Page 1 of 23

CHAPTER 8 AN INTRODUCTION TO ASSET PRICING MODELS Answers to !est"ons

1. Explain why the set of points between the risk-free asset and a portfolio on the Markowitz efficient frontier is a straight line. It can be shown that the expected return function is a weighted average of the individual returns. In addition, it is shown that co bining any portfolio with the risk-free asset, that the standard deviation of the co bination is only a function of the weight for the risky asset portfolio. !herefore, since both the expected return and the variance are si ple weighted averages, the co bination will lie along a straight line. ". #raw a graph that shows what happens to the Markowitz efficient frontier when you co bine a risk-free asset with alternative risky asset portfolios on the Markowitz efficient frontier. Explain this graph. Expected $ate of $eturn M% $&$ ' % % ( %) E Expected $isk * of return+ !he existence of a risk-free asset excludes the E-) seg ent of the efficient frontier because any point below ) is do inated by the $&$. In fact, the entire efficient frontier below M is do inated by points on the $&$-M ,ine *co binations obtained by investing a part of the portfolio in the riskfree asset and the re ainder in M+, e.g., the point ' do inates the previously efficient ( because it has lower risk for the sa e level of return. )s shown, M is at the point where the ray fro $&$ is tangent to the efficient frontier. !he new efficient frontier thus beco es $&$-M-&. % &

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.. #raw and explain why the line fro do inant set of portfolio possibilities. Expected $ate of $eturn M
/

the $&$ that is tangent to the efficient frontier defines the

$&$

( )

E Expected $isk * of return+ !his figure indicates what happens as a risk-free asset is co bined with risky portfolios higher and higher on the efficient frontier. In each case, as you co bine with the higher return portfolio, the new line will do inate all portfolios below this line. !his progra continues until you co bine with the portfolio at the point of tangency and this line beco es do inant over all prior lines. It is not possible to do any better because there are no further risky asset portfolios at a higher point. 0. #iscuss what risky assets are in portfolio M and why they are in it. !he 1M2 or 1 arket2 portfolio contains all risky assets available. If a risky asset, be it an obscure bond or a rare sta p, was not included in the arket portfolio, then there would be no de and for this asset, and conse3uently, its price would fall. 4otably, the price decline would continue to the point where the return would ake the asset desirable such that it would be part of the M portfolio e.g., if the bonds of )(/ /orporation were selling for 155 and had a coupon of - percent, the investor6s return would be - percent7 however, if there was no de and for )(/ bonds the price would fall, say to -5, at which point the 15 percent *-58-55+ return ight ake it a desirable invest ent. /onversely, if the de and for )(/ bonds was greater than supply, prices would be bid up to the point where the return would be in e3uilibriu . In either case, )(/ bonds would be included in the arket portfolio. 9.#isscuss leverage and its effect on the /M,. ,everage indicates the ability to borrow funds and invest these added funds in the arket portfolio of risky assets. !he idea is to increase the risk of the portfolio *because of the leverage+, and also the expected return fro the portfolio. It is shown that if you can borrow at the $&$ then the set of leveraged portfolios is si ply a linear extension of the set of portfolios along the line fro the $&$ to the arket portfolio. !herefore, the full /M, beco es a line fro the $&$ to the M portfolio and continuing upward .

