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Chapter 9 - Answers to All Problems

- MBA711 - Answers to Book - Chapter 3
- MBA711 - Chapter 10 - Answers to All Questions
- MBA711 - Chapter11 - Answers to All Homework Problems
- MBA711 - Answers to Book - Chapter 5
- Valuewalk.com-Ray Dalio Part Two Bridgewater Grows
- Valuing Bonds
- Chapter 13 - HW With Solutions
- MBA711- Answers to Book - Chapter 4
- bny
- Chapter 9 - HW Solutions
- Chapter 12 - HW Solutions
- MBA711 - Answers to All Chapter 7 Problems
- MBA711 - Answers to All Chapter 7 Problems
- Chapter 14 - HW With Solutions
- Chapter 10 - HW Solutions
- Chp_11_&_12-extra question 12.312.412.5
- MBA711 - Chpt 6 - Valuing Bonds - classnotes.pdf
- The Cost of Capital Lecture (Revised)
- Chap- 4 Problems
- Real Estate

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Questions

LG1

1. Why is the percentage return a more useful measure than the dollar return?

The dollar return is most important relative to the amount invested. Thus, a $100 return is

more impressive from a $1,000 investment than a $5,000 investment. The percentage

return incorporates both the dollar return and the amount invested. Therefore, it is easier

to compare percentage return across different investments.

LG2

2. Characterize the historical return, risk, and risk-return relationship of the stock, bond

and cash markets.

Examining Table 9.2, it is clear that the stock market has earned about double the return

since 1950 than bonds. Bonds have earned about 50% higher return than the cash

markets. The risk in the stock market is also higher than the bond and cash markets

according to the standard deviation measurement (Table 9.4). Another illustration of the

high risk is that the stock market frequently losses money and sometimes does not earn

more than the bond and cash markets over short periods of time (Table 9.2). The riskreturn relationship tells us that we should expect higher returns for the riskier market. We

do see higher realized returns over the long term to the higher risk asset classes.

LG3

Risk is defined as the volatility of an assets returns over time. Specifically, the standard

deviation of returns is used to measure risk. This computation measures the deviation

from the average return. The idea is to use standard deviation, a measure of volatility of

past returns to proxy for how variable returns are expected to be in the future.

LG3

4. What are the two components of total risk? Which component is part of the risk-return

relationship? Why?

Total risk includes firm specific risk and market risk. The firm specific risk portion can be

eliminated through diversification by owning many different investments. The portion of

total risk that is left after diversifying, market risk, is the risk that is expected to be

rewarded. Thus, market risk in the risk of the risk-return relationship.

LG3

5. Whats the source of firm-specific risk? Whats the source of market risk?

Firm-specific risk stems from the uncertainty arising from micro-events that primarily

impact the firm or industry. Market risk comes from the macro events that impact all

firms to some extent.

9-1

Chapter 9, Solutions

LG3

6. Which company is likely to have lower total risk, General Electric or Coca-Cola? Why?

General Electric is a firm that has diversified business lines. It makes kitchen appliances,

medical devices, and own the TV network NBC. Thus, much of GEs firm specific risk is

reduced. Coca-Cola does not have such business line diversification. So GEs total risk is

likely to be lower because its firm specific risk is lower.

LG3

7. Can a company change its total risk level over time? How?

A company can change is risk level over time. The company can change the mix of

business lines it pursues. Some industries are riskier than others. For example, the airline

industry has much risk while the utility industry has much less risk. Companies can also

change their risk by changing the amount of money they have borrowed (more borrowing

is riskier).

LG4

8. What does the coefficient of variation measure? Why is a lower value better for the

investor?

The coefficient of variation measures the amount of risk taken for each one percent of

return achieved. It is computed by dividing the standard deviation of return by the total

return. Investors would prefer to achieve a high return with little risk. In other words, they

would like a high return with little standard deviation. This is realized in the coefficient of

variation measure by a lower number.

LG4

9. You receive an investment newsletter advertisement in the mail. The letter claims that

you should invest in a stock that has doubled the return of the S&P 500 Index over the last

three months. It also claims that this stock is a surefire safe bet for the future. Explain how

these two claims are inconsistent with finance theory.

A stock that can earn a large return quickly versus the market is a very volatile stock.

Thus, it is a high risk stock. The stock may indeed increase in the future. However, high

risk means that it could also decrease much in price in the future. It is not a surefire safe

bet.

LG5

10. What does diversification do to the risk and return characteristics of a portfolio?

Diversifying does little for the return of the portfolio. The portfolio return is the weighted

average of the investment returns in the portfolio. However, diversification can do much

for reducing the total risk of the portfolio as measured by the standard deviation. By

combining assets that perform differently in different economic environments, the overall

level of the risk in the portfolio is reduced. In addition, diversifying reduces the firm

specific portion of each assets total risk.

