9%

What is the standard deviation of return?

Solution:

Probabilit
State of Return in
y of Deviation
the % pi x Ri
occurrence (Ri-R) Pi x (Ri R)2
economy Ri
pi
Boom 0.2 30 6 12.3 30.26
Normal 0.5 18 9 0.3 0.05
Recession 0.3 9 2.7 -8.7 22.71

Expected return R = 17.7 SUM= 53.01

Standard deviation = [53.01]1/2 = 7.28

6. The probability distribution of the rate of return on a stock is given below:

State of the Economy Probability of Occurrence Rate of Return

Boom 0.60 45 %
Normal 0.20 16 %
Recession 0.20 - 20%

What is the standard deviation of return?

Solution:

Probabilit
State of Return in
y of
the % pi x Ri Deviation
occurrence Pi x (Ri R)2
economy Ri (Ri-R)
pi
Boom 0.6 45 27 18.8 212.06
Normal 0.2 16 3.2 -10.2 20.81
Recession 0.2 -20 -4 -46.2 426.89
Expected return R = 26.2 SUM= 659.76
Standard deviation = [659.76]1/2 = 25.69
 PORTFOLIO THEORY

1. The returns of two assets under four possible states of nature are given below:

State of nature Probability Return on asset 1 Return on asset 2

1 0.40 -6% 12%
2 0.10 18% 14%
3 0.20 20% 16%
4 0.30 25% 20%

a. What is the standard deviation of the return on asset 1 and on asset 2?

b. What is the covariance between the returns on assets 1 and 2?
c. What is the coefficient of correlation between the returns on assets 1 and 2?

Solution:

(a)
E (R1) =0.4(-6%) + 0.1(18%) + 0.2(20%) + 0.3(25%)
=10.9 %
E (R2) =0.4(12%) + 0.1(14%) + 0.2(16%) + 0.3(20%)
=15.4 %
(R1) = [.4(-6 10.9) 2 + 0.1 (18 10.9)2 + 0.2 (20 10.9)2 + 0.3 (25 10.9)2]
= 13.98%
(R2) = [.4(12 15.4)2 + 0.1(14 15.4)2 + 0.2 (16 15.4)2 + 0.3 (20 15.4)2]
= 3.35 %

(b) The covariance between the returns on assets 1 and 2 is calculated below

State of Probability Return Deviation Return on Deviation Product of

nature on asset of return asset 2 of the deviation
1 on asset 1 return on times
from its asset 2 probability
mean from its
mean
(1) (2) (3) (4) (5) (6) (2)x(4)x(6)
1 0.4 -6% -16.9% 12% -3.4% 22.98
2 0.1 18% 7.1% 14% -1.4% -0.99
3 0.2 20% 9.1% 16% 0.6% 1.09
4 0.3 25% 14.1% 20% 4.6% 19.45
Sum = 42.53
Thus the covariance between the returns of the two assets is 42.53.

(c) The coefficient of correlation between the returns on assets 1 and 2 is:
Covariance12 42.53
= = 0.91
1 x 2 13.98 x 3.35

2. The returns of 4 stocks, A, B, C, and D over a period of 5 years have been as

follows:

1 2 3 4 5
A 8% 10% -6% -1% 9%
B 10% 6% -9% 4% 11%
C 9% 6% 3% 5% 8%
D 10% 8% 13% 7% 12%

Calculate the return on:

a. portfolio of one stock at a time

b. portfolios of two stocks at a time
c. portfolios of three stocks at a time.
d. a portfolio of all the four stocks.

Assume equiproportional investment.

