Chapter 09 – Characterizing Risk and Return
CHAPTER 9 – CHARACTERIZING RISK AND RETURN
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
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 returned about 50 percent more than the cash markets. The risk in
the stock market is also higher than the bond and cash markets according to the standard
LG3 3. How do we define risk in this chapter and how do we measure it?
Risk is defined as the volatility of an asset’s returns over time. Specifically, the standard
LG3 4. What are the two components of total risk? Which component is part of the risk-return
relationship? Why?
LG3 5. What’s the source of firm-specific risk? What’s the source of market risk?
LG3 6. Which company is likely to have lower total risk, General Electric or Coca-Cola? Why?
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LG3 7. Can a company change its total risk level over time? How?
A company can change its risk level over time by changing the mix of business lines it pursues.
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
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.
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
LG5 11. Describe the diversification potential of two assets with a -0.8 correlation. What is the
potential if the correlation is +0.8?
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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
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?
LG5 14. Many employees believe that their employer’s stock is less likely to lose half of its value
than a well diversified portfolio of stocks. Explain why this belief is erroneous.
LG6 15. Explain what we mean when we say that one portfolio dominates another portfolio?
LG6 16. Explain what the efficient frontier is and why it is important to investors.
LG6 17. If an investor’s desired risk level changes over time, should the investor change the
composition of his or her portfolio? How?
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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.
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 200
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?
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LG2 9-3 Investment Return A corporate bond that you own at the beginning of the year is worth
$975. During the year, it pays $35 in interest payments and ends the year valued at $965. What
LG2 9-4 Investment Return A Treasury bond that you own at the beginning of the year is worth
$1,055. During the year, it pays $35 in interest payments and ends the year valued at $1,065.
LG3 9-5 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 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.
LG3 9-6 Total Risk Rank the following three stocks by their total risk level, highest to lowest. Night
Ryder has an average return of 12 percent and standard deviation of 32 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.
LG4 9-7 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.
LG4 9-8 Risk versus Return Rank the following three stocks by their risk-return relationship,
best to worst. Night Ryder has an average return of 12 percent and standard deviation of 32
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Chapter 09 – Characterizing Risk and Return
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.
LG6 9-9 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
15 percent and 17 percent, and for the Purple portfolio are 14 percent and 21 percent.
LG6 9-10 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.
LG7 9-11 Portfolio Weights An investor owns $6,000 of Adobe Systems stock, $5,000 of Dow
Chemical, and $5,000 of Office Depot. What are the portfolio weights of each stock?
LG7 9-12 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?
LG7 9-13 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, 25 percent Valero Energy, and 45 percent McDonalds,
what is your portfolio return?
LG7 9-14 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
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Chapter 09 – Characterizing Risk and Return
have a portfolio made up of 30 percent Yum Brands, 30 percent Raytheon, and 40 percent Coca-
Cola, what is your portfolio return?
intermediate problems
LG1 9-15 Average Return The past five monthly returns for Kohl’s are 4.11 percent, 3.62 percent,
LG1 9-16 Average Return The past five monthly returns for PG&E are -3.17 percent, 3.88 percent,
3.77 percent, 6.47 percent, and 3.58 percent. What is the average monthly return?
LG3 9-17 Standard Deviation Compute the standard deviation of Kohls’ monthly returns shown in
Problem 9-15.
√
(
4 .11 −2. 548
)
2+
(
3. 62 −2 .548
)
2+
(
−1. 68 −2 .548
)
2+
(
9 . 25 −2. 548
)
2+
(
−2. 56 −2. 548
)
2
5−1=4 .81
LG3 9-18 Standard Deviation Compute the standard deviation of PG&E’s monthly returns shown in
Problem 9-16.
√
(
−3 .17 −2 . 906
)
2+
(
3 .88 −2 . 906
)
2+
(
3 .77 −2. 906
)
2+
(
6 . 47 −2 . 906
)
2+
(
3 .58 −2 . 906
)
2
5−1=3 .60
LG2&4 9-19 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 3.88
1970s 1.19
1980s 1.12
1990s 1.35
2000s 1.29
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
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LG2&4 9-20 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 CoV
1950s 0.40
1960s 0.33
1970s 0.29
1980s 0.29
1990s 0.24
2000s 0.68
LG4&5 9-21 Diversifying Consider the characteristics of the following three stocks:
Expected
Return
Standard
Deviation
Thumb
Devices
13% 23%
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 -0.21. The correlation between Air Comfort and Sport Garb is
0.77. If you can pick only two stocks for your portfolio, which would you pick? Why?
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Chapter 09 – Characterizing Risk and Return
LG4&5 9-22 Diversifying Consider the characteristics of the following three stocks:
Expected
Return
Standard
Deviation
Pic Image 11% 19%
Tax Help 9 19
Warm Wear 14 25
The correlation between Pic Image and Tax Help is 0.88. The correlation between Pic Image and
LG7 9-23 Portfolio Weights If you own 200 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?
LG7 9-24 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 = (400 × $17.34) + (500 × $8.15) + (350 × $44.73) = $26,666.50
LG7 9-25 Portfolio Return At the beginning of the month, you owned $5,500 of General
Dynamics, $7,500 of Starbucks, and $8,000 of Nike. The monthly returns for General
Dynamics, Starbucks, and Nike were 7.44 percent, -1.36 percent, and -0.54 percent. What is
your portfolio return?
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LG7 9-26 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. What’s your portfolio return?
advanced problems
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