9-2

Chapter 9, Solutions

LG5

11. Describe the diversification potential of two assets with a 0.8 correlation. Whats

the potential if the correlation is +0.8?

The diversification potential is very good with two assets that have a 0.8 correlation.

Since these two assets tend to move in opposite directions, the combination will greatly

reduce the risk or volatility an investor would experience with only one of the assets.

There is not much diversification potential for two assets with a correlation close to one,

like +0.8.

LG5

12. You are a risk adverse investor with a low-risk portfolio of bonds. How is it possible

that adding some stocks (which are riskier than bonds) to the portfolio can lower the total

risk of the portfolio?

Bonds and stocks have a low correlation (see Table 9.6). In some economic

environments, stocks do well and bonds do not. During other times, bonds do better.

Adding a small portion of stocks to a bond portfolio can actually decrease the volatility of

the portfolio.

LG5

13. You own only two stocks in your portfolio but want to add more. When you add a

third stock, the total risk of your portfolio declines. When you add a tenth stock to the

portfolio, the total risk declines. Adding which stock, the third or the tenth, likely reduced

the total risk more? Why?

A portfolio of two stocks likely still has much firm specific risk left. Assuming that the

stocks are not highly correlated, a nine stock portfolio should already have much of its

firm specific risk diversified away. Therefore, the third stock added has much more

potential for reducing the risk of the portfolio than the tenth stock added.

LG5

14. Many employees believe that their employers stock is less likely to lose half of its

value than a well diversified portfolio of stocks. Explain why this belief is erroneous.

A single firm has a lot of firm specific risk. This means that it has more volatility in its

returns than the overall stock market. Remember, high volatility means large price

changes. Also consider that if a well diversified stock portfolio falls by half, this means

large declines for the overall stock market and all firms, including the employers stock

(known as market risk). But a large decline in the employers stock does not mean a large

decline occurs in the overall market (firm specific risk).

LG6

15. Explain what we mean when we say that one portfolio dominates another portfolio?

A dominate portfolio has a better risk return relationship. This means that it either has

high return for the level of risk taken or lower risk for the level of return achieved. No

investor should want a dominated portfolio.

LG6

16. Explain what the efficient frontier is and why it is important to investors.

9-3

Chapter 9, Solutions

The efficient frontier is the set of efficient, or dominating, portfolios. These portfolios

have the highest return for each level of risk desired. Since all other portfolios are

dominated by the efficient frontier portfolios, all investors should and these efficient

portfolios.

LG6

17. If an investors desired risk level changes over time, should the investor change the

composition of his or her portfolio? How?

Yes, investors should modify their portfolios to be consistent with their level of risk. For

example, many people want to reduce their level of risk as they approach their retirement

years. One way to change the level of risk in a portfolio is to change the allocation of

stocks and bonds. An increase in bonds would cause a decrease in the risk of the

portfolio.

LG7

18. Say you own 200 shares of Mattel and 100 shares of RadioShack. Would your

portfolio return be different if you instead owned 100 shares of Mattel and 200 shares of

RadioShack? Why?

The portfolio return would be the weighted average of the Mattel and RadioShack stock

returns. The weights are determined by the proportion of money invested in each firm.

The portfolios return in these two cases would be different because the proportions of

money invested in each stock are different.

Problems

Basic

Problems

LG1

9-1 Investment Return FedEx Corp stock ended the previous year at $103.39 per share.

It paid a $0.35 per share dividend last year. It ended last year at $106.69. If you owned

300 shares of FedEx, what was your dollar return and percent return?

Dollar Return Ending Value Beginning Value Income $106.69 300 - $103.39 300 $0.35 300 $

LG1

9-2 Investment Return Sprint Nextel Corp stock ended the previous year at $23.36 per

share. It paid a $2.37 per share dividend last year. It ended last year at $18.89. If you

owned 500 shares of Sprint, what was your dollar return and percent return?

Dollar Return Ending Value Beginning Value Income $18.89 500 - $23.36 500 $2.37 500 $

LG3

9-3 Total Risk Rank the following three stocks by their level of total risk, highest to

lowest. Rail Haul has an average return of 12 percent and standard deviation of 25

9-4

Chapter 9, Solutions

percent. The average return and standard deviation of Idol Staff are 15 percent and 35

percent; and of Poker-R-Us are 9 percent and 20 percent.

Rank by standard deviation: Idol Staff, Rail Haul, and then Poker-R-Us

LG3

9-4 Total Risk Rank the following three stocks by their total risk level, highest to lowest.

Night Ryder has an average return of 13 percent and standard deviation of 29 percent.

