A B C D E F

1 Tool Kit Chapter 6 11/20/2018

2
3 Risk and Return
4
5 6-1 Investment Returns and Risk
6
7 Amount invested $1,000
8 Amount received in one year $1,100
9 Dollar return (Profit) $100
10 Rate of return = Profit/Investment = 10%
11
12 6-2 Measuring Risk for Discrete Distributions
13
14 The relationship between risk and return is a fundamental axiom in finance. Generally speaking, it is
totally logical to assume that investors are only willing to assume additional risk if they are adequately
15 compensated with additional return. This idea is rather fundamental, but the difficulty in finance arises
16 from interpreting the exact nature of this relationship (accepting that risk aversion differs from investor
17 to investor). Risk and return interact to determine security prices, hence it is of paramount importance
in finance.
18
19
20
21
22 A listing of possible outcomes and their probabilities is called a probability distribution, as shown
23 below.
24
25
26 Scenario Probability of Rate of Return
Scenario in Scenario
27 Best Case 0.30 37%
28 Most Likely 0.40 11%
29 Worst Case 0.30 −15%

30 1.00

31
32
33 Figure 6-1
34 Discrete Probability Distribution for Three Scenarios
35
36 Probability of Scenario
37 Most
38 0.5 Likely
39 0.4 Best
Worst
40 Case Case
41 0.4
42 0.3
43 0.3
44 0.2
45
46 0.2
47 0.1
48 0.1
49 0.0
−15% 11% 37%
Outcomes: Market Returns for 3 Scenarios
 0.3
0.3
0.2
0.2
0.1
0.1
0.0 A B C D E F
50
−15% 11% 37%
51
52 Outcomes: Market Returns for 3 Scenarios
53
54
55
56 Given the probabilities and the outcomes for possible returns, it is possible to calculate the expected
57 return and standard deviation.
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58
59 Figure 6-2
60 Calculating Expected Returns and Standard Deviations: Discrete Probabilities
61 INPUTS: Expected Return Standard Deviation

Product of Deviation from

62 Probability of Market Rate of Probability and Expected Squared
Scenario Return Return Return Deviation
Scenario (1) (2) (3) = (1) × (2) (4) = (2) − D66 (5) = (4)2
63 Best Case 0.30 37% 11.1% 0.2600 0.0676
64 Most Likely 0.40 11% 4.4% 0.0000 0.0000
65 Worst Case 0.30 −15% −4.5% -0.2600 0.0676

66 1.00 Exp. ret. = Sum = 11.0% Sum = Variance =

67 Std. Dev. = Square

root of variance =
68 Note: Calculations are not rounded in intermediate steps.
69
70
71 6-3 Risk in a Continuous Distribution
72
73 It is possible to add more scenarios.
74
Panel A: Panel B:
75 Scenario Probability of Probability of
Market Return Stock Return Rate of Return
Scenario Scenario in Scenario
76 1 0.0002 0.0198 -66%
77 2 0.0011 0.0307 -55%
78 3 0.0054 0.0452 -44%
79 4 0.0205 0.0625 -33%
80 5 0.0575 0.0806 -22%
81 6 0.1201 0.0969 -11%
82 7 0.1870 0.1082 0%
83 8 0.2167 0.1123 11%
84 9 0.1870 0.1082 22%
85 10 0.1201 0.0969 33%
86 11 0.0575 0.0806 44%
87 12 0.0205 0.0625 55%
88 13 0.0054 0.0452 66%
89 14 0.0011 0.0307 77%
90 15 0.0002 0.0198 88%
91 1.0000 1.0000
92
93 Average = 11.0% 11.0%
94 Std. dev. = 20.2% 36.2%
95
96
97 Figure 6-3
98 Discrete Probability Distributions for 15 Scenarios
99 Panel A: Market Return for 15 Scenarios: Standard Devation = 20.2%
100 Probability
0.25

0.20

0.15

0.10

0.05
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Probability
101 0.25
102
103
104 0.20
105
106
107 0.15
108
109
110 0.10
111
112
113 0.05
114
115
116 0.00
117 -66% -55% -44% -33% -22% -11% 0% 11% 22% 33% 44% 55% 66% 77% 88%