Solution:

Expected rates of returns on equity stock A, B, C and D can be computed as

follows:

A: 8 + 10 6 -1+ 9 = 4%
5

B: 10+ 6- 9+4 + 11 = 4.4%

5

C: 9 + 6 + 3 + 5+ 8 = 6.2%
5

D: 10 + 8 + 13 + 7 + 12 = 10.0%
5

(a) Return on portfolio consisting of stock A = 4%

(b) Return on portfolio consisting of stock A and B in equal

proportions = 0.5 (4) + 0.5 (4.4)
 = 4.2%

(c) Return on portfolio consisting of stocks A, B and C in equal

proportions = 1/3(4 ) + 1/3(4.4) + 1/3 (6.2)
= 4.87%

(d) Return on portfolio consisting of stocks A, B, C and D in equal

proportions = 0.25(4) + 0.25(4.4) + 0.25(6.2) +0.25(10)
= 6.15%

3. A portfolio consists of 4 securities, 1, 2, 3, and 4. The proportions of these securities

are: w1=0.3, w2=0.2, w3=0.2, and w4=0.3. The standard deviations of returns on these
securities (in percentage terms) are: 1=5, 2=6, 3=12, and 4=8. The correlation
coefficients among security returns are: 12=0.2, 13=0.6, 14=0.3, 23=0.4, 24=0.6,
and 34=0.5. What is the standard deviation of portfolio return?

Solution:

The standard deviation of portfolio return is:

p= [w1212 + w2222 + w3232 + w 4242 + 2 w1 w2 12 1 2 + 2 w1 w3 13 1 3 + 2 w1 w4

14 14 + 2 w2 w3 23 2 3 + 2 w2 w4 24 2 4 + 2 w3 w4 34 3 4 ]1/2

= [0.32 x 52 + 0.22 x 62 + 0.22 x 122 + 0.32 x 82 + 2 x 0.3 x 0.2 x 0.2 x 5 x 6

+ 2 x 0.3 x 0.2 x 0.6 x 5 x 12 + 2 x 0.3 x 0.3 x 0.3 x 5 x 8
+ 2 x 0.2 x 0.2 x 0.4 x 6 x 12 + 2 x 0.2 x 0.3 x 0.6 x 6 x 8
+ 2 x 0.2 x 0.3 x 0.5 x 12 x 8]1/2

= 5.82 %

4. Assume that a group of securities has the following characteristics: (a) the standard
deviation of each security is equal to A; (b) covariance of returns AB is equal for
each pair of securities in the group.

What is the variance of a portfolio containing six securities which are equally
weighted?

Solution:

When there are 6 securities, you have 6 variance terms and 6 x 5 = 30 covariance terms.

As all variance terms are the same, all covariance terms are the same, and all securities
are equally weighted, the portfolio variance is:

6wA2 A2 + 30 wA2 AB
5. Which of the following portfolios constitute the efficient set:

Portfolio Expected return (%) Standard deviation (%)

1 15 18
2 18 22
3 10 9
4 12 15
5 15 20
6 13 16
7 22 22
8 14 17

Solution:

Let us arrange the portfolio in the order of ascending expected returns.

Portfolio Expected return (%) Standard deviation (%)

3 10 9
4 12 15
6 13 16
8 14 17
5 15 20
1 15 18
2 18 22
7 22 22

Examining the above we find that (i) portfolio 7 dominates portfolio 2 because it offers a
higher expected return for the same standard deviation and (ii) portfolio 1 dominates
portfolio 5 as it offers the same expected return for a lower standard deviation. So, the
efficient set consists of all the portfolios except portfolio 2 and portfolio 5.
6. Which of the following portfolios constitute the efficient set:

Portfolio Expected return (%) Standard deviation (%)

1 10 12
2 8 10
3 20 18
4 15 11
5 22 20
6 18 15
7 15 12

Solution:

Let us arrange the portfolio in the order of ascending expected returns.

Portfolio Expected return (%) Standard deviation (%)

2 8 10

1 10 12
4 15 11
7 15 12
6 18 15
3 20 18
5 22 20

Examining the above we find that (i) portfolio 7 dominates portfolio 1 because it offers a
higher expected return for the same standard deviation and (ii) portfolio 4 dominates
portfolio 7 as it offers the same expected return for a lower standard deviation. So, the
efficient set consists of all the portfolios except portfolio 1 and portfolio 7.

7. Consider two stocks, P and Q

Expected return (%) Standard deviation (%)
Stock P 18 % 12 %
Stock Q 24 % 17 %

The returns on the stocks are perfectly negatively correlated.