The average return and standard deviation of WholeMart are 11 percent and 25 percent;

and of Fruit Fly are 16 percent and 40 percent.

Rank by standard deviation: Fruit Fly, Night Ryder, and then WholeMart

LG4

9-5 Risk versus Return Rank the following three stocks by their risk-return relationship,

best to worst. Rail Haul has an average return of 12 percent and standard deviation of 25

percent. The average return and standard deviation of Idol Staff are 15 percent and 35

percent; and of Poker-R-Us are 9 percent and 20 percent.

Rank by coefficient of variation: Rail Haul

CoV=20/9=2.22, and Idol Staff CoV=35/15=2.33.

LG4

CoV=25/12=2.08,

Poker-R-Us

9-6 Risk versus Return Rank the following three stocks by their risk-return relationship,

best to worst. Night Ryder has an average return of 13 percent and standard deviation of

29 percent. The average return and standard deviation of WholeMart are 11 percent and

25 percent; and of Fruit Fly are 16 percent and 40 percent.

Rank by coefficient of variation: Night Ryder CoV=29/13=2.23, WholeMart

CoV=25/11=2.27, and Fruit Fly CoV=40/16=2.5.

LG6

9-7 Dominant Portfolios Determine which one of these three portfolios dominates

another. Name the dominated portfolio and the portfolio that dominates it. Portfolio Blue

has an expected return of 12 percent and risk of 18 percent. The expected return and risk

of portfolio Yellow are 13 percent and 17 percent, and for the Purple portfolio are 14

percent and 20 percent.

Portfolio Yellow dominates Portfolios Blue and Purple because it has both a higher

expected return and a lower risk level.

LG6

9-8 Dominant Portfolios Determine which one of the three portfolios dominates another.

Name the dominated portfolio and the portfolio that dominates it. Portfolio Green has an

expected return of 15 percent and risk of 21 percent. The expected return and risk of

portfolio Red are 13 percent and 17 percent, and for the Orange portfolio are 13 percent

and 16 percent.

9-5

Chapter 9, Solutions

Portfolio Orange dominates Portfolios Red and Green because it has the same or lower

expected return with a lower risk level.

LG7

9-9 Portfolio Weights An investor owns $4,000 of Adobe Systems stock, $5,000 of Dow

Chemical, and $6,000 of Office Depot. What are the portfolio weights of each stock?

Total portfolio is $4,000 + $5,000 + $6,000 = $15,000

Adobe System weight = $4,000 / $15,000 = 0.2667

Dow Chemical weight = $5,000 / 15,000 = 0.3333

Office Depot weight = $6,000 / $15,000 = 0.4

LG7

9-10 Portfolio Weights An investor owns $3,000 of Adobe Systems stock, $6,000 of Dow

Chemical, and $7,000 of Office Depot. What are the portfolio weights of each stock?

Total portfolio is $3,000 + $6,000 + $7,000 = $16,000

Adobe System weight = $3,000 / $16,000 = 0.1875

Dow Chemical weight = $6,000 / 16,000 = 0.375

Office Depot weight = $7,000 / $16,000 = 0.4375

LG7

9-11 Portfolio Return Year-to-date, Oracle had earned a 1.34 percent return. During the

same time period, Valero Energy earned 7.96 percent and McDonalds earned 0.88 percent.

If you have a portfolio made up of 30 percent Oracle, 20 percent Valero Energy, and 50

percent McDonalds, what is your portfolio return?

Portfolio Return is 0.31.34% + 0.27.96% + 0.50.88% = 1.63%

LG7

9-12 Portfolio Return Year to date, Yum Brands had earned a 3.80 percent return.

During the same time period, Raytheon earned 4.26 percent and Coca-Cola earned 0.46

percent. If you have a portfolio made up of 30 percent Yum Brands, 30 percent Raytheon,

and 40 percent Coca-Cola, what is your portfolio return?

Portfolio Return is 0.33.80% + 0.34.26% + 0.40.46% = 2.23%

Intermediate

Problems 9-13 Average Return The past five monthly returns for Kohls are 3.54 percent, 3.62

percent, 1.68 percent, 1.42 percent, and 8.75 percent. What is the average monthly

LG1

return?

Average Return = (3.54%+3.62%1.68%1.42%+8.75%) / 5 = 2.562%

LG1

9-14 Average Return The past five monthly returns for PG&E are 2.14 percent, 1.37

percent, 3.77 percent, 6.47 percent, and 3.58 percent. What is the average monthly return?

Average Return = (2.14%1.37%+3.77%+6.47%+3.58%) / 5 = 2.918%

9-6

Chapter 9, Solutions

LG3

9-15 Standard Deviation Compute the standard deviation of Kohls monthly returns

shown in Problem 9-13.