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Page 3 of 23

:. #isscuss and ;ustify a easure of diversification for a portfolio in ter s of capital arket theory. <ou can easure how well diversified a portfolio is by co puting the extent of correlation between the portfolio in 3uestion and a co pletely diversified portfolio - i.e., the arket portfolio. !he idea is that, if a portfolio is co pletely diversified and, therefore, has only syste atic risk, it should be perfectly correlated with another portfolio that only has syste atic risk. =. >hat changes would you expect in the standard deviation for a portfolio of between 0 ? 15 stocks, between 15 ? "5 stocks and between 95 ? 155 stocks@ Atandard deviation would be expected to decrease with an increase in stocks in the portfolio because an increase in nu ber will increase the probability of having ore inversely correlated stocks. !here will be a a;or decline fro 0 to 15 stocks, a continued decline fro 15 to "5 but at a slower rate. &inally, fro 95 to 155 stocks, there is a further decline but at a very slow rate because al ost all unsyste atic risk is eli inated by about 1- stocks. -.#iscuss why the invest ent and financing decisions are separate when you have a /M,. Biven the existence of the /M,, everyone should invest in the sa e risky asset portfolio, the arket portfolio. !he only difference a ong individual investors should be in the financing decision they ake, which depends upon their risk preference. Apecifically, investors initially ake invest ent decisions to invest in the arket portfolio, M. Aubse3uently, based upon their risk preferences, they ake financing decisions as to whether to borrow or lend to attain the preferred point on the /M,. C. Biven the /M,, discuss and ;ustify the relevant easure of risk for an individual security. $ecall that the relevant risk variable for an individual security in a portfolio is its average covariance with all other risky assets in the portfolio. Biven the /M,, however, there is only one relevant portfolio and this portfolio is the arket portfolio that contains all risky assets. !herefore, the relevant risk easure for an individual risky asset is its covariance with all other assets, na ely the arket portfolio 15. /apital arket theory divides the variance of returns for a security into syste atic variance and unsyste atic or uni3ue variance. #escribe each of these ter s. Ayste atic risk refers to that portion of total variability of returns caused by factors affecting the prices of all securities, e.g., econo ic, political and sociological changes -factors that are uncontrollable, external, and broad in their effect on all securities. Dnsyste atic risk refers to factors that are internal and 1uni3ue2 to the industry or co pany, e.g., anage ent capability, consu er preferences, labor strikes, etc. 4otably, it is not possible to get rid of the overall syste atic risk, but it is possible to eli inate the 1uni3ue2 risk for an individual asset in a diversified portfolio.

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Page # of 23

11. !he capital asset pricing odel */)'M+ contends that there is syste atic ? unsyste atic risk of individual security. >hat is the relevant risk variable and why is it relevant@ In a capital asset pricing odel */)'M+ world the relevant risk variable is the security6s syste atic risk - its covariance of return with all other risky assets in the arket. !his risk cannot be eli inated. !he unsyste atic risk is not relevant because it can be eli inated through diversification - for instance, when you hold a large nu ber of securities, the poor anage ent capability, etc., of so e co panies will be offset by the above average capability of others. 1". Eow does AM, differ fro /M,@ &or plotting, the AM, the vertical axis easures the rate of return while the horizontal axis easures nor alized syste atic risk *the security6s covariance of return with the arket portfolio divided by the variance of the arket portfolio+. (y definition, the beta *nor alized syste atic risk+ for the arket portfolio is 1.5 and is zero for the risk-free asset. It differs fro the /M, where the easure of risk is the standard deviation of return *referred to as total risk+. 1.. Identify and briefly discuss three criticis s of beta as used in the capital asset pricing */)'M+. /&) Exa ination I *1CC.+ )ny three of the following are criticis s of beta as used in /)'M. 1. !heory does not easure up to practice. In theory, a security with a zero beta should give a return exactly e3ual to the risk-free rate. (ut actual results do not co e out that way, i plying that the arket values so ething besides a beta easure of risk. ". (eta is a fickle short-ter perfor er. Ao e short-ter studies have shown risk and return to be negatively related. &or exa ple, (lack, Fensen and Acholes found that fro )pril 1C9= through #ece ber 1C:9, securities with higher risk produced lower returns than less risky securities. !his result suggests that *1+ in so e short periods, investors ay be penalized for taking on ore risk, *"+ in the long run, investors are not rewarded enough for high risk and are overco pensated for buying securities with low risk, and *.+ in all periods, so e unsyste atic risk is being valued by the arket. .. Esti ated betas are unstable. Ma;or changes in a co pany affecting the character of the stock or so e unforeseen event not reflected in past returns ay decisively affect the security6s future returns. 0. (eta is easily rolled over. $ichard $oll has de onstrated that by changing the arket index against which betas are easured, one can obtain 3uite different easures of the risk level of individual stocks and portfolios. )s a result, one would ake different predictions about the expected returns, and by changing indexes, one could change the risk-ad;usted perfor ance ranking of a anager. odel

