Fundamentals of Financial Management 2019
1
TUTORIAL 5: RISK & RETURN
1. You intend to make an investment in one stock and have the following stocks to choose from:
Stock
Expected
Return
Standard
Deviation
A
20% p.a.
10% p.a.
B
30% p.a.
50% p.a.
C
15% p.a.
12% p.a.
D
20% p.a.
15% p.a.
E
35% p.a.
40% p.a.
F
25% p.a.
15% p.a.
Since every person’s preferred investment will differ, depending on their level of risk aversion, we
cannot say for certain which stock you will choose. The risk-return characteristics of some stocks,
however, clearly dominates others.
Begin by plotting each stock on a graph with risk (standard deviation) on the horizontal axis and
expected return on vertical axis. Just plot a single point for each stock.
a. If you had to choose just between stocks A and D, which dominates? Explain.
b. If you had to choose just between stocks D and E, which dominates? Explain.
c. If you had to choose just between stocks B and E, which dominates? Explain.
d. If you had to choose just between stocks A and C, which dominates? Explain.
e. If you had to choose just between stocks A and F, which dominates? How about E and F? how
about C and D? Explain.
2. Assume the following data:
The market risk premium is 7% p.a.
The variance of the return on the market is 0.14, and
The risk-free rate is 6% p.a.
Your task is to determine a discount rate appropriate for a single company, BHP. If the variance of
BHP’s return is 0.30 and its beta is 1.20, what is the expected return of BHP?
3. In a small economy, the market portfolio comprises shares in only three companies: D, E and F.
Details are set out in the table below.
Company name
Shares issued
Price per share
Expected
Return
D
1,000,000
$2.00
8%
E
500,000
$8.00
10%
F
1,600,000
$2.50
21%
There is also a risk-free asset that offers a return of 4%.
a. Calculate the expected return on the market portfolio.
b. Assume that the capital asset pricing model (CAPM) applies in this market; calculate the beta of
company E.