118 Outcomes: Market Returns

119
120 Panel B: Single Company's Stock Return for 15 Scenarios: Standard Devation = 36.2%
121
122 Probability
123 0.25
124
125
0.20
126
127
128 0.15
129
130
131 0.10
132
133
134 0.05
135
136
137 0.00
138 -66% -55% -44% -33% -22% -11% 0% 11% 22% 33% 44% 55% 66% 77% 88%

139 Outcomes: Stock Returns

140
141
142
143
144 At some point, it becomes impractical to keep adding scenarios. Many analysts use the normal
145 distribution to estimate stock returns.
146
147 Here is an example of a normal distribution with a similar mean and standard deviation as the discrete
148 distribution shown above.
149
150
151
152 Normal Distribution
153 Probability
0.2500

0.2000

0.1500

0.1000

0.0500

0.0000
 Normal Distribution
A Probability B C D E F
154 0.2500
155
156 0.2000
157
158
159 0.1500
160
161 0.1000
162
163
164 0.0500
165
166 0.0000
167
168 -80% -60% -40% -20% 0% 20% 40% 60% 80% 100%
169 Return
170
171
172
173 6-4 Using Historical Data to Estimate Risk
174
175 Investors often use historical data to estimate risk. This is quite easy in Excel by using the AVERAGE and
176 STDEV functions.
177
178
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179
180 Standard Deviation Based On a Sample of Historical Data
181 Inputs: Realized
182 Year return
183 2017 15.0%
184 2018 −5.0%
185 2019 20.0%
186 Calculations:
187 =AVERAGE(E183:E185) 10.0%
188 =STDEV(E183:E185) 13.2%
189
190
191
192
193 Measuring the Standard Deviation of MicroDrive
194
195 The monthly stock returns for MicroDrive and one of its competitors, SnailDrive, during the past 48
months are shown in the figure below. The actual data are below the figure.
196
197
198
199 Figure 6-5
200 Historical Monthly Stock Returns for MicroDrive and SnailDrive
201
202 Monthly Rate of Return MicroDrive
203
40%
204
205 SnailDrive
30%
206
207
20%
208
209
10%
210
211
0%
212
213
-10%
214
215
-20%
216
217
218 -30%
219
220 -40%
221 0 6 12 18 24 30 36 42 48
Month of Return
222
223 MicroDrive SnailDrive
224 Average Return (annualized) 12.0% 9.3%
225 Standard Deviation (annualized) 51.8% 34.2%
226
227
228 Portfolio weights
229 SnailDrive:
230 MicroDrive:
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231 Period Market MicroDrive SnailDrive
232 1 2.37% 2.81% 14.93%
233 2 12.68% 14.79% −3.26%
234 3 −1.13% 0.79% −10.57%
235 4 10.93% 8.71% −10.76%
236 5 −0.02% 0.83% 9.71%
237 6 −3.31% −32.42% 6.40%
238 7 11.89% 22.56% 0.26%
239 8 −3.96% −24.21% 0.52%
240 9 −4.90% 8.00% −8.67%
241 10 7.10% −1.29% 21.62%
242 11 2.94% 4.43% 3.87%
243 12 −6.52% −6.36% 5.00%
244 13 3.72% 11.79% −12.32%
245 14 4.74% 21.32% −2.43%
246 15 −8.21% −10.28% 4.87%
247 16 −5.15% 3.96% −17.85%
248 17 3.92% 34.98% −10.89%
249 18 1.08% 2.56% −16.68%
250 19 −2.48% −10.80% 9.02%
251 20 3.92% −6.70% 22.60%
252 21 3.13% −2.31% 14.25%
253 22 0.17% 8.26% −7.68%
254 23 5.17% 0.51% −2.52%
255 24 2.56% −14.61% 9.32%
256 25 −5.41% −4.56% −1.38%
257 26 −2.09% −12.08% 13.92%
258 27 1.08% 31.68% 3.91%
259 28 10.47% 4.43% 8.91%
260 29 −3.74% 0.32% −3.76%
261 30 2.94% 4.59% −3.95%
262 31 −9.50% 2.08% −1.43%
263 32 −3.10% −15.49% −6.38%
264 33 7.95% 32.39% 12.00%
265 34 10.93% 15.15% −2.00%
266 35 −1.70% −3.72% −12.51%
267 36 −3.96% −15.40% −0.49%
268 37 5.17% −12.67% 9.91%
269 38 −0.75% −10.43% −8.21%
270 39 −9.04% −7.14% −11.27%
271 40 −9.50% −4.85% −10.32%
272 41 4.74% 8.15% 9.19%
273 42 −0.38% −14.72% −0.43%