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10. (riefly explain whether investors should expect a higher return fro holding portfolio ) versus portfolio ( under capital asset pricing theory */)'M+.)ssu e that both portfolios are fully diversified. 'ortfolio ) 'ortfolio ( Ayste atic risk *beta+ 1 1 Apecific risk for each individual security Eigh ,ow /&) Exa ination I *1CC.+ Dnder /)'M, the only risk that investors should be co pensated for bearing is the risk that cannot be diversified away *syste atic risk+. (ecause syste atic risk * easured by beta+ is e3ual to one for both portfolios, an investor would expect the sa e return for 'ortfolio ) and 'ortfolio (. Aince both portfolios are fully diversified, it doesn6t atter if the specified risk for each individual security is high or low. !he specific risk has been diversified away for both portfolios. 19. <ou have been recently been appointed chief invest ent officer of a a;or charitable foundation. Its large endow ent fund is currently invested in a broadly diversified portfolio of stocks *:5G+ and bonds *05G+.!he foundation6s board of trustees is a group of pro inent individuals whose knowledge of invest ent theory and practice is superficial. <ou decide a discussion of basic invest ent principle would be helpful. 19*a+ Explain the concepts of specific risk, variance, covariance, standard deviation and beta as they relate to invest ent anage ent. /&) Exa ination II *1CC0+ 19*a+. !he concepts are explained as followsH !he &oundation6s portfolio currently holds a nu ber of securities fro two asset classes. Each of the individual securities has its own risk *and return+ characteristics, described as specific risk. (y including a sufficiently large nu ber of holdings, the specific risk of the individual holdings offset each other, diversifying away uch of the overall specific risk and leaving ostly no diversifiable or arket-related risk. Ayste atic risk is arket-related risk that cannot be diversified away. (ecause syste atic risk cannot be diversified away, investors are rewarded for assu ing this risk. !he variance of an individual security is the su of the probability-weighted average of the s3uared differences between the security6s expected return and its possible returns. !he standard deviation is the s3uare root of the variance. (oth variance and standard deviation easure total risk, including both syste atic and specific risk. )ssu ing the rates of return are nor ally distributed, the likelihood for a range of rates ay be expressed using standard deviations. &or exa ple, :- percent of returns ay be expressed using standard deviations. !hus, :- percent of returns can be expected to fall within I or -1 standard deviation of the ean, and C9 percent within " standard deviations of the ean. /ovariance easures the extent to which two securities tend to ove, or not ove, together. !he level of covariance is heavily influenced by the degree of correlation between the securities *the correlation coefficient+ as well as by each security6s standard deviation. )s long as the correlation coefficient is less than 1, the portfolio standard deviation is less than the weighted average of the --9

Page % of 23

individual securities6 standard deviations. !he lower the correlation, the lower the covariance and the greater the diversification benefits *negative correlations provide ore diversification benefits than positive correlations+. !he capital asset pricing odel */)'M+ asserts that investors will hold only fully diversified portfolios. Eence, total risk as easured by the standard deviation is not relevant because it includes specific risk *which can be diversified away+. Dnder the /)'M, beta easures the syste atic risk of an individual security or portfolio. (eta is the slope of the characteristic line that relates a security6s returns to the returns of the arket portfolio. (y definition, the arket itself has a beta of 1.5. !he beta of a portfolio is the weighted average of the betas of each security contained in the portfolio. 'ortfolios with betas greater than 1.5 have syste atic risk higher than that of the arket7 portfolios with betas less than 1.5 have lower syste atic risk. (y adding securities with betas that are higher *lower+, the syste atic risk *beta+ of the portfolio can be increased *decreased+ as desired. <ou believe that the addition of other asset classes to endow ent portfolio would i prove the portfolio by reducing risk and enhancing return. <ou are aware that depressed conditions in D.A. real estate arkets are providing opportunities for property ac3uisition at levels of expected return that are unusually high by historical standards.<ou believe that an invest ent in D.A. real estate would be both appropriate and ti ely and have decided to reco end a "5G position be established with funds taken e3ually fro stocks ? bonds. 'reli inary discussions revealed that several trustees believe real estate is too risky to include in the portfolio.!he board chair an,however,has scheduled a special eeting for further discussion of the atter and has asked you to provide back ground infor ation that will clarify the risk issue. !o assist you,the following expectational data have been developedH /J$$E,)!IJ4 M)!$IK )sset class $eturn Atandard DA DA DA $eal Estate DA !-(ills deviation Atocks (onds DA Atocks 1"G "1G 1.55 DA (onds -G 15.9G 5.10 1.55 DA $eal Estate 1"G CG -5.50 -5.5. 1.55 DA !-(ills 0G 5 -5.59 -5.5. 5."9 1.55 19*b+ Explain the effect on both portfolio risk and return that would result fro the addition of D.A. real estate. Include in your answer two reasons for any change you expect in portfolio risk. >ithout perfor ing the calculations, one can see that the portfolio return would increase becauseH *1+ $eal estate has an expected return e3ual to that of stocks. *"+ Its expected return is higher than the return on bonds. !he addition of real estate would result in a reduction of risk becauseH *1+ !he standard deviation of real estate is less than that of both stocks and bonds. *"+ !he covariance of real estate with both stocks and bonds is negative. !he addition of an asset class that is not perfectly correlated with existing assets will reduce variance. !he fact that real estate has a negative covariance with the existing asset classes will reduce risk even ore. 19*c+ <our understanding of capital arket theory causes you to doubt the validity of the expected --:

