ASSIGNMENT 2

Name:
ERP ID:
Course:

Saif Ali Momin

08003
Business Finance II

Solution
Coefficient of Variation COV = Risk / Return = /
for Stock D
COV = 8/10 = 0.8
for Stock E
COV = 24/36 = 0.67
Hence, Stock D has greater risk per unit of return than Stock E

Solution
= = 1.8
= = 16%
= = 10%
= ?
We know from CAPM
= + ( )
16% = + (10% )1.8
= . %

Solution
a. Expected rate of return for Stock Y
= (35 0.1) + (0 0.2) + (20 0.4) + (25 0.2) + (45 0.1) = 14%
b.
Standard Deviation for Stock X
Expected Return
Average Return
-10
12
2
12
12
12
20
12
38
12

(Variance)2
484
100
0
64
676

Probability
0.1
0.2
0.4
0.2
0.1

(Variance)2 x Probability
48.4
20
0
12.8
67.6
Sum = 100.4

(Variance)2
2401
196
36
121
961

Probability
0.1
0.2
0.4
0.2
0.1

(Variance)2 x Probability
240.1
39.2
14.4
24.2
96.1
Sum = 414

= 100.4 = 10.02
10.02
= =
= 0.835

12
Standard Deviation for Stock Y
Expected Return
Average Return
-35
14
0
14
20
14
25
14
45
14
= 414 = 20.35
20.35
= =
= 1.453

14
With the above mentioned probabilities it would not be possible to regard Stock Y as less risky. However, if other
investors have more sample data and have different probabilities than mentioned which might reduce its COV.

Solution
Portfolio: $7,500 in each 20 different common stock
= 1.12
7500
= =
= 0.05
7500 20
Sold a stock for $7,500 having 1 = 1
= 1.75
= 1 1 + 2 2 + + 20 20
since weightage is same for all stocks
= (1 + 2 + + 20 )
1.12 = 0.05(1 + 2 + + 20 )
2 + 3 + + 20 = 21.4
Now adding stock of $7,500 with new beta
= ( + 2 + + 20 )
= 0.05(1.75 + 21.4)
= .

Solution
a. Expected value of gamble
There is 50/50 chance of getting head or tail if coin if flipped once.
So, Expected value = 50% x $1,000,000 + 50% x $0 = $500,000
b. I would prefer to take sure $500,000 because in gamble there is a chance of getting nothing.
c. I am a risk averter based on my choice of not to gamble
d. 1) Expected dollar profit on stock investment, considering 50/50 chance of worthless
Expected profit on stock = 50% x $(1,150,000 500,000) + 50% x $( 500,000) = $75,000
d. 2) Expected rate of return on stock investment
Expected rate of return on stock = 75,000 / 500,000 = 15%
d. 3) Considering the returns and 50% risk of loss associated with stock I would invest in T-bond to make my investment
secure
d. 4) It would depend upon the risk taken. I would prefer to take more than 15% (more than twice of the T-bond)
d. 5) If all stocks lose at the same time and profit at the same time then there is no change in the return as shown below,
(50% x $(11,500 5,000) + 50% x $(5,000) x 100 = $75,000

If we consider half of the stocks position are positively correlated with market and other negatively, then it would
reduce the risk of complete loss in case of all stocks get worthless at year end. This would make sure that at least half of
the expected return (75,000/2 = $37,500) is always there at the year end.
So, correlation here will definitely matter in portfolio of different stocks.

Solution
a. Average rate of return for each stock
Stock A
18 + 33 + 15 .5 + 27
=
= 11.3%
5
Stock B
14.5 + 21.8 + 30.5 7.6 + 26.3
=
= 11.3%
5
b. Realized Return for both stock with 50/50 weightage
= 50% + 50% = 0.5 11.3 + 0.5 11.3 = 11.3%

c. & d. Standard Deviation and COV for both stocks and for portfolio
Stock A
Year

Stock A
Returns

2004
2005
2006
2007
2008

Average
Return

-18
33
15
-0.5
27

11.3
11.3
11.3
11.3
11.3

(Variance)2
858.49
470.89
13.69
139.24
246.49
Sum 1728.8

= 1728.8 = 41.58
41.58
= =
= 3.679

11.3
Stock B
Year
2004
2005
2006
2007
2008

Average
Stock B
Return
Returns
-14.5
11.3
21.8
11.3
30.5
11.3
-7.6
11.3
26.3
11.3

(Variance)2
665.64
110.25
368.64
357.21
225
Sum 1726.74

= 1725.74 = 41.55
41.55
= =
= 3.677

11.3
Portfolio

Year
2004
2005
2006
2007
2008

Stock A
Stock B
Portfolio Returns
Returns
Returns
50% + 50%
-18
-14.5
-16.25
33
21.8
27.4
15
30.5
22.75
-0.5
-7.6
-4.05
27
26.3
26.65

Average
Return
11.3
11.3
11.3
11.3
11.3

(Variance)2
759.0025
259.21
131.1025
235.6225
235.6225
Sum 1620.56

= 1620.56 = 40.26
40.26
= =
= 3.562

11.3
e. If I am risk averse I will prefer Portfolio investment. As the risk per unit return i.e. COV is somewhat less than
individual COVs for Stock A and Stock B. However, there is not a huge gap between COVs calculated above so other
options are also good.