CP

Stock R has a beta of 1.5, Stock S has a beta of 0.75, the expected rate of return on an average

stock is 13 percent, and the risk-free rate of return is 7 percent. By how much does the required

return on the riskier stock exceed the required return on the less risky stock?

Stocks A and B have the following historical returns:

Year Stock A’s Returns, rA Stock B’s Returns, rB

1998 (18.00%) (14.50%)

1999 33.00 21.80

2000 15.00 30.50

2001 (0.50) (7.60)

2002 27.00 26.30

a.Calculate the average rate of return for each stock during the period 1998 through 2002.

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

1998 through 2002? 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?

You have observed the following returns over time:

Year Stock X Stock Y Market

1998 14% 13% 12%

1999 19 7 10

2000  16  5  12

2001 3 1 1

2002 20 11 15

Assume that the risk-free rate is 6 percent and the market risk premium is 5 percent.

a.What are the betas of Stocks X and Y?

b.What are the required rates of return for Stocks X and Y?

c.What is the required rate of return for a portfolio consisting of 80 percent of Stock X and 20

percent of Stock Y?

d.If Stock X’s expected return is 22 percent, is Stock X under- or overvalued?

Spreadsheet Problem

Start with the partial model in the fileCh 03 P14 Build a Model.xlsfrom the textbook’s web

site. Bartman Industries’ and Reynolds Incorporated’s stock prices and dividends, along with the

Market Index, are shown below for the period 1997-2002. The Market data are adjusted to in-

clude dividends.

Bartman Industries Reynolds Incorporated Market Index

Year Stock Price Dividend Stock Price Dividend Includes Divs.

2002 $17.250 $1.15 $48.750 $3.00 11,663.98

2001 14.750 1.06 52.300 2.90 8,785.70

2000 16.500 1.00 48.750 2.75 8,679.98

1999 10.750 0.95 57.250 2.50 6,434.03

1998 11.375 0.90 60.000 2.25 5,602.28

1997 7.625 0.85 55.750 2.00 4,705.97

3–14
BUILD A MODEL: EVALUATING
RISK AND RETURN

3–13

FINANCIAL CALCULATOR

NEEDED; EXPECTED AND

REQUIRED RATES OF RETURN

3–12

REALIZED RATES OF RETURN

3–11

REQUIRED RATE OF RETURN

Spreadsheet Problem 143

Risk and Return 141