What is the expected return of a portfolio comprising of stocks P and Q when the
portfolio is constructed to drive the standard deviation of portfolio return to zero?
Solution:

The weights that drive the standard deviation of portfolio to zero, when the returns are
perfectly correlated, are:

Q 17
wP = = = 0.586
P + Q 12 + 17
wQ = 1 wP = 0.414

The expected return of the portfolio is:

0.586 x 18 % + 0.414 x 24 % = 20.484 %

8. Consider two stocks, X and Y

Expected return (%) Standard deviation (%)
Stock X 10 % 18 %
Stock Y 25 % 24 %
The returns on the stocks are perfectly negatively correlated.

What is the expected return of a portfolio comprising of stocks X and Y when the
portfolio is constructed to drive the standard deviation of portfolio return to zero?

Solution:

The weights that drive the standard deviation of portfolio to zero, when the returns
are perfectly correlated, are:
Y 24
wX = = = 0.571
X + Y 18 + 24
wY = 1 wX = 0.429

The expected return of the portfolio is:

0.571 x 10 % + 0.429 x 25 % = 16.435 %

9. The following information is available.
Stock A Stock B
Expected return 24% 35%
Standard deviation 12% 18%
Coefficient of correlation 0.60

a. What is the covariance between stocks A and B ?

b. What is the expected return and risk of a portfolio in which A and B are
equally weighted?

Solution:

(a) Covariance (A,B) = PAB x A x B

= 0.6 x 12 x 18 = 129.6

(b) Expected return = 0.5 x 24 + 0.5 x 35 = 29.5 %

Risk (standard deviation) = [w2A 2A + w2B 2
B + 2 Cov (A,B)]

= [0.52 x 144 + 0.52 x 324 + 2 x 129.6]

= 27.93%

10. The following information is available.

Stock A Stock B
Expected return 12% 26 %
Standard deviation 15% 21 %
Coefficient of correlation 0.30

a. What is the covariance between stocks A and B?

b. What is the expected return and risk of a portfolio in which A and B are
weighted 3:7?

Solution:

(a) Covariance (A,B) = PAB x A x B

= 0.3 x 15 x 21 = 94.5

(b) Expected return = 0.3 x 12 + 0.7 x 26 = 21.8 %

Risk (standard deviation) = [w2A 2A + w2B 2B + 2 Cov (A,B)]

= [0.32 x 225 + 0.72 x 441 + 2 x 94.5]

= 20.62 %
 CAPITAL ASSET PRICING MODEL

1. The following table, gives the rate of return on stock of Apple Computers and on
the market portfolio for five years

Year Return on the stock Return

Apple Computers (%) Market Portfolio (%)
1 -13 -3
2 5 2
3 15 8
4 27 12
5 10 7

(i) What is the beta of the stock of Apple Computers?

(ii) Establish the characteristic line for the stock of Apple Computers.

Solution:

Year RA RM RA - RA RM - RM (RA - RA) (RM - RM) (RM - RM)2

1 -13 -3 -21.8 -8.2 178.76 67.24
2 5 2 -3.8 -3.2 12.16 10.24
3 15 8 6.2 2.8 17.36 7.84
4 27 12 18.2 6.8 123.76 46.24
5 10 7 1.2 1.8 2.16 3.24

Sum 44 26 334.2 134.8

Mean 8.8 5.2

134.8 334.2
M
2
= = 33.7 Cov A,M = = 83.55
5-1 5-1

83.55
A = = 2.48
33.7

(ii) Alpha = R A A R M

= 8.8 (2.48 x 5.2) = - 4.1

Equation of the characteristic line is

RA = - 4.1 + 2.48 RM
2. The rate of return on the stock of Sigma Technologies and on the market portfolio
for 6 periods has been as follows:
 Period Return on the stock Return on the
of Sigma Technologies (%) market portfolio (%)

1 16 14
2 12 10
3 -9 6
4 32 18
5 15 12
6 18 15

(i) What is the beta of the stock of Sigma Technologies.?