3.54% 2.562% 2 3.62% 2.562% 2 1.68% 2.562% 2 1.42% 2.562% 2 8.75% 2.562% 2

5 1

LG3

4.31%

9-16 Standard Deviation Compute the standard deviation of PG&Es monthly returns

shown in Problem 9-14.

2.14% 2.918% 2 1.37% 2.918% 2 3.77% 2.918% 2 6.47% 2.918% 2 3.58% 2.918% 2

5 1

LG2&4 9-17 Risk versus Return in Bonds Assess the risk-return relationship of the bond market

(see Tables 9.2 and 9.4) during each decade since 1950.

Compute the coefficient of variation for each decade using the standard deviation and

average return:

Decade

CoV

1950s

NA

1960s

3.85

1970s

1.19

1980s

1.12

1990s

1.35

2000s

0.77

The lower the coefficient of variation, the better the risk-return relationship. The early two

decades, 1950s and 1960s, have a poor risk return relationship for bonds. The 1950s

coefficient of variation is not defined because the average is zero. The poor relationship in

the 1950s is caused by the very low return in that decade. The three full decades since

1970 have had good risk-return relationship.

LG2&4 9-18 Risk versus Return in T-bills Assess the risk-return relationship in T-bills (see

Tables 9.2 and 9.4) during each decade since 1950.

Compute the coefficient of variation for each decade using the standard deviation and

average return:

Decade

1950s

1960s

1970s

1980s

CoV

0.40

0.33

0.29

0.29

9-7

2.86%

Chapter 9, Solutions

1990s

0.24

2000s

0.55

The lower the coefficient of variation, the better the risk-return relationship. All these

CoVs are very low. While they appear to have great risk-return relationships, it is because

the risk is very low. T-bills are very safe instruments. However, they offer very low

returns.

LG4&5 9-19 Diversifying Consider the characteristics of the following three stocks:

Expected

Standard

Return

Deviation

Thumb

13%

23%

Devices

Air Comfort

10%

19%

Sport Garb

10%

17%

The correlation between Thumb Devices and Air Comfort is 0.12. The correlation

between Thumb Devices and Sport Garb is 0.13. The correlation between Air Comfort

and Sport Garb is 0.85. If you can pick only two stocks for your portfolio, which would

you pick? Why?

Air Comfort and Sport Garb have similar expected returns and standard deviations. Since

their correlation is very high, not much risk will be reduced when combined. Combining

either stock with Thumb Devices has good potential because it has higher return and they

have low (negative) correlation it. Since Sport Garb has both lower risk (standard

deviation) and lower correlation with Thumb Devices than does Air Comfort, combine

Sport Garb and Thumb Devices.

LG4&5 9-20 Diversifying Consider the characteristics of the following three stocks:

Expected

Standard

Return

Deviation

Pic Image

11%

19%

Tax Help

10%

19%

Warm Wear

14%

24%

The correlation between Pic Image and Tax Help is 0.88. The correlation between Pic

Image and Warm Wear is 0.21. The correlation between Tax Help and Warm Wear is

0.19. If you can pick only two stocks for your portfolio, which would you pick? Why?

Pic Image and Tax Help have similar expected returns and standard deviations. Since

their correlation is very high, not much risk will be reduced when combined. Combining

either stock with Warm Wear has good potential because it has higher return and they have

low (negative) correlation it. Since Pic Image has both higher expected return and lower

correlation with Warm Wear than does Tax Help, combine Pic Image and Warm Wear.

9-8

Chapter 9, Solutions

LG7

9-21 Portfolio Weights If you own 300 shares of Alaska Air at $42.88, 350 shares of Best

Buy at $51.32, and 250 shares of Ford Motor at $8.51, what are the portfolio weights of

each stock?

Total portfolio is 300$42.88 + 350$51.32 + 250$8.51 = $32,953.50

Alaska Air weight = 300$42.88 / $32,953.50 = 0.390

Best Buy weight = 350$51.32 / $32,953.50 = 0.545

Ford Motor weight = 250$8.51 / $32,953.50 = 0.065

LG7

9-22 Portfolio Weights If you own 400 shares of Xerox at $17.34, 500 shares of Qwest at

$8.15, and 350 shares of Liz Claiborne at $44.73, what are the portfolio weights of each

stock?

Total portfolio is 400$17.34 + 500$8.15 + 350$44.73 = $26,666.50

Xerox weight = 400$17.34 / $26,666.50 = 0.260

Qwest weight = 500$8.15 / $26,666.50 = 0.153

Liz Claiborne weight = 350$44.73 / $26,666.50 = 0.587

LG7

9-23 Portfolio Return At the beginning of the month, you owned $5,500 of General

Motors, $7,500 of Starbucks, and $9,000 of Nike. The monthly returns for General

Motors, Starbucks, and Nike were 6.80 percent, 1.36 percent, and 0.22 percent. What

is your portfolio return?