Page & of 23

return and risk for D.A. real estate .Fustify your skepticis . /apital arket theory holds that efficient arkets prevent ispricing of assets and that expected return is proportionate to the level of risk taken. In this instance, real estate is expected to provide the sa e return as stocks and a higher return than bonds. <et, it is expected to provide this return at a lower level of risk than both bonds and stocks. If these expectations were realistic, investors would sell the other asset classes and buy real estate, pushing down its return until it was proportionate to the level of risk. )ppraised values differ fro transaction prices, reducing the accuracy of return and volatility easures for real estate. /apital arket theory was developed and applied to the stock arket, which is a very li3uid arket with relatively s all transaction costs. In contrast to the stock arket, real estate arkets are very thin and lack li3uidity. 1:. In the e pirical testing of the /)'M, what are two a;or concerns@ >hy are they i portant@ &irst, the stability of betaH It is i portant to know whether it is possible to use past betas as esti ates of future betas. Aecond, is there a relationship between beta and rates of return@ !his would indicate whether the /)'M is a relevant pricing odel that can explain rates of return on risky assets 1=. (riefly discuss why it is i portant for beta coefficients to be stationary over ti e. Biven that beta is the principal risk easure, stable betas ake it easier to forecast future beta easures of syste atic risk - i.e., can betas easured fro past data be used in aking invest ent decisions. 1-. #iscuss the e pirical results relative to beta stability for individual stocks and portfolios of stocks. !he results of the stability of beta studies indicate that betas for individual stocks are generally not stable, but portfolios of stocks have stable betas. 1C. In the tests of the relationship between syste atic risk *beta+ and return, what are you looking for@ Is there a positive linear relationship between the syste atic risk of risky assets and the rates of return on these assets@ )re the coefficients positive and significant@ Is the intercept close to the risk-free rate of return@

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"5. #raw an ideal AM, .(ased on the early e pirical results, what did the actual risk return relationship look like relative to the ideal relationship i plied by the /)'M@ E*$+ $&$ $M 1.5 $isk *(eta+ In the e pirical line, low risk securities did better than expected, while high risk securities did not do as well as predicted. "1. )ccording to the /)'M, what assets are included in the arket portfolio and what are the relative weightings@ In e pirical studies of the /)'M, what are the typical proxies used for the arket portfolio@ !he 1 arket2 portfolio contains all risky assets available. If a risky asset, be it an obscure bond or rare sta p, was not included in the arket portfolio, then there would be no de and for this asset and, conse3uently, its price would fall. 4otably, the price decline would continue to the point where the return would ake the asset desirable such that it would be part of the 1 arket2 portfolio. !he weights for all risky assets are e3ual to their relative arket value. "". )ssu ing that the e pirical proxy for the arket portfolio is not a good proxy, what factors related to the /)'M will be affected@ )ccording to $oll, a istakenly specified proxy for the arket portfolio can have two effects. &irst, the beta co puted for alternative portfolios would be wrong because the arket portfolio is inappropriate. Aecond, the AM, derived would be wrong because it goes fro the $&$ through the i properly specified arket portfolio. In general, when co paring the perfor ance of a portfolio anager to the 1bench ark2 portfolio, these errors will tend to o'erest"(ate the perfor ance of portfolio anagers because the proxy arket portfolio e ployed is probably not as efficient as the true arket portfolio, so the slope of the AM, will be underesti ated ".. Ao e studies related to the efficient arket hypothesis generated results that i plied additional factors beyond beta should be considered to esti ate expected returns. >hat are these other variables and why should they be considered@ Atudies of the efficient arkets hypothesis suggest that additional factors affecting esti ates of expected returns include fir size, the price-earnings ratio, and financial leverage. !hese variables have been shown to have predictive ability with respect to security returns. "0. )ccording to &e a-&rench study, discuss what variables you should consider when selecting a cross section of stocks. &a a and &rench found that size, leverage, earnings-price ratios, and book value to arket value of e3uity all have a significant i pact on univariate tests on average return. In ultivariate tests, size and book to arket e3uity value are the a;or explanatory factors. --!heoretical AM, E pirical AM,