(ii) Establish the characteristic line for the stock of Sigma Technologies

Solution:

(i

Year RA (%) RM (%) RA-RA RM-RM (RA-RA) (RM-RM)2

x(RM-RM)

1 36 28 8.8 2.4 21.12 5.76

2 24 20 -3.2 -5.6 17.92 31.36
3 -20 -8 -47.2 -33.6 1585.92 1128.96
4 46 52 18.8 26.4 496.32 696.96
5 50 36 22.8 10.4 237.12 108.16

RA = 136 RM = 128 2358.4

Cov A,M =
RA = 27.2 RM = 25.6 5-1

M2 = 1971.2
51

(ii) Alpha = 2358.4

RA A/ (5-1)
RM
A = -------------------
= = x 25.6)
27.2 (1.196 1.196 = -3.42
Equation of the1971.2 / (5-1) line is
characteristic

RA = - 3.42 + 1.196 RM

3. The rate of return on the stock of Omega Electronics and on the market portfolio for
6 periods has been as follows:
 Period Return on the stock Return on the
of Omega Electronics market portfolio
(%) (%)

1 18% 15%
2 10% 12%
3 -5% 5%
4 20% 14%
5 9% -2%
6 18% 16%

(i)What is the beta of the stock of Omega Electronics?

(ii) Establish the characteristic line for the stock of Omega Electronics.

Solution:

RM
Perio R0 (%) (R0 R0) (RM RM) (R0 R0) (RM RM) (RM - RM)2
(%)
d
1 18 15 6.33 5 31.65 25
2 10 12 -1.67 2 - 3.34 4
3 -5 5 -16.67 -5 83.35 25
4 20 14 8.33 4 33.32 16
5 9 -2 - 2.67 -12 32.04 144
6 18 16 6.33 6 37.98 36
R0 = 70 RM = 60 (R0-R0) (RM-RM) = 215 250
R0 =11.67 RM = 10
250 215
=M
2
= 50 CovO,M = = 43.0
5 5
43.0
0 = = 0.86
50.0
(ii) Alpha = RO A RM
= 11.67 (0.86 x 10) = 3.07
Equation of the characteristic line is
RA = 3.07 + 0.86 RM

4. The risk-free return is 8 percent and the return on market portfolio is 16 percent.
Stock X's beta is 1.2; its dividends and earnings are expected to grow at the constant
 rate of 10 percent. If the previous dividend per share of stock X was Rs.3.00, what
should be the intrinsic value per share of stock X?

Solution:

The required rate of return on stock A is:

RX = RF + X (RM RF)
= 0.08 + 1.2 (0.16 0.08)
= 0. 176

Intrinsic value of share = D1 / (r- g) = Do (1+g) / ( r g)

Given Do = Rs.3.00, g = 0.10, r = 0.176

3.00 (1.10)
Intrinsic value per share of stock X =
0.176 0.10

= Rs. 43.42

5. The risk-free return is 7 percent and the return on market portfolio is 13 percent.
Stock P's beta is 0.8; its dividends and earnings are expected to grow at the constant
rate of 5 percent. If the previous dividend per share of stock P was Rs.1.00, what
should be the intrinsic value per share of stock P?

Solution:

The required rate of return on stock P is:

RP = RF + P (RM RF)
= 0.07 + 0.8 (0.13 0.07)
= 0. 118

Intrinsic value of share = D1 / (r- g) = Do (1+g) / ( r g)

Given Do = Rs.1.00, g = 0.05, r = 0.118

1.00 (1.05)
Intrinsic value per share of stock P =
0.118 0.05

= Rs. 15.44
6. The risk-free return is 6 percent and the expected return on a market portfolio is 15
percent. If the required return on a stock is 18 percent, what is its beta?

Solution:

The SML equation is RA = RF + A (RM RF)

Given RA = 18%. RF = 6%, RM = 15%, we have

0.18 = .06 + A (0.15 0.06)

0.12
i.e. A = = 1.33
0.09

Beta of stock = 1.33

7. The risk-free return is 9 percent and the expected return on a market portfolio is 12
percent. If the required return on a stock is 14 percent, what is its beta?

