 Solutions to Problems

1.
Beginning Value Ending Value Return %
2007 $50,000 $55,000 10.0%
2008 $55,000 $58,000 5.5%
2009 $58,000 $65,000 12.1%
2010 $65,000 $70,000 7.7%
Average 8.8%
3. a. Average portfolio return for each year: rp  (wL  rL)  (wM  rM )

Expected
Asset L Asset M Portfolio Return
Year (wL  rL)  (wM  rM)  rp
2012 (14%  0.40  5.6%) (20%  0.60  12.0%)  17.6%
2013 (14%  0.40  5.6%) (18%  0.60  10.8%)  16.4%
2014 (16%  0.40  6.4%) (16%  0.60  9.6%)  16.0%
2015 (17%  0.40  6.8%) (14%  0.60  8.4%)  15.2%
2016 (17%  0.40  6.8%) (12%  0.60  7.2%)  14.0%
2017 (19%  0.40  7.6%) (10%  0.60  6.0%)  13.6%

b. Portfolio return:

 n 
rp    wj  rj   n
 j 1 
17.6  16.4  16.0  15.2  14.0  13.6
rp   15.467
6

n
c. Standard deviation: s p   (r
i=1
p  r )2  (n  1)

s p  [(17.6%  15.5%)2  (16.4%  15.5%)2  (16.0%  15.5%)2

 [(15.2%  15.5%)2  (14.0%  15.5%)2  (13.6%  15.5%)2 ]

6 1

[(2.1%)2  (.9%)2  (.5%)2  ( .3%)2  ( 1.5%)2  ( 1.9%)2 ]

sp 
5

(4.41%  .81%  .25%  .09%  2.25%  3.61%)

sp 
5

11.42
sp   2.284  1.511
5

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 5

 d. The assets are negatively correlated.
e. By combining these two negatively correlated assets, overall portfolio risk is reduced.

n
5. a. Average portfolio return: rp   w j  k j
j 1

Alternative 1: 100% Asset F

16%  17%  18%  19%
rp   17.5%
4
Alternative 2: 50% Asset F  50% Asset G

Portfolio
Asset F Asset G Return
Year (wF  rF)  (wG  rG)  rp
2012 (16%  0.50  8.0%)  (17%  0.50  8.5%)  16.5%
2013 (17%  0.50  8.5%)  (16%  0.50  8.0%)  16.5%
2014 (18%  0.50  9.0%)  (15%  0.50  7.5%)  16.5%
2015 (19%  0.50  9.5%)  (14%  0.50  7.0%)  16.5%

66
rp   16.5%
4
Alternative 3: 50% Asset F  50% Asset H

Asset F Asset H Portfolio

Year (wF  rF)  (wH  rH)  Return rp
2012 (16.0%  0.50  8.0%)  (14%  0.50  7.0%)  15.0%
2013 (17.0%  0.50  8.5%)  (15%  0.50  7.5%)  16.0%
2014 (18.0%  0.50  9.0%)  (16%  0.50  8.0%)  17.0%
2015 (19.0%  0.50  9.5%)  (17%  0.50  8.5%)  18.0%

66
rp   16.5%
4
 n 
b. Standard deviation: sP    (ri  r )2   (n  1)
 i 1 
(1)

[(16.0%  17.5%) 2 + (17.0%  17.5%) 2  (18.0%  17.5%) 2  (19.0%  17.5%)]

sF 
4 1
[(1.5%) 2 + (0.5%)2  (0.5%) 2  (1.5%) 2 ]
sF 
3
(2.25%  0.25%  0.25%  2.25%)
sF 
3
5
sF   1.667  1.291


Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 5

 (2)

[(16.5%  16.5%)2  (16.5%  16.5%)2  (16.5%  16.5%)2  (16.5%  16.5%)]

sFG 
4 1
[(0)2  (0)2  (0)2  (0)2 ]
sFG  0
3
(3)

[(15.0%  16.5%) 2  (16.0%  16.5%) 2  (17.0%  16.5%) 2  (18.0%  16.5%) 2 ]

sFH 
4 1

[( 1.5%) 2  (0.5%) 2  (0.5%) 2  (1.5%) 2 ]

sFH 
3
(2.25%  0.25%  0.25%  2.25%)
sSH 
3
5
sSH   1.667  1.291
3
c. Summary: rp: Average

Portfolio Return rp sp
Alternative 1 (F) 17.5% 1.291
Alternative 2 (FG) 16.5% 0
Alternative 3 (FH) 16.5% 1.291

Since the assets have different average returns, the standard deviation and the correlation patterns
should be used to determine the best portfolio. Alternative 3, the same risk as Alternative 1 and a
lower return (or the same return as Alternative 2 and a lower return), is the worst choice. It is
obviously not on the efficient frontier. Alternative 1 has the highest average return but does not
offer the opportunity to reduce risk. For the investor seeking to eliminate risk, Alternative 2 is the
best choice because its components are perfectly negatively correlated, resulting in a standard
deviation of zero.