Total portfolio is $5,500 + $7,500 + $9,000 = $22,000

General Motors weight = $5,500 / $22,000 = 0.25

Starbucks weight = $7,500 / $22,000 = 0.341

Nike weight = $9,000 / $22,000 = 0.409

So Portfolio Return is 0.256.80% + 0.3411.36% + 0.4090.22% = 1.15%

LG7

9-24 Portfolio Return At the beginning of the month, you owned $6,000 of News Corp,

$5,000 of First Data, and $8,500 of Whirlpool. The monthly returns for News Corp, First

Data, and Whirlpool were 8.24 percent, 2.59 percent, and 10.13 percent. Whats your

portfolio return?

Total portfolio is $6,000 + $5,000 + $8,500 = $19,500

News Corp weight = $6,000 / $19,500 = 0.308

First Data weight = $5,000 / $19,500 = 0.256

Whirlpool weight = $8,500 / $19,500 = 0.436

So Portfolio Return is 0.3088.24% + 0.2562.59% + 0.43610.13% = 6.29%

Advanced

Problems

LG2&5

9-25 Asset Allocation You have a portfolio with an asset allocation of 50 percent stocks,

40 percent long-term Treasury Bonds, and 10 percent T-bills. Use these weights and the

returns in Table 9.2 to compute the return of the portfolio in the year 2000 and each year

9-9

Chapter 9, Solutions

since. Then compute the average annual return and standard deviation of the portfolio and

compare them with the risk and return profile of each individual asset class.

These answers were computed using a spreadsheet. The portfolio return is computed as:

0.5-9.1% + 0.420.11% +0.15.9% = 4.08%

Portfolio

Stocks Bonds T-bills Return

2000

-9.1% 20.11%

5.9%

4.08%

2001 -11.9% 4.56%

3.5%

-3.78%

2002 -22.1% 17.17%

1.6%

-4.02%

2003 28.7% 2.06%

1.0%

15.27%

2004 10.9% 7.70%

1.4%

8.67%

2005

4.9% 6.50%

3.1%

5.37%

2006 15.8% 1.85%

4.7%

9.11%

2007

3.5% 9.81%

3.4%

6.01%

Ave =

2.59%

StdDev= 16.42%

8.72%

6.73%

3.08%

1.70%

5.09%

6.51%

The portfolio has the second highest return with the second lowest risk. Combining these

assets achieved some risk reduction.

LG2&5 9-26 Asset Allocation You have a portfolio with an asset allocation of 60 percent stocks,

30 percent long-term Treasury Bonds, and 10 percent T-bills. Use these weights and the

returns in Table 9.2 to compute the return of the portfolio in the year 2000 and each year

since. Then compute the average annual return and standard deviation of the portfolio and

compare them with the risk and return profile of each individual asset class.

These answers were computed using a spreadsheet. The portfolio return is computed as:

0.6-9.1% + 0.320.11% +0.15.9% = 1.16%

Portfolio

Stocks Bonds T-bills Return

2000

-9.1% 20.11%

5.9%

1.16%

2001 -11.9% 4.56%

3.5%

-5.42%

2002 -22.1% 17.17%

1.6%

-7.95%

2003 28.7% 2.06%

1.0%

17.94%

2004 10.9% 7.70%

1.4%

8.99%

2005

4.9% 6.50%

3.1%

5.20%

2006 15.8% 1.85%

4.7%

10.51%

2007

3.5% 9.81%

3.4%

5.38%

Ave =

2.59%

StdDev= 16.42%

8.72%

6.73%

3.08%

1.70%

4.48%

8.47%

9-10

Chapter 9, Solutions

The portfolio has the second highest return with the second highest risk. Combining these

assets achieved some risk reduction.

LG7

9-27 Portfolio Weights You have $15,000 to invest. You want to purchase shares of

Alaska Air at $42.88, Best Buy at $51.32, and Ford Motor at $8.51. How many shares of

each company should you purchase so that your portfolio consists of 30 percent Alaska

Air, 40 percent Best Buy, and 30 percent Ford Motor? Report only whole stock shares.

Alaska Air: 0.30$15,000$42.88 = 105 shares

Best Buy: 0.40$15,000$51.32 = 117 shares

Ford Motor: 0.30$15,000$8.51 = 528 shares

Because of rounding up, this adds up to slightly more than $15,000. So, one less share of

one of these stocks should be purchased.