Page ) of 23

Pro*+e(s an, so+!t"on

Pro*+e( 1- )ssu e that you expect the econo y6s rate of inflation to be . percent, giving an $&$ of : percent and a arket return *$ + of 1" percent. a. #raw the AM, under these assu ptions. b. Aubse3uently, you expect the rate of inflation to increase fro . percent to : percent. >hat effect would this have on the $&$ and the $ @ #raw another AM, on the graph fro part a. c. #raw an AM, on the sa e graph to reflect an $&$ of C percent and an $ of 1= percent. Eow does this AM, differ fro that derived in part b@ Explain what has transpired. Solution: 1. $ate of AM,c $eturn AM,b E*$ c+ .1= AM,c E*$ b+ .19 E*$ c+ .1" $&$cL$&$b .5C $&$a .5:

1.5

Ayste atic $isk *(eta+

In *b+, a change in risk-free rate, with other things being e3ual, would result in a new AM,b, which would intercept with the vertical axis at the new risk-free rate *.5C+ and would be parallel in the original AM,a. In *c+, this indicates that not only did the risk-free rate change fro .5: to .5C, but the arket risk pre iu per unit of risk ME*$ + - $fN also changed fro .5: *.1" - .5:+ to .5*.1= - .5C+. !herefore, the new AM,c will have an intercept at .5C and a different slope so it will no longer be parallel to AM,a.

Pro*+e( 2--C

Page 1. of 23

<ou expect an $&$ of 15 percent and the arket return *$ + of 10 percent. /o pute the expected *re3uired+ return for the following stocks, and plot the on an AM, graph. Atock D 4 # (eta 5.-9 1."9 -5."5 E*$i+

Solution: E *$i+ L $&$ I i*$M - $&$+ L .15 I i*.10 - .15+ L .15 I .50i Atock D 4 # (eta -9 1."9 -."5 *$e3uired $eturn+ E*$i+ L .15 I .50i .15 I .50*.-9+ L .15 I .5.0 L .1.0 .15 I .50*1."9+L .15 I .59 L .195 .15 I .50*-."5+ L .15 - .55- L .5C"

- - 15

Page 11 of 23

Pro*+e( 3<ou ask a stockbroker what the fir 6s research depart ent expects for the three stocks in proble ". !he broker responds with the following infor ationH Atock /urrent price Expected price Expected #ividend D "" "0 5.=9 4 091 ".55 # .= 05 1."9 Solution: Sto/0 /urrent Expected Expected Est"(ate, Ret!rn 'rice 'rice #ividend U "0 "" + 5.=9 = .1"95 "" "0 5.=9 ""

0-

91

".55

91 0- + ".55 = .150" 005 .= + 1."9 = .110C .=

.=

05

1."9

Atock D 4 #

(eta .-9 1."9 -."5

$e3uired .1.0 .195 .5C"

Esti ated .1"95 .150" .110C

Evaluation Jvervalued Jvervalued Dndervalued

If you believe the appropriateness of these esti ated returns, you would buy stocks # and sell stocks D and 4. E*$+ 4
10G D %D6 %#6 % 46

-5.9

-5."

5.9

.5-9

1.5

1."9

Pro*+e( 11(ased on five years of the co panies listed. /o pany Ot *Intercept+

onthly data, you derive the following infor ation for Pt - - 11 r

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Intel &ord )nheuser (usch Merck A ? ' 955

5."" 5.15 5.1= 5.59 5.55

1".15G 10.:5 =.:5 15."5 9.95

5.=" 5... 5.99 5.:5 1.55

a. co pute the beta coefficient for each stock. b. )ssu ing a risk-free rate of - percent and an expected return for the arket portfolio of 19 percent and an expected return for the arket portfolio of 19 percent, co pute the expected *re3uired+ return for all the stocks and plot the on the AM,. c. 'lot the following esti ated returns for the next year on the AM, and indicate which stocks are undervalued or overvalued. Intel Q "5 percent. &ord -19 percent. )nheuser (usch Q 1C percent. Merck Q 15 percent. Solution: a.
(i = /JRi,
"

and ri, =

( i )( )