7.
2012 2013 2014
Asset A 12 14 16
Asset B 16 14 12
Asset C 12 14 16
Portfolio Return 13.33 14 14.67

Mean return  1/3 (13.33)  1/3(14)  1/3(14.67)  14%

Standard deviation  [(13.33  14)2  (14  14)2  (14.67  14)2 ] / 2
 [0.4489  0  0.4489] / 2
 0.4489  0.67

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 5

 The return would be the same with slightly higher risk. This is because the assets are no longer
perfectly negatively correlated. Two-thirds of the portfolio has one characteristic return pattern,
and one-third of the portfolio is constant over time.

9.

To calculate portfolio returns enter the formula =.5*B2+.5*C2 in cell D2, then copy the formula from
D2 to D11. The annual average annual returns for Home Depot are calculated using the EXCEL
formula =average(B2:B11); for Lowes and the portfolio, copy the formula across columns C and D.

11. Using the table in the solution to problem 9, enter the Excel formula =correl(B2:B11,C2:C11). The
correlation coefficient between returns on Home Depot stock and Lowes stock is 0.3837, which
indicates a weak positive relationship between the returns on these two stocks. 0.3837 is a fairly
typical correlation coefficient for returns on companies in similar lines of business.

13. See screenshot for problem 12.

15. You should buy Buyme because it provides the same return at lower risk (beta).

17. A beta of 1.2 suggests that this security is 20% riskier than the market.

a. If the market increases 15%, the security has an expected return of 1.2(15%) = 18%.

b. If the market increases 8%, the security has an expected return of 1.2(8%) = 9.6%.

c. If the market increases 0%, the security has an expected return of 1.2(0%) = 0%.

19. Because each investment has an equal weight, the portfolio beta is simply 1/3(1.4) + 1/3(0.8) + 1/3(–
.9) = 0.43.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 5

21.
Risk-Free Market
Security Rate Return Beta Ri = rrf + β(rm – rf)
A 5 8 1.3 8.9
B 8 12 0.9 11.6
C 9 12 0.2 9.6
D 10 15 1.0 15.0
E 6 10 0.6 8.4

23. If the risk-free rate is 7% and the market return is 12%:

a. Investment E is the most risky because it has the highest beta, 2.00. Investment D, with a beta of
0, is the least risky.
b. Capital asset pricing model: ri  RF  [bi  (rm  RF)]

Investment ri RF  [bi  (rm  RF)]

A 14.5%  7%  [1.50 (12%  7%)]
B 12%  7%  [1.00 (12%  7%)]
C 10.75%  7%  [0.75 (12%  7%)]
D 7%  7%  [0 (12%  7%)  7%)]
E 17%  7%  [2.00 (12%  7%)]

c. The figure showing the security market line (SML) can be found on the book’s website at
www.pearsonhighered.com/smart.

d. Based on the above graph and the calculations, there is a linear relationship between risk and
return.

25. a. and b.

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 5

 c. Only undiversifiable risk is relevant because, as shown by the graph, diversifiable risk can be
virtually eliminated through holding a portfolio of at least 20 securities that are not positively
correlated. Jack Cashman’s portfolio, assuming diversifiable risk could no longer be reduced by
additions to the portfolio, has 6.47% relevant risk.

27. a.
Stock Beta
Most risky B 1.40
A 0.80
Least risky C 0.30

b. and c.

Increase in Impact on Decrease in Impact on

Stock Beta Market Return Asset Return Market Return Asset Return
A 0.80 0.12 0.096 0.05 0.04
B 1.40 0.12 0.168 0.05 0.07
C 0.30 0.12 0.036 0.05 0.015

d. In a declining market, an investor would choose the defensive stock, Stock C. While the market
declines, the return on C increases.
e. In a rising market, an investor would choose Stock B, the aggressive stock. As the market rises
1 point, Stock B rises 1.40 points.
29. Required returnA  2  [0.935  (12  2)]  2  9.35  11.35
Required returnB  2  [1.11  (12  2)]  2  11.10  13.10

Smart/Gitman/Joehnk, Fundamentals of Investing, 12/e Chapter 5