274 43 4.32% 32.45% 0.99%
275 44 −1.89% −28.34% 3.96%
276 45 −3.96% −5.55% −8.50%
277 46 6.58% 5.81% 16.10%
278 47 −1.32% 4.02% 8.86%
279 48 4.74% 4.38% 1.30%
280 Full 48 Months Market MicroDrive SnailDrive
281 Average monthly return: 0.9% 1.00% 0.77%
282 Standard deviation of monthly returns: 5.7% 14.94% 9.87%
283 Average return (annual): 10.8% 12.0% 9.3%
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284 Standard deviation (annual): 19.9% 51.8% 34.2%
285 Maximum of monthly returns: 12.7% 34.98% 22.60%
286 Minimum of monthly returns: -9.5% -32.42% -17.85%
287 Past 12 Months Month Market MicroDrive SnailDrive
288 37 5.2% -12.7% 9.9%
289 38 -0.8% -10.4% -8.2%
290 39 -9.0% -7.1% -11.3%
291 40 -9.5% -4.9% -10.3%
292 41 4.7% 8.1% 9.2%
293 42 -0.4% -14.7% -0.4%
294 43 4.3% 32.4% 1.0%
295 44 -1.9% -28.3% 4.0%
296 45 -4.0% -5.6% -8.5%
297 46 6.6% 5.8% 16.1%
298 47 -1.3% 4.0% 8.9%
299 48 4.7% 4.4% 1.3%
300 Past 12 Months Market MicroDrive SnailDrive
301 Average monthly return: -0.11% -2.41% 0.97%
302 Average return (annual): -1.3% -28.9% 11.6%
303 Standard deviation (annual): 18.9% 52.4% 31.4%
304 Total compound return: -2.9% -34.3% 7.3%
305
306
307
308 6-5 Risk in a Portfolio Context
309
310 Now we are going to analyze the risk of a portfolio instead of the stand-alone risk of individual assets.
311
312
313 Creating a Portfolio
314
315
Look at the data for MicroDrive and SnailDrive shown above. The last column shows a portfolio with the
316 weights shown below. Here are the results for the two companies and for the portfolio. Notice that the
317 portfolio has a higher return than SnailDrive and less risk than either of the two stocks.
318
319
320
321 Portfolio weights
322 SnailDrive: 75%
323 MicroDrive: 25%
324
325 Full 48 Months Market MicroDrive SnailDrive
326 Average monthly return: 0.9% 1.0% 0.8%
327 Standard deviation of monthly returns: 5.7% 14.9% 9.9%
328 Average return (annual): 10.8% 12.0% 9.3%
329 Standard deviation (annual): 19.9% 51.8% 34.2%
330
331
332 Correlation
333
334 Loosely speaking, correlation measures the tendency of two variables to move together.
335
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336 Correlation between MicroDrive and SnailDrive:
337 r= -0.133 =CORREL(E232:E279,F232:F279)
338
339
340 6-6 The Relevant Risk of a Stock: The Capital Asset Pricing Model (CAPM)
341
342 The Capital Asset Pricing Model (CAPM) provides a measure of risk.
343
344 Contribution to Market Risk: Beta
345
346 The relevant risk of an individual stock as defined by its beta. Beta measures how much risk a stock
347 contributes to a well-diversified portfolio.
348
349 Beta for Stock i = bi = riM(si/sM)
350
351 A portfolio's beta is the weighted average of the stock's individual betas. Consider the following
352 example.
353
354 Contribution of
355 Weight in Stock to
356 Stock Beta: Portfolio: Portfolio Beta:
357 bi wi bi x wi x sM
358 Stock 1 0.6 25.0% 0.150
359 Stock 2 1.2 25.0% 0.300
360 Stock 3 1.2 25.0% 0.300
361 Stock 4 1.4 25.0% 0.350
362 Portfolio beta = 1.100
363
364 The standard deviation of a well-diversified portfolio is:
365
366 Std. Dev. of portfolio = sp = bp (sM) Note: if the bp is negative, then σp = |bp| (σM).
367
368 If the example portfolio had more than 4 stocks and was well-diversified, then its standard deviation
369 would be:
370
371 Beta of portfolio = bp = 1.1

