BFW2631

FINANCIAL MANAGEMENT
TUTORIAL SET 7 - SOLUTIONS
RISK AND RETURN
IMPORTANT: The questions that we encounter within the tutorial set throughout the
semester are an indication of the standard that you will face in the final examination. You are
required to attempt all tutorial questions on your own prior to attending class.
Question One
Mr. Henry can invest in Highbull shares and Slowbear shares. His projection of the returns on these
two shares based on the state of the economy are given as follows:
State of
Economy
Recession
Normal
Boom
a)
b)
c)
d)

Probability of
State Occurring
0.25
0.60
0.15

Return on
Highbull Stock (%)
-2
9.2
15.4

Return on
Slowbear Stock (%)
5
6.2
7.4

Calculate the expected return on each share.

Calculate the standard deviation of returns on each share.
Calculate the covariance and correlation between the returns on the two shares.
Create an equally weighted portfolio and calculate the expected return and standard
deviation for this portfolio.

Solution
a.

E(RHB) = (0.25)(-2) + (0.60)(9.2) + (0.15)( 15.4)

= 7.33%
The expected return on Highbulls share is 7.33%.
E(RSB) = (0.25)(5) + (0.60)(6.2) + (0.15)(7.4)
= 6.08%
The expected return on Slowbears share is 6.08%.

b.

VarianceA (HB) = (0.25)(-2 7.33)2 + (0.60)(9.2 7.33)2 + (0.15)(15.4 7.33)2

= 33.63
Standard DeviationA (HB) = (33.631/2 = 5.80%
The standard deviation of the returns on Highbulls share is 5.80%.
VarianceB (SB) = (0.25)(5 6.08)2 + (0.60)(6.2 6.08)2 + (0.15)(7.4 6.08)2
= 0.56
Standard DeviationB (SB) = (0.56)1/2= 0.75%
The standard deviation of the returns on Slowbears share is 0.75%.
1

c. Covariance(RHB, RSB)

HB,SB = (0.25)(-2 7.33)(5 6.08) + (0.60)(9.2 7.33)(6.2 6.08)+(0.15)(15.4 7.33) (7.4 6.08)
= 4.25

The covariance between the returns on Highbull shares and Slowbear shares
returns is 4.25
Correlation r

= Covariance(RHB, RSB) / (HB * SB)

= 4.25/ (5.8 x0.75))
= 0.9770

HB,SB

The correlation between the returns on Highbulls share and Slowbears share
is 0.9770.
d.

Expected Return on a portfolio with 50% Highbull and 50% Slowbear,

so E(RP)= (0.5)( 7.33) + (0.5)(6.08) = 6.71%
Standard Deviation of a Portfolio with 50% Highbull and 50% Slowbear
2P

= (HB2wHB2)+ (SB2wSB2)+2HBSBwHBwSB rHB,SB

= (0.5025.82)+(0.5020.752) + 20.500.505.80.750.9770
= 10.6756

10.6756 = 3.27%

Question Two
The following table provides a sample of the last six monthly percentage price changes for two
market indexes. You are encouraged to make use of the statistical functionality available with your
calculator when answering this question.
Month
1
2
3
4
5
6

Nikkei
8
15
-12
11
9
-6

Russell_2000
12
9
-7
13
4
-14

Calculate the following:

a)
The expected monthly rate of return and standard deviation for each series
b)
The covariance between the rates of return for NikkeiRussell_2000
c)
The correlation coefficient for Nikkei-Russell_2000

Solution
IMPORTANT NOTE TO STUDENTS: You MUST be familiar with the statistical
functionality available within your calculator. These solutions discuss how to calculate
descriptive statistics making use of the Sharp El 735S / SHARP EL-738 Business financial
calculator. If you are using another calculator, it is your responsibility to learn how to use it.
Sharp El 735S / SHARP EL-738 Business Financial Calculator
Step One: place the calculator in Stats mode for linear calculation: [MODE] [1] [1]
Procedure
Key Operation
Display
Enter calculator into STATS [MODE] [1] [1]
Stat 1
mode
0.00
Step Two: enter the data as follows;
Procedure
Key Operation
Enter cash flow data
8 (x,y) 12[ENT]