/JRi,

!hen /JRi, L *ri, +*i+* + 1or Inte+/JR i, L *.="+*.1"15+*.5995+ L .550=C

(eta = .550=C .550=C = = 1.9C= .55.5 *.599+ "

1or 1or,/JR i, L *...+*.10:5+*.5995+ L .55":9

(eta = .55":9 = .--. .55.5

1or An2e!ser 3!s/2/JR i, L *.99+*.5=:5+*.5995+ L .55".5 - - 1"

Page 13 of 23

(eta =

.55".5 = .=:= .55.5

1or Mer/0/JR i, L *.:5+*.15"5+*.5995+ L .55..=

(eta = .55..= = 1.1". .55.5

11*b+.

E*$i+ L $&$ I (i*$M - $&$+ L .5- I (i*.19 - .5-+ L .5- I .5=(i Atock Intel &ord )nheuser (usch Merck (eta 1.9C= .--. .=:= 1.1". E*$i+ L .5- I .5=(i .5- I .111- L .1C1.5- I .5:1- L .101.5- I .59.= L .1..= .5- I .5=-: L .19-:

11*c+.

."5 %)( %&ord %Merck

%Intel

$M L .19 .15 $&$L.5-

1.5

(eta

Pro*+e( 12/alculate the expected *re3uired+ return for each of the following stocks when the risk-free rate is 5.5- and you expect the arket return to be 5.10. Atocks ) - - 1. (eta 1.="

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( / # E & Solution: E*$i+ L $&$ I i *$M - $&$+ L .5:- I i *.10 - .5-+ L .5- I .5:i 1"*a+. 1"*b+. 1"*c+. 1"*d+. 1"*e+. 1"*f+.

1.10 5.=: 5.00 5.5. -5.=C

E*$)+ L .5- I .5:*1.="+ L .5- I .1595 L .1-95 L 1-.95G E*$(+ L .5- I .5:*1.10+ L .5- I .5:-0 L .10-0 L 10.-0G E*$/+ L .5- I .5:*5.=:+ L .5- I .509: L .1"9: L 1".9:G E*$#+ L .5- I .5:*5.00+ L .5- I .5":0 L .15:0 L 15.:0G E*$E+ L .5- I .5:*5.5.+ L .5- I .551- L .5-1- L -.1-G E*$&+ L .5- I .5:*-5.=C+ L .5- - .50=0 L .5.": L ..":G

Pro*+e( 13!he following are the historic returns for the /helle /o puter /o panyH 4ear 1 C2e++e Co(5!ter 3& - - 10 Genera+ In,e6 1$

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2 ) 13 3 711 1# # 8 7) $ 11 12 % # ) (ased on this infor ation, co pute the followingH a. the correlation coefficient between /helle /o puter and the Beneral Index. b. !he standard deviation for the co pany and index. c. !he beta for the /helle /o puter /o pany. Solution: . <ear 1 " . 0 9 : )nita *$1+ .= C -11 11 0 L 9Beneral Index *$M+ 19 1. 10 -C 1" C L 90 $1 - E*$1+ "=... -.:= -"5.:= -1.:= 1... -9.:= $M - E*$M+ : 0 9 -1. 5 *$1 - E*$1+ x $M - E*$M+ 1:..C-".:-15...9 .5.5: ..CC 5.55 L C".55

E*$1+ L C.:=
Rar1 = 1"11... = "51.-C :

E*M+ L C
RarM = 015 = :-... :

1 = "51.-C = 10."1
C".55 = 19... :

M = :-... = -."=

/JR1, M =

1.*a+. !he correlation coefficient can be co puted as followsH

/JR1,M 19... 19... = = .1. *10."1+*-."=+ 11=.9"

r1,M =

1 M

1.*b+. !he standard deviations areH 10."1G for )nita /o puter and -."=G for index, respectively. - - 19

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1.*c+. (eta for )nita /o puter is co puted as followsH

(1 = /JR1,M RarM = 19... = .""00 :-...