Solution:

The SML equation is RA = RF + A (RM RF)

Given RA = 14%. RF = 9%, RM = 12%, we have

0.14 = .09 + A (0.12 0.09)

0.05
i.e.A = = 1.67
0.03

Beta of stock = 1.67

8. The risk-free return is 5 percent. The required return on a stock whose beta is 1.1 is
18 percent. What is the expected return on the market portfolio?

Solution:

The SML equation is: RX = RF + X (RM RF)

We are given 0.18 = 0.05 + 1.1 (RM 0.05) i.e., 1.1 RM = 0.185 or RM = 0.1681

Therefore return on market portfolio = 16.81 %

9. The risk-free return is 10 percent. The required return on a stock whose beta is 0.50
is 14 percent. What is the expected return on the market portfolio?

Solution:

The SML equation is: RX = RF + X (RM RF)

We are given 0.14 = 0.10 + 0.50 (RM 0.10) i.e., 0.5 RM = 0.09 or RM = 0.18

Therefore return on market portfolio = 18 %

10. The required return on the market portfolio is 15 percent. The beta of stock A is
1.5. The required return on the stock is 20 percent. The expected dividend growth
on stock A is 6 percent. The price per share of stock A is Rs.86. What is the
expected dividend per share of stock A next year?

What will be the combined effect of the following on the price per share of stock?

(a) The inflation premium increases by 3 percent.

(b) The decrease in the degree of risk-aversion reduces the differential between the
return on market portfolio and the risk-free return by one-fourth.
(c) The expected growth rate of dividend on stock A decrease to 3 percent.
(d) The beta of stock A falls to1.2

Solution:

RM = 15% A = 1.5 RA =20 % g = 6 % Po = Rs.86

Po = D1 / (r - g)

Rs.86 = D1 / (0.20 - .06)

So D1 = Rs.12.04 and Do = D1 / (1+g) = 12.04 /(1.06) = Rs.11.36

RA = Rf + A (RM Rf)

0.20 = Rf + 1.5 (0.15 Rf)

0.5Rf = 0.025

So Rf = 0.05 or 5%.
Original Revised

Rf 5% 8%
RM Rf 10% 7.5%
g 6% 3%
A 1.5 1.2
 Revised RA = 8 % + 1.2 (7.5%) = 17 %

Price per share of stock A, given the above changes is

11.36 (1.03)
= Rs. 83.58
0.17 0.03

11. The required return on the market portfolio is 16 percent. The beta of stock A is
1.6. The required return on the stock is 22 percent. The expected dividend growth
on stock A is 12 percent. The price per share of stock A is Rs.260. What is the
expected dividend per share of stock A next year?

What will be the combined effect of the following on the price per share of stock?

(a) The inflation premium increases by 5 percent.

(b) The decrease in the degree of risk-aversion reduces the differential between the
return on market portfolio and the risk-free return by one-half.
(c) The expected growth rate of dividend on stock A decrease to 10 percent.
(d) The beta of stock A falls to 1.1

Solution:

RM = 16% A = 1.6 RA =22 % g = 12 % Po = Rs. 260

Po = D1 / (r - g)

Rs.260 = D1 / (0.22 - .12)

So D1 = Rs. 26 and Do = D1 / (1+g) = 26 /(1.12) = Rs.23.21

RA = Rf + A (RM Rf)

0.22 = Rf + 1.6 (0.16 Rf)

0.6Rf = 0.036

So Rf = 0.06 or 6%.
Original Revised

Rf 6% 11%
RM Rf 10% 5%
g 12 % 10 %
A 1.6 1.1

Revised RA = 11% + 1.1 (5%) = 16.5 %

 Price per share of stock A, given the above changes is

23.21 (1.10)
= Rs. 392.78
0.165 0.10

12. The following information is given:

Expected return for the market = 15%

Standard deviation of the market return = 25%
Risk-free rate = 8%
Correlation coefficient between stock A and the market = 0.8
Correlation coefficient between stock B and the market = 0.6
Standard deviation for stock A = 30%
Standard deviation for stock B = 24%

(i) What is the beta for stock A?