372 Std. Dev. of market = sM = 20%

373 Std. Dev. of portfolio = sp = 22%
374
375
376 Figure 6-7
377 The Contribution of Individual Stocks to Portfolio Risk: The Effect of Beta
378
379 Portfolio standard deviation = 22%
380
b1w
b4w 1s
381
4s M=
382
M= 3.0
7.0 %
% b2w
2s
M=
6.0
b3w %
3s
M=
6.0
 Portfolio standard deviation = 22%
b1w
b4w 1s
4s M=
A B M= C 3.0 D E F
383 7.0 %
384 % b2w
385 2s
386 M=
387 6.0
388
b3w %
389
3s
390 M=
391 6.0
392 %
393
394
395 Market standard deviation = sM = 20.0%
396
397 Contribution of Contribution of
398 Weight in Stock to Stock to
399 Stock Beta: Portfolio: Portfolio Beta: Portfolio Risk:
400 bi wi bi x wi bi x wi x sM
401 Stock 1 0.6 25.0% 0.150 3.0%
402 Stock 2 1.2 25.0% 0.300 6.0%
403 Stock 3 1.2 25.0% 0.300 6.0%
404 Stock 4 1.4 25.0% 0.350 7.0%
405 1.100 22.0%
406
407
408 Estimating Beta
409
410 We can use the data shown previously for MicroDrive and SnailDrive to estimate their betas.
411
412
413 Calculating Beta Market MicroDrive SnailDrive
414 Standard deviation (annual): 19.89% 51.75% 34.17%
415 Correlation with the market: 0.511 0.264
416 bi = riM(si/sM) 1.330 0.454
417
418 Beta can also be calculated as the slope of a regression of the stock (on the y-axis) and the market (on
419 the x-axis). This can be done using the SLOPE function or by plotting the returns and specifying that the
chart show the TRENDLINE.
420
421
422 Calculating Beta as the Slope of a Regression Using Excel Functions (See Excel explanations to right)

423 MicroDrive SnailDrive

424 bi = riM(si/sM) 1.330 0.454
425 Intercept -0.002 0.004
 A B C D E F
426 R squared 0.261 0.070

427 Calculating Confidence Intervals using Excel Functions

428 Input desired probability for confidence interval 95% 95%
429 Lower boundary of confidence interval for beta 0.666 -0.037
430 Upper boundary of confidence interval for beta 1.994 0.946
431 Lower boundary of confidence interval for intercept -0.040 -0.025
432 Upper boundary of confidence interval for intercept 0.036 0.032
433
434
435 Figure 6-8
436 Stock Returns of MicroDrive and the Market: Estimating Beta
437
438 y-axis: Historical
439 MicroDrive Returns
440
441
442 35%
443
444
445 f(x) = 1.32999971632459 x − 0.002005742168358
446 R² = 0.261161438456474
447
448
449
450
451
452
453
454
455 −35% 35%
456
457 x-axis: Historical
458 Market Returns
459
460
461
462
463
464
465
466
467 −35%
468
469
470
471
 A B C D E F
472
473 EXAMPLE: CALCULATING BETA COEFFICIENTS FOR AN ACTUAL COMPANY
474
475 Now we show how to calculate beta for an actual company, General Electric.
476
477 Step 1. Retrieve Data
478
479 We downloaded stock prices and dividends from http://finance.yahoo.com for General Electric, using its
ticker symbol GE, and for the S&P 500 Total Retun Index ( symbol ^SP500TR), which is an index
480 incorporating the prices and dividends of the 500 companies listed in the S&P 500, which tracks 500
481 actively traded large stocks. For example, to download the GE data, enter its ticker symbol in the upper
482 left section and click Go. Then select Historical Prices from the upper left side of the new page. After the
483 daily prices come up, click monthly prices, enter a start and stop date, and click "Get Prices." When
presenting monthly data, the date shown is for the first date in the month, but the data are actually for the
484 last day of trading in the month, so be alert for this. Note that these prices are "adjusted" to reflect any
485 dividends or stock splits. Scroll to the bottom of the page and click "Download to Spreadsheet."
486
487
488 The downloaded data are in csv format. Convert to xlsx by opening a new Excel worksheet, copying the
489 date and adjusted index price data to it, and saving as an xlsx file. Then repeat the process to get the S&P
490 index data. At this point you have returns data for GE and the S&P 500 Total Return Index, as we show
below.
491
492
493 Step 2. Calculate Returns
494 Next, calculate the percentage change in adjusted prices (which already reflect dividends) for GE and
495 the S&P to obtain returns, with the spreadsheet set up as shown below.
Yahoo actually adjusts the stock prices to reflect any stock splits or dividend payments. For example,
496 suppose the stock price is $100 in July, the company has a 2-for-1 split, and the actual price in August is
497 $60. The reported adjusted price for August would be $60, but the reported price for July would be $50,
498 which reflects the stock split. This gives an accurate stock return of 20%: ($60-$50)/$50 = 20%, the
same as if there had not been a split, in which case the return would have been ($120-$100)/$100 =
499 20%.
500 Or suppose the actual price in September is $50, the company pays a $10 dividend, and the actual
501 price in October is $60. Shareholders have had a return of ($60+$10-$50)/$50 = 40%. Yahoo reports an
adjusted price of $60 for October, and an adjusted price of $42.857 for September, which gives a return
502 of ($60-$42.857)/$42.857 = 40%.
503 In other words, the percent change in the adjusted price accurately reflects the actual return.
504
505
506
507
508 At this point, we are ready to calculate some statistics and to find GE's beta coefficient. This is shown
509 below the data.
510
511
512 Not in Textbook: Stock Return Data for GE and the S&P 500 Total Return Index