LG7

9-28 Portfolio Weights You have $20,000 to invest. You want to purchase shares of

Xerox at $17.34, Qwest at $8.15, and Liz Claiborne at $44.73. How many shares of each

company should you purchase so that your portfolio consists of 25 percent Xerox, 40

percent Qwest, and 35 percent Liz Claiborne? Report only whole stock shares.

Xerox: 0.25$20,000$17.34 = 288 shares

Qwest: 0.40$20,000$8.15 = 982 shares

Liz Claiborne: 0.35$20,000$44.73 = 156 shares

Excluding commissions paid, you will still have a cash balance of $24.90.

LG7

9-29 Portfolio Return The table below shows your stock positions at the beginning of the

year, the dividends that each stock paid during the year, and the stock prices a the end of

the year. What is your portfolio dollar return and percentage return?

Beginning Dividend

End of

Company

Shares

of Year

per share

Year

Price

Price

Washington Mutual

300

$43.50

$2.06

$43.43

PepsiCo

200

$59.08

$1.16

$62.55

JDS Uniphase

500

$18.88

$16.66

Duke Energy

250

$27.45

$1.26

$33.21

Solution by spreadsheet:

Company

beginning

value

Washington

Mutual

$13,050.00

PepsiCo

$11,816.00

JDS

Uniphase

$9,440.00

Duke

$6,862.50

portfolio

weight

0.31699

0.287016

Capital

Gain

Income

Total Return

Percentage

Return

($21.00) $618.00

$694.00 $232.00

$597.00

$926.00

4.57%

7.84%

0.229302 ($1,110.00)

$0.00

0.166693 $1,440.00 $315.00

($1,110.00)

$1,755.00

-11.76%

25.57%

9-11

Chapter 9, Solutions

Energy

total =

LG7

$41,168.50

$2,168.00

Portfolio

Return =

5.27%

9-30 Portfolio Return The table below shows your stock positions at the beginning of the

year, the dividends that each stock paid during the year, and the stock prices a the end of

the year. What is your portfolio dollar return and percentage return?

Beginning Dividend

End of

Company

Shares

of Year

per share

Year

Price

Price

Johnson Controls

300

$72.91

$1.17

$85.92

Medtronic

200

$57.57

$0.41

$53.51

Direct TV

500

$24.94

$24.39

Qualcomm

250

$43.08

$0.45

$37.79

Solution by spreadsheet:

Company beginning

value

Johnson

Controls

$21,873.00

Medtronic $11,514.00

Direct TV $12,470.00

Qualcomm $10,770.00

total =

$56,627.00

portfolio

weight

Capital

Gain

Income

0.203331

($812.00) $82.00

0.220213

($275.00)

$0.00

0.190192 ($1,322.50) $112.50

Total Return

Percentage

Return

$4,254.00

19.45%

($730.00)

-6.34%

($275.00)

-2.21%

($1,210.00)

-11.23%

$2,039.00

Portfolio

Return =

3.60%

LG3&4 9-31 Risk, Return, and Their Relationship Consider the following annual returns of

Estee Lauder and Lowes Companies:

Estee Lauder

Lowes

Companies

2006

23.4%

6.0%

2005

26.0%

16.1%

2004

17.6%

4.2%

2003

49.9%

48.0%

2002

16.8%

19.0%

Compute each stocks average return, standard deviation, and coefficient of variation.

Which stock appears better? Why?

Solution by spreadsheet:

9-12

Chapter 9, Solutions

Estee

Lowes

Lauder Companies

Ave =

30.30%

22.77%

StDev=

17.22%

22.65%

CoV = 0.568318

0.994799

Estee Lauder has experienced a higher average return then Lowes with a lower risk

(standard deviation). Thus, it is not a surprise that Estee Lauder has a better (lower)

coefficient of variation. Estee Lauder was better.

LG3&4 9-32 Risk, Return, and Their Relationship Consider the following annual returns of

Molson Coors and International Paper:

Molson Coors

International

Paper

2006

16.3%

4.5%

2005

9.7%

17.5%

2004

36.5%

0.2%

2003

6.9%

26.6%

2002

16.2%

11.1%

Compute each stocks average return, standard deviation, and coefficient of variation.

Which stock appears better? Why?

Solution by spreadsheet:

Molson International

Coors

Paper

Ave =

23.00%

15.55%

StDev=

11.69%

15.63%

CoV = 0.508324

1.004956

Molson Coors has experienced a higher average return then IP with a lower risk (standard

deviation). Thus, it is not a surprise that Molson Coors has a better (lower) coefficient of

variation. Molson Coors was better.

9-33 Excel Problem Below are the monthly returns for May 2002 to June 2007 of three

international stock indices; All Ordinaries of Australia, Nikkei 225 of Japan, and FTSE

100 of England.