Display
DATA SET =
1.00

15 (x,y) 9 [ENT]

DATA SET =
2.00

12 [+/-] (x,y) 7 [+/-] [ENT]

DATA SET =
3.00

11 (x,y) 13[ENT]

DATA SET =
4.00

9 (x,y) 4 [ENT]

DATA SET =
5.00

6[+/-] (x,y) 14 [+/-] [ENT]

DATA SET =
6.00

Compute expected return

for Nikkei
Compute expected return
for Russell_2000
Compute std. deviation for
Nikkei
Compute std. deviation for
Russell_2000
Compute correlation for
Nikkei-Russell_2000
Compute covariance for
Nikkei-Russell_2000

[RCL] [4]

X=

Y=
SX =

[RCL] [7]
[RCL] [5]
[RCL] [8]

SY =

[RCL] [(]r

r=

[RCL] [(]r []
[RCL] [5] []
[RCL] [8]

rSxSy =

R Nikkei

R
i 1

R Russel

i 1

10.647
11.017

101.433

8 15 (12) 11 9 (6)
4.17%
6

12 9 (7) 13 4 (14)
0.0283 or 2.83%
6

2.833

0.8647

a)

4.167

Nikkei

i 1

n 1
(8 4.17) (15 4.17) 2 (12 4.17) 2 (11 4.17) 2 (9 4.17) 2 (6 4.17) 2

113.37
6 1
2

NIKKEI 113.37 10.65%

Russel

i 1

n 1
(12 2.83) 2 (9 2.83) 2 (7 2.83) 2 (13 2.83) 2 (4 2.83) 2 (14 2.83) 2

121.37
6 1

Russel

121.37 11.02%

R
n

b)

ij

t 1

it

R i R jt R j

let i = Nikkei and j = Russell_2000

n 1
8 4.1712 2.83 15 4.179 2.83 ...... 6 4.17 14 2.83 101.43
ij
6 1

c)

rNikkei,Russell

Nikkei,Russell
Nikkei Russell

101.43
0.8647
10.65 11.02

Question Three
Which of the following statements are true about the efficient market hypothesis?
i)
It implies perfect forecasting ability
ii) It implies that prices reflect all available information
iii) It implies that prices do not fluctuate
iv) It results from keen competition among investors
Solution
i)

False. Market efficiency implies that prices reflect all available information, but
it does not imply certain knowledge. Many pieces of information that are available
and reflected in prices are uncertain. Efficiency of markets does not eliminate that
uncertainty and therefore does not imply perfect forecasting ability.

ii)

True. Market efficiency exists when prices reflect all available information. To be
efficient in the weak form, the market must incorporate all historical data into prices.
Under the semi-strong form of the hypothesis, the market incorporates all publicly
available information in addition to the historical data. In strong form efficient
markets, prices reflect all publicly and privately available information.

iii)

False. In efficient markets, prices reflect all available information. Thus, prices will
fluctuate whenever new information becomes available.

iv)

True. Competition among investors results in the rapid transmission of new market
information. In efficient markets, prices immediately reflect new information as
investors bid the stock price up or down.

Question Four
Suppose the market is semi-strong form efficient. Can you expect to earn excess returns if you
make trades based on:
a) Your brokers information about record earnings for a stock?
b)
Rumors about a merger of a firm?
c)
Yesterdays announcement of a successful new product test?
Solution
a) No. Earnings information is in the public domain and would be reflected in the current
stock price in a semi strong efficient market.
b) Possibly. If the rumors were publicly disseminated, the prices would have already adjusted
for the possibility of a merger. If the rumor is information that you received from an
insider, you could earn abnormal returns, although trading on that information is illegal.
c) No. The information is already public, and thus, should already be reflected in the
price.

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