513 Market Level

(S&P 500 Total GE Adjusted
Return Index) Market's Stock Price at GE's
Month at Month End Return Month End Return
514 November 2017 5,155.44 3.1% $18.29 -9.3%
515 October 2017 5,002.03 2.3% $20.16 -15.8%
516 September 2017 4,887.97 2.1% $23.94 -1.5%
517 August 2017 4,789.18 0.3% $24.31 -4.1%
518 July 2017 4,774.56 2.1% $25.36 -4.4%
519 June 2017 4,678.36 0.6% $26.52 -1.4%
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520 May 2017 4,649.34 1.4% $26.88 -5.6%
521 April 2017 4,584.82 1.0% $28.46 -2.7%
522 March 2017 4,538.21 0.1% $29.26 0.8%
523 February 2017 4,532.93 4.0% $29.04 0.4%
524 January 2017 4,359.81 1.9% $28.93 -5.3%
525 December 2016 4,278.66 2.0% $30.55 2.7%
526 November 2016 4,195.73 3.7% $29.74 5.7%
527 October 2016 4,045.89 -1.8% $28.13 -1.0%
528 September 2016 4,121.06 0.0% $28.41 -5.2%
529 August 2016 4,120.29 0.1% $29.97 0.3%
530 July 2016 4,114.51 3.7% $29.87 -0.3%
531 June 2016 3,968.21 0.3% $29.97 4.1%
532 May 2016 3,957.95 1.8% $28.78 -1.7%
533 April 2016 3,888.13 0.4% $29.28 -3.3%
534 March 2016 3,873.11 6.8% $30.27 10.0%
535 February 2016 3,627.06 -0.1% $27.52 0.1%
536 January 2016 3,631.96 -5.0% $27.49 -5.9%
537 December 2015 3,821.60 -1.6% $29.20 4.0%
538 November 2015 3,882.84 0.3% $28.07 3.5%
539 October 2015 3,871.33 8.4% $27.11 15.7%
540 September 2015 3,570.17 -2.5% $23.43 0.8%
541 August 2015 3,660.75 -6.0% $23.24 -4.2%
542 July 2015 3,895.80 2.1% $24.25 -0.9%
543 June 2015 3,815.85 -1.9% $24.48 -2.6%
544 May 2015 3,891.18 1.3% $25.13 0.7%
545 April 2015 3,841.78 1.0% $24.95 9.1%
546 March 2015 3,805.27 -1.6% $22.86 -3.7%
547 February 2015 3,866.42 5.7% $23.73 8.8%
548 January 2015 3,656.28 -3.0% $21.81 -4.6%
549 December 2014 3,769.44 -0.3% $22.86 -4.6%
550 November 2014 3,778.96 2.7% $23.96 2.6%
551 October 2014 3,679.99 2.4% $23.34 1.6%
552 September 2014 3,592.25 -1.4% $22.98 -1.4%
553 August 2014 3,643.33 4.0% $23.30 3.3%
554 July 2014 3,503.19 -1.4% $22.56 -3.5%
555 June 2014 3,552.18 2.1% $23.38 -1.9%
556 May 2014 3,480.29 2.3% $23.83 -0.4%
557 April 2014 3,400.46 0.7% $23.92 3.9%
558 March 2014 3,375.51 0.8% $23.03 2.5%
559 February 2014 3,347.38 4.6% $22.46 1.4%
560 January 2014 3,200.95 -3.5% $22.16 -9.6%
561 December 2013 3,315.59 2.5% $24.52 5.1%
562 November 2013 3,233.72 NA $23.32 NA
563
564 Description of Data
565 Average return (annual): 12.2% -4.3%
566 Standard deviation (annual): 9.6% 18.7%
567 Minimum monthly return: -6.0% -15.8%
568 Maximum monthly return: 8.4% 15.7%
569 Correlation between GE and the market: 0.51
570 Beta: bGE = rGE,M (sGE / sM) 0.99
571
572 Beta (using the SLOPE function): 0.99
 A B C D E F
573 Intercept (using the INTERCEPT function): -0.01
574 R2 (using the RSQ function): 0.26
575
576
 A B C D E F
577 Step 3. Examine the Data and Calculate Beta
578
579 Using the AVERAGE function and the STDEV function, we found the average historical
return and standard deviation for GE and the market. (We converted these from
580 monthly figures to annual figures. Notice that you must multiply the monthly standard
581 deviation by the square root of 12, and not 12, to convert it to an annual basis.) These