Date

All

Ordinaries

Nikkei

225

FTSE

100

Date

9-13

All

Ordinaries

Nikkei

225

FTSE

100

Chapter 9, Solutions

(Australia)

Jun 2007

May

2007

Apr

2007

Mar

2007

Feb 2007

(Japan)

(England)

1.82%

0.55%

1.65%

-0.49%

1.47%

-0.20%

2.98%

2.73%

2.67%

3.00%

2.79%

0.65%

-1.80%

2.24%

2.21%

Jan 2007

Dec

2006

Nov

2006

1.02%

1.27%

-0.51%

2.01%

0.91%

-0.28%

3.35%

5.85%

2.84%

Oct 2006

2.03%

-0.76%

-1.31%

Sep 2006

Aug

2006

4.69%

1.69%

2.83%

0.65%

-0.08%

0.93%

Jul 2006

2.48%

4.42%

-0.37%

Jun 2006

May

2006

Apr

2006

Mar

2006

Feb 2006

-1.53%

-0.31%

1.63%

1.24%

0.24%

1.91%

-4.51%

-8.51%

-4.97%

2.35%

4.28%

-0.90%

5.27%

0.98%

2.99%

Jan 2006

Dec

2005

Nov

2005

-0.04%

-2.67%

0.54%

3.64%

3.34%

2.52%

2.73%

8.33%

3.61%

Oct 2005

3.87%

9.30%

1.99%

Sep 2005

Aug

2005

-3.92%

0.24%

-2.93%

4.06%

9.35%

3.41%

Jul 2005

1.54%

4.32%

0.28%

Jun 2005

May

2005

Apr

2005

2.76%

2.72%

3.31%

3.92%

2.73%

3.01%

3.23%

2.43%

3.38%

(Australia)

Nov

2004

Oct

2004

Sep

2004

Aug

2004

Jul 2004

Jun

2004

May

2004

Apr

2004

Mar

2004

Feb

2004

Jan

2004

Dec

2003

Nov

2003

Oct

2003

Sep

2003

Aug

2003

Jul 2003

Jun

2003

May

2003

Apr

2003

Mar

2003

Feb

2003

Jan

2003

Dec

2002

Nov

2002

Oct

2002

Sep

2002

9-14

(Japan)

(England)

2.80%

5.41%

2.36%

4.13%

1.19%

1.71%

3.04%

-0.48%

1.17%

3.17%

0.45%

-2.33%

-2.15%

2.50%

1.05%

0.45%

-4.50%

-1.14%

2.12%

5.54%

0.75%

1.44%

-4.47%

-1.31%

-0.25%

0.40%

2.37%

1.30%

6.10%

-2.37%

2.71%

2.40%

2.31%

-0.68%

1.00%

-1.93%

3.45%

5.70%

3.09%

-2.64%

-4.35%

1.28%

3.34%

3.33%

4.80%

-0.83%

3.10%

-1.20%

8.16%

-1.68%

0.10%

3.59%

5.29%

3.12%

0.64%

7.82%

-0.42%

0.30%

7.57%

3.11%

4.29%

-1.77%

8.65%

2.53%

-4.67%

-1.16%

-5.35%

0.28%

2.47%

-1.35%

-2.79%

-9.47%

-1.64%

-6.91%

-5.49%

1.01%

6.66%

3.21%

2.28%

-7.92%

8.54%

Chapter 9, Solutions

Mar

2005

Feb 2005

Jan 2005

Dec

2004

-3.84%

-1.34%

-5.66%

-0.61%

-1.89%

-1.49%

1.21%

3.10%

2.39%

1.32%

-0.88%

0.79%

Aug

2002

Jul 2002

Jun

2002

May

2002

-4.73%

1.36%

-2.45%

-2.62%

-11.96%

-0.45%

-4.13%

-7.00%

-8.81%

-4.87%

-9.71%

-8.43%

A. Compute and compare each indices monthly average return and standard deviation.

B. Compute the correlation between i) All Ordinaries and Nikkei 225, ii) All Ordinaries

and FTSE 100, and iii) Nikkei 225 and FTSE 100, and compare them.

C. Form a portfolio consisting of one third of each of the indices and show the portfolio

return each year, and the portfolios return and standard deviation.

A.

All

Ordinaries

(Australia)

1.10%

Nikkei

225

(Japan)

0.81%

FTSE 100

(England)

0.52%

Ave =

StDev

=

2.62%

4.53%

3.69%

The All Ordinaries index had the highest monthly return with the lowest risk. The FTSE

100 had the lowest return and had the middle level of risk.

B. Correlations

All

Ordinaries

(Australia)

All Ordinaries

(Australia)

Nikkei 225 (Japan)

FTSE 100 (England)

1

0.559

0.692

Nikkei

225

(Japan)

1

0.442

FTSE 100

(England)

The Nikkei and the FTSE are the least correlated. The All Ordinaries and the FTSE have

the highest correlation.

