Principles of Corporate Finance_ 12th Edition

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212 Part Two Risk

A number of textbooks on portfolio selection explain both Markowitz’s original theory and some inge-

nious simplified versions. See, for example,

E. J. Elton, M. J. Gruber, S. J. Brown, and W. N. Goetzmann: Modern Portfolio Theory and Investment

Analysis, 9th ed. (New York: John Wiley & Sons, 2014).

The literature on the capital asset pricing model is enormous. There are dozens of published tests of

the capital asset pricing model. Fischer Black’s paper is a very readable example. Discussions of

the theory tend to be more uncompromising. Two excellent but advanced examples are Campbell’s

survey paper and Cochrane’s book.

F. Black, “Beta and Return,” Journal of Portfolio Management 20 (Fall 1993), pp. 8–18.

J. Y. Campbell, “Asset Pricing at the Millennium,” Journal of Finance 55 (August 2000), pp. 1515–1567.

J. H. Cochrane, Asset Pricing, revised ed. (Princeton, NJ: Princeton University Press, 2005).

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FURTHER

READING

Select problems are available in McGraw-Hill’s Connect.

Please see the preface for more information.

BASIC

1. Portfolio risk and return Here are returns and standard deviations for four investments.

Calculate the standard deviations of the following portfolios.

a. 50% in Treasury bills, 50% in stock P.

b. 50% each in Q and R, assuming the shares have

∙ perfect positive correlation.

∙ perfect negative correlation.

∙ no correlation.

c. Plot a figure like Figure 8.3 for Q and R, assuming a correlation coefficient of .5.

d. Stock Q has a lower return than R but a higher standard deviation. Does that mean that Q’s

price is too high or that R’s price is too low?

2. Portfolio risk and return For each of the following pairs of investments, state which
   would always be preferred by a rational investor (assuming that these are the only invest-
   ments available to the investor):
   a. Portfolio A r = 18% σ = 20%
   Portfolio B r = 14% σ = 20%
   b. Portfolio C r = 15% σ = 18%
   Portfolio D r = 13% σ = 8%
   c. Portfolio E r = 14% σ = 16%
   Portfolio F r = 14% σ = 10%

Return (%) Standard Deviation (%)

Treasury bills 6 0

Stock P 10 14

Stock Q 14.5 28

Stock R 21 26

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PROBLEM

SETS