582 are shown in the rows above. We also used the CORREL function to find the correlation
between GE and the market. We used the SLOPE, INTERCEPT, and RSQ functions to
583 estimate the regression for beta.
584
585
586
587 6-7 The Relationship between Risk and Return in the Capital Asset Pricing Model
588
589 The SML shows the relationship between the stock's beta and its required return, as predicted by the CAPM.
590
591 rRF 6% << Varies over time, but is constant for all firms at a given time.
592 rM 11% << Varies over time, but is constant for all firms at a given time.
593 bi 0.5 << Varies over time, and varies from firm to firm.
594
595 The SML predicts stock i's required return to be:
596
597 RPM = rM - rRF
598 ri = rRF + bi(RPM)
599
600 RPM = rM - rRF = 5%
601
602 ri = rRF + bi(RPM) 8.5%
603
604 With the above data, we can generate a Security Market Line that is flexible enough to allow for changes in
605 any of the input factors. We generate a table of values for beta and expected returns, and then plot the
606 graph as a scatter diagram.
607
608
Security Market Risk-Free Rate
609 Line: ri
Beta
610 0.00 6.0% 6%
611 0.50 8.5% 6%
612 1.00 11.0% 6%
613 1.50 13.5% 6%
614 2.00 16.0% 6%
615
 A B C D E F
616 Figure 6-9
617 The Security Market Line
618
619
620
621 Required Return
622
623 18%
624
625
626
627
628
629 12%
630
631
632
633
634
6%
635
636
637
638
639
640 0%
641 0.00 0.50 1.00 1.50 2.00 2.50
642
643 Beta
644
645
646
The Security Market Line shows the projected changes in expected return, due to changes in the beta
647 coefficient. However, we can also look at the potential changes in the required return due to variations
648 in other factors, for example the market return and risk-free rate. In other words, we can see how
649 required returns can be influenced by changing inflation and risk aversion. The level of investor risk
aversion is measured by the market risk premium (r M – rRF), which is also the slope of the SML. Hence, an
650
increase in the market return results in an increase in the maturity risk premium, other things held
651 constant.
652
653
654
655 Portfolio Returns
656
657 The same relationship holds for required returns: The required return on a portfolio is simply a
658 weighted average of the required returns of the individual assets in the portfolio. The weights are the
659 percentage of total portfolio funds invested in each asset. The required return on a portfolio is also
equal to:
660
661
662 rp = rRF + bp(RPM)
663
664
665 The expected return on a portfolio is simply a weighted average of the expected returns of the individual
666 assets in the portfolio. The weights are the percentage of total portfolio funds invested in each asset.
667 Consider the following portfolio and the hypothetical illustrative returns data.
 A B C D E F
668
669
670
Amount of Portfolio Expected Weighted
671 Stock
Investment Weight Return
Expected
Return
672 Southwest Airlines $300,000 0.3 15.0% 4.5%
673 Starbucks $100,000 0.1 12.0% 1.2%
674 FedEx $200,000 0.2 10.0% 2.0%
675 Dell $400,000 0.4 9.0% 3.6%
676 Total investment = $1,000,000 1.0
677
678 Portfolio's Expected Return = 11.3%