C.

Portfolio

0.81%

3.02%

Research It!

9-15

Chapter 9, Solutions

Following a Portfolio

Following stocks in a portfolio is easier than ever. Many financial websites have the

capability to follow the stocks in your portfolio over time. Just enter your stocks, the

number of shares, your purchase price, and your commission cost and you can see how

your portfolio is doing. These portfolio managers will update your portfolio as stock

prices change, minute to minute. Yahoo! Finance has a portfolio management tool. Go to

the site and start a portfolio to watch (which required free registration). Try entering

symbols EBAY, T, LMT, DUK, and GSK. As a start, assume you own 200 shares of each.

You watch the value of the portfolio change and see how each stock is doing every day.

(http://finance.yahoo.com/)

The portfolio might look something like this:

Many more types of investments are available besides stocks, bonds, and cash securities.

Many people invest in real estate and in precious metals, primarily gold. What is the risk

and return characteristics of these investments and do they provide diversification

opportunities to the typical stock investor?

You can invest in real estate in many ways. You can build properties, own rental

units, and trade raw land. These activities take enormous time and expertise. One of the

easiest ways to invest in real estate is through real estate investment trusts (REITs) that

trade like stocks on the stock exchanges. A REIT represents ownership in a portfolio

consisting of a pool of real estate assets. An index of all REITs is a good measure of the

performance of the real estate market. The table below shows the annual returns for the

All REITs Index along side the returns of the S&P 500 Index.

S&P 500

Index

All

REITs

Gold

Price

9-16

Chapter 9, Solutions

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

37.2%

23.8%

-7.2%

6.6%

18.4%

32.4%

-4.9%

21.4%

22.5%

6.3%

32.2%

18.5%

5.2%

16.8%

31.5%

-3.2%

30.6%

7.7%

10.0%

1.3%

37.4%

23.1%

33.4%

28.6%

21.0%

-9.1%

-11.9%

-22.1%

28.7%

10.9%

4.9%

15.8%

3.5%

Index

36.3%

49.0%

19.1%

-1.6%

30.5%

28.0%

8.6%

31.6%

25.5%

14.8%

5.9%

19.2%

-10.7%

11.4%

-1.8%

-17.3%

35.7%

12.2%

18.5%

0.8%

18.3%

35.8%

18.9%

-18.8%

-6.5%

25.9%

15.5%

5.2%

38.5%

30.4%

8.3%

34.4%

-17.8%

Changes

-19.9%

-4.1%

22.6%

37.0%

126.5%

15.2%

-32.6%

14.9%

-16.3%

-19.2%

5.7%

21.3%

22.2%

-15.3%

-2.8%

-1.5%

-10.1%

-5.7%

17.7%

-2.2%

1.0%

-4.6%

-21.4%

-0.8%

0.9%

-5.4%

0.7%

25.6%

19.9%

4.6%

17.8%

24.0%

31.1%

Gold has been a highly sought-after asset all over the world, and has retained at

least some economic value over thousands of years. The United States has had a very

chaotic history with gold. Americans have sought to strike it rich through gold rushes in

North Carolina (early 1800s), California and Nevada (mid-1800s), and Alaska (late

1800s). Struggling in the Great Depression, President Franklin D. Roosevelt ordered U.S.

citizens to hand in all the gold they possessed. The ban on U.S. citizens owning gold was

not lifted until the end of 1974.. The table also shows the return from gold prices.

9-17

Chapter 9, Solutions

The returns for stocks, real estate, and gold are all volatile. However, during many

years, the return of one asset is up while the others are down. This looks promising for

diversification opportunities.

A. Using a spreadsheet, compute the average return and standard deviation of each of

the three asset class.

B. Compute the annual returns of a portfolio consisting of 50% stocks / 40% real

estate / 10% gold. What is the average return and standard deviation of this portfolio?

Also compute the average return and standard deviation of the following portfolios:

75%/20%/5% and 80%/5%/15%. How do these portfolios perform compared to

owning just stocks?

C. Plot the average return and standard deviation of the three assets and the three

portfolios on a risk-return graph like Figure 9.3.

SOLUTION:

A.

Ave =

Std. Dev.=

Index

Index

Price

14.3%

15.3%

7.5%

15.6%

17.7% 27.2%

B.

50/40/10 75/20/5 80/5/15

14.0% 14.1% 13.3%

Ave =

Std.

Dev.=

12.3% 13.2% 13.0%

The first two portfolios would have had similar returns as the all stock portfolio, but both

would have had lower risk. Thus, these two portfolios performed better than the all stock

portfolio.

9-18

Chapter 9, Solutions

C.

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