Solution:

Cov (A,M) Cov (A,M)

AM = ; 0.8 = Cov (A,M) = 600
A M 30 x 25

M2 = 252 = 625

Cov (A,M) 600

A = = = 0.96
M2 625

(ii) What is the expected return for stock A?

Solution:

E(RA) = Rf + A (E (RM) - Rf)

= 8% + 0.96 (7%) = 14.72%

13. The following table gives an analysts expected return on two stocks for particular
market returns.

Market Return Aggressive Stock Defensive Stock

5% - 5% 10%
25% 45% 16%
(i) What is the ratio of the beta of the aggressive stock to the beta of the defensive
stock?

Solution:

45 (-5)
Beta of aggressive stock = = 2.5
25 5

16 - 10
Beta of defensive stock = = 0.30
25 5
Ratio = 2.5/0.30 = 8.33

(ii) If the risk-free rate is 7% and the market return is equally likely to be 5% and
25% what is the market risk premium?

Solution:

E (RM) = 0.5 x 5 + 0.5 x 25 = 15%

Market risk premium = 15% - 7% = 8%

(iii) What is the alpha of the aggressive stock?

Solution:
Expected return = 0.5 x 5 + 0.5 x 45 = 20%
Required return as per CAPM = 7% + 2.5 (8%) = 27%
Alpha = - 7%
14. The following table gives an analysts expected return on two stocks for particular
market returns.

Market Return Aggressive Stock Defensive Stock

8% 2% 10%
20% 32% 16%

(i) What is the beta of the aggressive stock?

Solution:
32% - 2%
Beta = = 2.5
20% - 8%
(ii) If the risk-free rate is 6% and the market return is equally likely to be 8% and
20%, what is the market risk premium?

Solution:
The expected return on the market portfolio is:
0.5 x 8% + 0.5 x 20% = 14%
Since the risk-free rate is 6%, the market risk premium is 8%

(iii) What is the alpha of the aggressive stock?

Solution:

Expected return on the aggressive stock = 0.5 x 2% + 0.5 x 32% = 17%

Required return = 6% + 8 x 2.5 = 26%
Alpha = 17 26% = 9%
 MINICASE 1

Mr. Nitin Gupta had invested Rs.8 million each in Ashok Exports and Biswas Industries
and Rs. 4 million in Cinderella Fashions, only a week before his untimely demise. As per
his will this portfolio of stocks were to be inherited by his wife alone. As the partition
among the family members had to wait for one year as per the terms of the will, the
portfolio of shares had to be maintained as they were for the time being. The will had
stipulated that the job of administering the estate for the benefit of the beneficiaries and
partitioning it in due course was to be done by the reputed firm of Chartered Accountants,
Talwar Brothers. Meanwhile the widow of the deceased was very eager to know certain
details of the securities and had asked the senior partner of Talwar Brothers to brief her in
this regard. For this purpose the senior partner has asked you to prepare a detailed note to
him with calculations using CAPM, to answer the following possible doubts.

1. What is the expected return and risk (standard deviation) of the portfolio?
2. What is the scope for appreciation in market price of the three stocks-are they
overvalued or undervalued?

You find that out the three stocks, your firm has already been tracking two viz. Ashok
Exports (A) and Biswas Industries (B)-their betas being 1.7 and 0.8 respectively.
Further, you have obtained the following historical data on the returns of Cinderella
Fashions(C):
Period Market return (%) Return on
Cinderella Fashions (%)
------------- ------------------------ ---------------
1 10 14
2 5 8
3 (2) (6)
4 (1) 4
5 5 10
6 8 11
7 10 15
On the future returns of the three stocks, you are able to obtain the following forecast
from a reputed firm of portfolio managers.
-------------------------------------------------------------------------------------------------------
State of the Probability Returns (in percentage)
Economy Treasury Ashok Biswas Cinderella Sensex
Bills Exports Industries Fashions
-------------------------------------------------------------------------------------------------------
Recession 0.3 7 5 15 (10) (2)
Normal 0.4 7 18 8 16 17
Boom 0.3 7 30 12 24 26

Required: Prepare your detailed note to the senior partner.