Pro*+e( 1#CFA Examination Level II !he following infor ation describes the expected return and risk relationship for the stocks of two of >)E6s co petitors. E65e/te, Ret!rn Stan,ar, De'"at"on 3eta Atock K 1".5G "5G 1.. Atock < C.5 19 5.= Market Index 15.5 1" 1.5 $isk-free rate 9.5 Dsing only the data shown in the preceding tableH a. draw and label a graph showing the security arket line and position stocks K and < relative to it.M 9 inutes N b. co pute the alphas both for stock K and for stock <. Ahow your work. M0 inutes N c. assu e that the risk-free rate increases to = percent with the other data in the preceding atrix re aining unchanged. Aelect the stock providing the higher expected risk-ad;usted return and ;ustify your selection. Ahow your calculations. M: inutesN Solution: 10. /&) Exa ination II *1CC9+

10*a+. !he security arket line *AM,+ shows the re3uired return for a given level of syste atic risk. !he AM, is described by a line drawn fro the risk-free rateH expected return is 9 percent, where beta e3uals 5 through the arket return7 expected return is 15 percent, where beta e3ual 1.5. 19G 1"G 15G CG 9G %Atock < %Market %Atock < Aecurity Market ,ine *AM,+

.9

.=

1.5

1..

1.9

".5

(eta*+

10*b+. !he expected risk-return relationship of individual securities - - 1:

ay deviate fro

that

Page 1& of 23

suggested by the AM,, and that difference is the asset6s alpha. )lpha is the difference between the expected *esti ated+ rate of return for a stock and its re3uired rate of return based on its syste atic risk )lpha is co puted as ),'E) *+ L E*ri+ - Mrf I *E*rM+ - rf+N where E*ri+ L expected return on Aecurity i rf L risk-free rate i L beta for Aecurity i E*rM+ L expected return on the arket /alculation of alphasH Atock KH L 1"G - M9G I 1..G *15G - 9G+N L 5.9G Atock <H L CG - M9G I 5.=G*15G - 9G+N L 5.9G In this instance, the alphas are e3ual and both are positive, so one does not do inate the other. )nother approach is to calculate a re3uired return for each stock and then subtract that re3uired return fro k L rf I i *rM - rf +. /alculations of re3uired returnsH Atock KH k L 9G I 1..*15G - 9G+ L 11.9G L 1"G - 11.9G L 5.9G Atock <H k L 9G I 5.=*15G - 9G+ L -.9G L CG - -.9G L 5.9G 10*c+. (y increasing the risk-free rate fro 9 percent to = percent and leaving all other factors a given expected return. !he for ula for re3uired return *k+ is

unchanged, the slope of the AM, flattens and the expected return per unit of incre ental risk beco es less. Dsing the for ula for alpha, the alpha of Atock K increases to 1.1 percent and the alpha of Atock < falls to -5.1 percent. In this situation, the expected return *1".5 percent+ of Atock K exceeds its re3uired return *15.C percent+ based on the /)'M. !herefore, Atock K6s alpha *1.1 percent+ is positive. &or Atock <, its expected return *C.5 percent+ is below its re3uired return *C.1 percent+ based on the /)'M. !herefore, Atock <6s alpha *-5.1 percent+ is negative. Atock K is preferable to Atock < under these circu stances. /alculations of revised alphasH - - 1=

Page 18 of 23

Atock K L 1"G - M=G I 1.. *15G - =GN L 1"G - 15.C9G L 1.1G Sto/0 4 8 )9 7 :&9 ; .<&=1.9 7 &9>? L CG - C.1G L -55.1G Pro*+e( 1$CFA Examination Level II )n analyst expects a risk-free return of 0.9 percent, a arket return of 10.9 percent, and the returns for stocks ) and ( that are shown in the following table. A!J/S I4&J$M)!IJ4 Sto/0 ) ( 3eta 1." 5.Ana+@stAs Est"(ate, Ret!rn 1: G 10 G

