CHAPTER 8

Exercise 10. Here are inflation rates and US stock market and Treasury bill returns between
1929 and 1933:
Year Inflation
Stock Market
Return T-bill Return
1929 -2 -14.5 4.8
1930 -6.0 -28.3 2.4
1931 -9.5 -43.9 1.1
1932 -10.3 -9.9 1.0
1933 0.5 57.3 0.3

a) What was the real return on the stock market each year?

Recall from Chapter 4 that: (1 + r
nominal
) = (1 + r
real
) (1 + inflation rate)
Therefore: r
real
= [(1 + r
nominal
)/(1 + inflation rate)] 1
The real return on the stock market in each year was:

1929: -12.8%
1930: -23.7%
1931: -38.0%
1932: 0.4%
1933: 56.5%


b) What was the average real return?

From the results for Part (a), the average real return was: -3.51%


c) What was the risk premium in each year?

The risk premium for each year was:


Year
Stock
Market
Return
T-bill
Return MRP
1929 -14,50% 4,80% -19,30%
1930 -28,30% 2,40% -30,70%
1931 -43,90% 1,10% -45,00%
1932 -9,90% 1,00% -10,90%
1
1933 57,30% 0,30% 57,00%


d) What was the average risk premium?

From the results for Part (c), the average risk premium was: 9.78%

e) What was the standard deviation of the risk premium?

The standard deviation () of the risk premium is calculated as follows:

[
2 2 2 2
0.0978)) 0.450 ( 0978)) 0 0.307 ( 0.0978)) 0.193 (
1 5
1
+ +

= ( . ( (

0.155739 0.0978)) (0.570 0.0978)) 0.109 (
2 2
= + + ] ( (

39.46% 0.394637 0.155739 = = =



Exercise 14. Lonesome Gulch Mines has a standard deviation of 42% per year and a beta of
+0.10. Amalgamated Copper has a standard deviation of 31% a year and a beta of +0.66. Explain
why Lonesome Gulch is the safer investment for a diversified investor.

In the context of a well-diversified portfolio, the only risk characteristic of a single security that
matters is the securitys contribution to the overall portfolio risk. This contribution is measured
by beta. Lonesome Gulch is the safer investment for a diversified investor because its beta
(+0.10) is lower than the beta of Amalgamated Copper (+0.66). For a diversified investor, the
standard deviations are irrelevant.


Exercise 15. Lambeth Walk invests 60% of her funds in stock I, and the balance in stock J. The
standard deviation of returns on I is 10% and on J is 20%. Calculate the variance of portfolio
returns, assuming:




a) The correlation between the returns is 1.0

x
I
= 0.60
I
= 0.10
x
J
= 0.40
J
= 0.20



1
IJ
=
)] x 2(x x x [
J I IJ J I
2
J
2
J
2
I
2
I
2
p
+ + =
2




0.0196 ] 0)(0.20) 40)(1)(0.1 2(0.60)(0. (0.20) 0.40) ( (0.10) (0.60) [
2 2 2 2
= + + =
b) The correlation is 0.5

x
I
= 0.60
I
= 0.10
x
J
= 0.40
J
= 0.20








0.50
IJ
=
)] x 2(x x x [
J I IJ J I
2
J
2
J
2
I
2
I
2
p
+ + =
0.0148 ] ) 0.10)(0.20 40)(0.50)( 2(0.60)(0. (0.20) 0.40) ( (0.10) (0.60) [
2 2 2 2
= + + =
c) The correlation is 0

x
I
= 0.60
I
= 0.10
x
J
= 0.40
J
= 0.20












Exercise 21. Your eccentric Aunt Gerlinda has left you 50,000 in Alcan shares plus 50,000
cash. Unfortunately her will requires that the Alcan stock not to be sold for one year and the
50,000 cash must be entirely invested in one of the stocks shown in table 8.9. What is the safest
attainable portfolio under these restrictions?







0
ij
=
)] x 2(x x x [
J I IJ J I
2
J
2
J
2
I
2
I
2
p
+ + =
0.0100 ] 0)(0.20) 40)(0)(0.1 2(0.60)(0. (0.20) 0.40) ( (0.10) (0.60) [
2 2 2 2
= + + =
Correlation Coefficients
Alcan BP
Deutsche
Bank Fiat Heineken LVMH Nestl
Standard
Deviation
Alcan 1,00 0,34 0,53 0,30 0,20 0,53 0,08 29,7%
BP 1,00 0,44 0,26 0,20 0,27 0,29 18,4%
3
Deutsche Bank 1,00 0,52 0,22 0,56 0,24 30,1%
Fiat 1,00 0,17 0,42 0,26 35,9%
Heineken 1,00 0,33 0,50 17,2%
LVMH 1,00 0,31 31,0%
Nestl 1,00 13,8%

Table 8.9
Standard Deviation of Returns and correlation coefficients for a sample of seven stocks.
Note: Correlations and standard deviations are calculated using returns in each countrys own currency; in other words,
they assume that the investor is protected against exchange risk.

Safest means lowest risk; in a portfolio context, this means lowest variance of return.
Half of the portfolio is invested in Alcan stock, and half of the portfolio must be invested
in one of the other securities listed. Thus, we calculate the portfolio variance for six
different portfolios to see which is the lowest. The safest attainable portfolio is
comprised of Alcan and Nestl.

Stocks Portfolio Variance
BP 0.039806
Deutsche 0.068393
Fiat 0.070266
Heineken 0.034557
LVMH 0.070476
Nestl 0.028453



Exercise 22. There are few, if any, real companies with negative betas. But suppose you found
one with = 0.25.


a) How would you expect this stocks rate of return to change if the overall market rose by an
extra 5%? What if the market fell by an extra 5%?

In general, we expect a stocks price to change by an amount equal to (beta change in
the market). Beta equal to 0.25 implies that, if the market rises by an extra 5%, the
expected change in the stocks rate of return is 1.25%. If the market declines an extra
5%, then the expected change is +1.25%.


b) You have $1 million invested in a well-diversified portfolio of stocks. Now you
receive an additional $20,000 bequest. Which of the following actions will yield the
safest overall portfolio return:

i) Invest $20,000 in Treasury Bills (which have =0)
ii) Invest $20,000 in stocks with =1
iii) Invest $20,000 in stocks with =-0.25
4

Explain your answer.

Safest implies lowest risk. Assuming the well-diversified portfolio is invested in
typical securities, the portfolio beta is approximately one. The largest reduction in beta is
achieved by investing the $20,000 in a stock with a negative beta. Answer (iii) is thus
correct.

Exercise 23: See BMA for the question text

Expected portfolio return = x
A
E[R
A
] + x
B
E[R
B
] = 12% = 0.12
Let x
B
= (1 x
A
)
x
A
(0.10) + (1 x
A
) (0.15) = 0.12 x
A
= 0.60 and x
B
= 1 x
A
= 0.40

Portfolio variance = x
A
2

A
2
+ x
B
2

B
2
+2(x
A
x
B

AB

B
)
= (0.60
2
) (20
2
) + (0.40
2
) (40
2
) + 2(0.60)(0.40)(0.50)(20)(40) = 592
Standard deviation = 24.33% 592 = =

5