Solution:

(1) Calculation of beta of Cinderella Fashions stock from the historical data

Period Return Return Rc-Rc Rm-Rm (Rm-Rm)2 (Rc-Rc)

Rc ( % ) Rm (%) x (Rm-Rm)
1 14 10 6 5 25 30
2 8 5 0 0 0 0
3 (6) (2) (14) (7) 49 98
4 4 (1) (4) (6) 36 24
5 10 5 2 0 0 0
6 11 8 3 3 9 9
7 15 10 7 5 25 35

Rc=56 Rm=35 (Rm-Rm)2= 144 (Rc-Rc)(Rm-Rm)= 196

2
Rc= 8 Rm= 5 m = 144/6 =24 Cov(c,m) = 196/6= 32.7

Beta of Cinderella Fashions c = 32.7/24= 1.36

(2) Calculation of expected returns, standard deviations and covariances

E(A) =[ 0.3x5] + [0.4x18] +[ 0.3x30] = 17.7
E(B)= [0.3x15] + [0.4x8] + [0.3x12] = 11.3
E(C)= [0.3x(-)10] + [0.4x16] +[0.3x24] = 10.6
E(M)= [0.3x(-)2]+ [0.4x17] + [0.3x26] = 14

A = [0.3(5-17.7)2 +0.4(18-17.7)2+0.3(30-17.7)2 ]1/2

= [48.4 + 0.1+45.4]1/2 = 9.7
B = [0.3(15-11.3)2 + 0.4(8-11.3)2 +0.3(12-11.3)2]1/2
= [4.11 +4.36+ 0.15]1/2 =2.94
c = [0.3(-10-10.6)2+0.4(16-10.6)2 + 0.3(24-10.6)2]1/2
= [ 127.31 +11.66+53.87]1/2 = 13.89
M = [0.3(-2-14)2 +0.4(17-14)2+0.3(26-14)2]1/2
= [76.8 +3.6 +43.2]1/2 = 11.1

Calculation of covariances between the stocks

State of Prob- RA-RA RB-RB RC-RC (2)x(3) (2)x(4)x(5) (2)x(3)x(5)

the abilit x (4)
Economy y (3) (4) (5)
(1) (2)
Recession 0.3 -12.7 3.7 -20.6 -14.1 -22.9 78.5
Normal 0.4 0.3 -3.3 5.4 -0.1 -7.1 0.6
Boom 0.3 12.3 0.7 13.4 2.6 2.8 49.4
A,B = -11.6 B,C= -27.2 A,C= 128.5
 Expected return and standard deviation of the portfolio
E(P) = (0.4x17.7) + (0.4x11.3) +(0.2x10.6)= 13.7
p = [ wA2 A2 + wB2 B2 + wC2 C2 + 2 wAwB A,B +2 wBwC B,C +2 wAwC A,C]1/2
= [ 15.1+ 1.4 +7.7-3.7-4.4+ 20.6]1/2 = 6.1

(3) Determining overpricing and underpricing using CAPM

A =1.7 B =0.8 C = 1.36 E(RM) = 14 Rf =7%

SML = 7 + (14 -7)xBeta

= 7 + 7 x Beta
Required return on Ashok Exports = 7 + (7 x 1.7) = 18.9 %
Required return on Biswas Industries = 7 + (7 x 0.8) = 12.6 %
Required return on Cinderella Fashions = 7 + (7 x 1.36) = 16.5 %

As the expected return of 17.7 % on Ashok Exports is slightly less than the required
return of 18.9%, its expected return can be expected to go up to the fair return
indicated by CAPM and for this to happen its market price should come down. So it
is slightly overvalued.

In the case of Biswas Industries stock, as the expected return of 11.3% is again
slightly less than the required return of 12.6 %, its expected return can be expected to
go up and for this to happen its market price should come down. So it is also slightly
overvalued.
In the case of Cinderella Fashions the expected return is 10.6 % against the required
return of 16.5 %. So it is considerably overvalued.
 MINICASE 2

Mr. Pawan Garg, a wealthy businessman, has approached you for professional
advice on investment. He has a surplus of Rs. 20 lakhs which he wishes to invest in
share market. Being risk averse by nature and a first timer to secondary market, he
makes it very clear that the risk should be minimum. Having done some research in
this field, you recommend to him a portfolio of two shares - stocks of an oil
exploration company ONGD and an oil marketing company BPDL. You tell him
that both are reputed, government controlled companies.
You have the following market data at your disposal.

