LG3 LG4LG5 LG6248 PART 2 Important Financial Concepts
SELF-TEST PROBLEMS (Solutions in Appendix B)
ST 5–1 Portfolio analysis You have been asked for your advice in selecting a portfolio
of assets and have been given the following data:No probabilities have been supplied. You have been told that you can create two
portfolios—one consisting of assets A and B and the other consisting of assets A
and C—by investing equal proportions (50%) in each of the two component
assets.
a. What is the expected return for each asset over the 3-year period?
b. What is the standard deviation for each asset’s return?
c. What is the expected return for each of the two portfolios?
d. How would you characterize the correlations of returns of the two assets
making up each of the two portfolios identified in part c?
e. What is the standard deviation for each portfolio?
f. Which portfolio do you recommend? Why?ST 5–2 Beta and CAPM Currently under consideration is a project with a beta, b,of
1.50. At this time, the risk-free rate of return, RF,is 7%, and the return on the
market portfolio of assets, km,is 10%. The project is actually expectedto earn
an annual rate of return of 11%.
a. If the return on the market portfolio were to increase by 10%, what would
you expect to happen to the project’s required return?What if the market
return were to decline by 10%?
b. Use the capital asset pricing model (CAPM) to find the required returnon
this investment.
c. On the basis of your calculation in part b,would you recommend this invest-
ment? Why or why not?
d. Assume that as a result of investors becoming less risk-averse, the market
return drops by 1% to 9%. What impact would this change have on your
responses in parts band c?Expected return
Year Asset A Asset B Asset C2004 12% 16% 12%
2005 14 14 14
2006 16 12 16given in Table 5.13. The graphical depiction of
CAPM is the security market line (SML), which
shifts over time in response to changing inflationary
expectations and/or changes in investor risk aver-
sion. Changes in inflationary expectations result in
parallel shifts in the SML in direct response to the
magnitude and direction of change. Increasing risk
aversion results in a steepening in the slope of the
SML, and decreasing risk aversion reduces the slope
of the SML. Although it has some shortcomings,
CAPM provides a useful conceptual framework for
evaluating and linking risk and return.