679
680
681 6-8 The Efficient Markets Hypothesis
682
683 The Efficient Markets Hypothesis (EMH) asserts that (1) stocks are always in equilibrium and (2) it is
684 impossible for an investor to “beat the market” and consistently earn a higher rate of return than is
685 justified by the stock’s risk.
686
687
688 6-9 The Fama-French Three-Factor Model
689
690 The Fama-French 3-Factor model shows the actual stock return given the risk-free rate, the return on
691 the market, the return on the SMB portfolio, and the return on the HML portfolio:
692
693
694
695
696
697 Suppose a company announces that it is going to include more outsiders on its board of directors and
698 that the company’s stock falls by 2% on the day of the announcement. Does that mean that investors
699 don’t want outsiders on the board?
700
701 Actual return on announcement day = -2%
702
703 Suppose you estimate the following coefficients of the Fama-French model using historical actual data
704 prior to the announcement date:
705
706 ai = 0.0
707 bi = 0.9
708 c i
= 0.2
709 di = 0.3
710
711 These are the returns on the announcement day:
712
713 rRF ≈ 0.0%
714 r M
= -3.0%
 A B C D E F
715 rSMB = -1.0%
716 rHML = -2.0%
717
718 The predicted return on the announcement day:
719
720 Predicted return = rRF,t + ai + bi(rM,t - rRF,t) + ci(rSMB,t) + di(rHML,t)
721 Predicted return = -3.5%
722
723 Unexplained return = Actual return - predicted return
724 Unexplained return = 1.5%
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Standard Deviation

62
Prob. × Sq. Dev.
(6) = (1) × (5)
63 0.0203
64 0.0000
65 0.0203

66 0.0406

67
20.1%
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227 Weights are specified in Section 6-5.
228
Portfolio weights
229 75%
230 25%
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231 Portfolio
232 11.90%
233 1.25%
234 −7.73%
235 −5.89%
236 7.49%
237 −3.30%
238 5.83%
239 −5.66%
240 −4.50%
241 15.89%
242 4.01%
243 2.16%
244 −6.29%
245 3.51%
246 1.08%
247 −12.40%
248 0.57%
249 −11.87%
250 4.07%
251 15.28%
252 10.11%
253 −3.69%
254 −1.76%
255 3.34%
256 −2.17%
257 7.42%
258 10.85%
259 7.79%
260 −2.74%
261 −1.82%
262 −0.55%
263 −8.65%
264 17.10%
265 2.28%
266 −10.31%
267 −4.22%
268 4.27%
269 −8.76%
270 −10.24%
271 −8.96%
272 8.93%
273 −4.00%
274 8.85%
275 −4.12%
276 −7.77%
277 13.52%
278 7.65%
279 2.07%
280 Portfolio
281 0.8%
282 7.8%
283 10.0%
 G
284 27.1%
285 17.1%
286 -12.4%
287 Portfolio
288 4.3%
289 -8.8%
290 -10.2%
291 -9.0%
292 8.9%
293 -4.0%
294 8.9%
295 -4.1%
296 -7.8%
297 13.5%
298 7.7%
299 2.1%
300 Portfolio
301 0.12%
302 1.5%
303 29.1%
304 -2.4%
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325 Portfolio
326 0.8%
327 7.8%
328 10.0%
329 27.1%
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if the bp is negative, then σp = |bp| (σM).
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400 Category Labels for chart.
401 b1w1sM
402 b2w2sM
403 b3w3sM
404 b4w4sM
405 b5w5sM
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424 =SLOPE(F232:F279,$D$232:$D$279)
425 =INTERCEPT(F232:F279,$D$232:$D$279)
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426 =RSQ(F232:F279,$D$232:$D$279)

427
428
429 See explanation to right.
430 See explanation to right.
431 See explanation to right.
432 See explanation to right.
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urn, as predicted by the CAPM.
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604 in
nough to allow for changes
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SECTION 6-1
SOLUTIONS TO SELF-TEST

Suppose you pay $500 for an investment that returns $600 in one year. What is the
annual rate of return?