Period Market return (%) Return (%) on

ONGD BPDL
-------- ------------- -------------------------------
1 10 18 8
2 12 16 10
3 8 12 14
4 -6 (12) 20
5 -4 -7 16
6 10 16 8
The current market price of a share of ONGD is Rs. 1200 and that of BPDL is Rs. 423.

On the future returns of the two stocks and the market, you are able to obtain the
following forecast from a reputed firm of portfolio managers.
-------------------------------------------------------------------------------------------------------
State of the Probability Returns (in percentage) on
Economy Treasury ONGD BPDL Market Index
Bills
-------------------------------------------------------------------------------------------------------
Recession 0.3 7 9 15 (2)
Normal 0.4 7 18 10 14
Boom 0.3 7 25 6 20

The firm also informs you that they had very recently made a study of the ONGD
stock and can advise that its beta is 1.65.

Mr. Garg requests you to answer the following questions:

a. What is the beta for BPDL stock?

b. What is the covariance of the returns on ONGD and BPDL? Use the forecasted
returns to calculate this.
c. If the forecasted returns on ONGD and BPDL are perfectly negatively correlated
( = -1), what will be expected return from a zero risk portfolio?
d. What will be the risk and return of a portfolio consisting of ONGD and BPDL
stocks in equal proportions?
 e. What is the scope for appreciation for the two stocks?

Solution:

a. Let the returns from the stocks of ONGD, BPDL and the market index be Ro, RB and
RM respectively.

Beta of BPDL = (-172/5) / (310/5) = -0.55

Expected return on ONGD = 0.3 x 9 + 0.4 x 18 + 0.3 x 25 = 17.4

Expected return on BPDL = 0.3 x 15 + 0.4 x 10+ 0.3 x 6 = 10.3
Expected return on Market index = 0.3 x (-2) + 0.4 x 14+ 0.3 x 20 = 11

Standard deviation of return on ONGD = [0.3(9-17.4)2 + 0.4(18-17.4)2 + 0.3(25-

17.4)2]1/2
= 6.22

Standard deviation of return on BPDL = [0.3(15- 10.3)2 + 0.4(10-10.3)2 + 0.3(6- 10.3)2]1/2

= 3.49

Covariance of the returns of ONGD and BPDL = -21.72

Coefficient of correlation between the two stocks = - 21.72 / (6.22 x 3.49) =

= - 21.72 / 21.71 = - 1
 As the two stocks are perfectly negatively correlated, it is possible to construct a
portfolio with almost nil risk.

b. wo = / ( 0 + ) = 3.49 / (6.22+ 3.49) = 0.36

he amount to be invested in ONGD = 0.36 x 20,00,000 = Rs. 7,20,000
No. of share of ONGD to be purchased = 720,000/ 1200 = 600
No. of share of BPDL to be purchased = (20,00,000 720,000) / 423 = 3026

c. Weight of ONGD in the portfolio = 0.36 and of BPDL =0.64

The portfolio return = 0.36 x 17.4 + 0.64 x 10.3 = 12.86 %

d. E(R) = 0.5 x 17.4 + 0.5 x 10.3 = 13.85 %

P = [ (0.5)2 x (6.22)2 + (0.5)2 x(3.49)2 - 2x0.5 x 0.5 x 21.72 ]1/2
= 1.36 %

e. Required return on ONGD as per CAPM = 7 + 1.65 x (11 -7) = 13.6 %

Expected return = 17.4
As the expected return is more than the required return, ONGD stock is
underpriced

Required return on BPDL as per CAPM = 7 0.55 x (11 -7) = 4.8 %

Expected return = 10.3

As the expected return is more than the required return, BPDL stock is also
underpriced.

So there is good scope for appreciation in the market prices of both the stocks.