Amount invested $500

Amount received in one year $600

Dollar return $100

Rate of return 20%

SECTION 6-2
SOLUTIONS TO SELF-TEST

An investment has a 20% chance of producing a 25% return, a 60% chance of producing a 10% return,
and a 20% chance of producing a -15% return. What is its expected return? What is its standard
deviation?

Probability Return Prob x Ret.

20% 25% 5.0%
60% 10% 6.0%
20% -15% -3.0%
Expected return = 8.0%

Alternatively, use the Excel SUMPRODUCT function, which will multiply each value in the first array be
the corresponding value in the next array, and the sum them. This is exactly the calculation shown in the
step-by-step manner above:

Expected return = 8.0%

Deviation
from
expected
Probability Return return Deviation2 Prob x Dev.2
20% 25% 17.0% 2.890% 0.578%
60% 10% 2.0% 0.040% 0.024%
20% -15% -23.0% 5.290% 1.058%
Variance = 0.01660
Standard deviation = 12.9%

Alternatively, use the Excel SUMPRODUCT function, which will multiply each value in the first array be
the corresponding value in the next array, and the sum them. If the first array has probabilities and the
second array subtracts the mean from the array of outcomes and is squared, then this is exactly the
calculation shown in the step-by-step manner above to find variance:

Variance = 0.01660
Standard deviation = 12.9%
SECTION 6-4
SOLUTIONS TO SELF-TEST

A stock’s returns for the past three years are 10%, -15%, and 35%. What is the historical average
return? What is the historical sample standard deviation?

Realized
Year return
1 10%
2 -15%
3 35%

Average = 10.0%
Standard deviation = 25.0%
SECTION 6-5
SOLUTIONS TO SELF-TEST

Stock A's returns the past five years have been 10%, −15%, 35%, 10%, and −20%. Stock B's returns
have been −5%, 1%, −4%, 40%, and 30%. What is the correlation coefficient for returns between
Stock A and Stock B?

Realized Returns
Year Stock A Stock B
1 10% -5%
2 -15% 1%
3 35% -4%
4 10% 40%
5 -20% 30%

Average = 4.0% 12.4%

Standard deviation = 22.2% 21.1%

Correlation between Stock A and Stock B: -0.35

SECTION 6-6
SOLUTIONS TO SELF-TEST

An investor has a 3-stock portfolio with $25,000 invested in Apple, $50,000 invested in Ford, and $25,000
invested in Walmart. Dell’s beta is estimated to be 1.20, Ford’s beta is estimated to be 0.80, and
Walmart's beta is estimated to be 1.0. What is the estimated beta of the investor’s portfolio?

Stock Investment Beta Weight Beta x Weight

Apple $25,000 1.2 0.25 0.30
Ford $50,000 0.8 0.50 0.40
Walmart $25,000 1.0 0.25 0.25
Total $100,000
Portfolio beta = 0.95
SECTION 6-7
SOLUTIONS TO SELF-TEST

A stock has a beta of 0.8. Assume that the risk-free rate is 5.5% and that the market risk premium is 6%.
What is the stock’s required rate of return?

Beta 0.8
Risk-free rate 5.5%
Market risk premium 6.0%

Required rate of return 10.30%

SECTION 6-9
SOLUTIONS TO SELF-TEST

An analyst has modeled the stock of a company using a Fama-French three-factor model and has estimate that a i = 0, bi = 0.7, ci = 1.2, and di =
0.7. Suppose the daily risk-free rate is approximately equal to zero, the market return is 11%, the return on the SMB portfolio is 3.2%, and the
return on the HML portfolio is 4.8% on a particular day. The stock had an actual return of 16.9% on that day. What is the stock's predicted
return for that day? What is the stock’s unexplained return for the day?

ai 0.0%
bi 0.70
ci 1.20
di 0.70

Actual stock return 16.9%

Risk-free rate 0.0%
Market return 11.0%
SMB return 3.2%
HML return 4.8%

Predicted return 14.90%

Unexplained return 2.00%

 = 0.7, ci = 1.2, and di =
ortfolio is 3.2%, and the
he stock's predicted