a. Ahow on the graph provided in the answer bookH *1+ where stock ) and ( would plot on the security arket line *AM,+ if they were fairly valued using the capital asset pricing odel */)'M+. *"+ >here stock ) and ( actually plot on the sa e graph according to the returns esti ated by the analyst and shown in the table M: inutesN b. state whether stock ) and ( are undervalued or overvalued if the analyst uses the AM, for strategic invest ent decisions.M0 inutesN Solution: /&) Exa ination II *1CC-+ 19*a+. Aecurity Market ,ine i. Fair-value plot. !he following te plate shows, using the /)'M, the expected return, E$, of Atock ) and Atock ( on the AM,. !he points are consistent with the following e3uationsH E$ on stock L $isk-free rate I (eta x *Market return Q $isk-free rate+ E$ for ) L 0.9G I 1."*10.9G - 0.9G+ L 1:.9G E$ for ( L 0.9G I 5.-*10.9G - 0.9G+ L 1".9G ii. Analyst estimate plot. Dsing the analyst6s esti ates, Atock ) plots below the AM, and Atock (, above the AM,. %Atock ) 10.9G %Atock (

0.9G 5.1." - - 1-

Page 1) of 23

19*b+. Jver vs. Dndervalue Sto/0 A "s o'er'a+!e, because it should provide a 1:.9G return according to the /)'M whereas the analyst has esti ated only a 1:.5G return. Sto/0 3 "s !n,er'a+!e, because it should provide a 1".9G return according to the /)'M whereas the analyst has esti ated a 10G return. Pro*+e( 1%relative to the <ear 1 " . 0 9 Biven the following results, indicate what will happen to the beta for stock E, arket proxy, co pared to the beta relative to the ti e arket portfolioH <early $ates Jf $eturn Atock E Market 'roxy !rue Market *'ercent+ *'ercent+ * 'ercent+ 15 : "5 10 11 -10 -15 -= -"5 -1-1" 19 1" 15 easured beta. #oes the suggested relationship appear

#iscuss the reason for the differences in reasonable@ >hy or why not@ Solution: $proxy L 1."7 $true L 1.:

!he beta for using the proxy is given by /ov*i,proxy+8Rar*proxy+. Biven the data, proxy L "9:.=8"59." L 1."91 true L 1-=.:815C.. L 1.=1:. !he proxy is not ean-variance efficient, as it is do inated by the true arket portfolio.

Pro*+e( 1&- - 1C

Page 2. of 23

#raw the i pled AM,s for the following two sets of conditionsH a. RFR L 5.5=7 Rm *A I ' 955+ L 5.1: b. Rt L 5.5C7 Rm *!rue+ L 5.1Dnder which set of conditions would it be ore difficult for a portfolio anager to be superior@ Solution: $ .1.1:

.5C .5= 1.5 It would be (eta arket index.

ore difficult to show superior perfor ance relative to the true

Pro*+e( 1&Dsing the graph and e3uations fro would be superior@ a. Ra L 11 G7 T L 5.5C b. Rb L 10 G7 T L 1.55 c. Rc L 1" G7 T L - 5.05 d. Rd L "5 G7 T L 1.15 #oes it atter which AM, you use@ Solution: AM,A?' L 5.5= I x*5.1: Q 5.5=+ AM,!rue L 5.5C I x*5.1- Q 5.5C+ 1-*a+. $a L 5.11, a L 5.5C Dsing the A?' proxyH E*$a+ L 5.5= I 5.5Cx*5.5C+ L 5.5= I 5.55-1 L 5.5=-1 - - "5 proble 1=, which of the following portfolios

Page 21 of 23

Dsing the true arketH E*$a+ L 5.5C I 5.5Cx*5.5C+ L 5.5C I 5.55-1 L 5.5C-1 ) would be superior in either case. 1-*b+. $b L .10, b L 1.55 Dsing the A?' proxyH E*$b+ L 5.5= I 1.5x5.5C L 5.1: Dsing the true arketH E*$b+ L 5.5C I 1.5x5.5C L 5.1Inferior perfor ance in both cases. 1-*c+. $c L 5.1" c L -5.0 Dsing the A?' proxyH E*$c+ L 5.5= Q 5.05x5.5C L 5.5= Q 5.5.: L 5.5.0 Dsing the true arketH E*$c+ L 5.5C Q 5.05x5.5C L 5.5C Q5.5.: L 5.590 1-*d+. Auperior perfor ance in both cases. $d L 5."5 d L 1.15 Dsing the arket proxyH E*$d+ L 5.5= I 1.1x5.5C L 5.5= I 5.CC L 5.1:C Dsing the true arketH E*$d+ L 5.5C I 1.1x5.5C L 5.5C I5.5CC L 5.1-C Auperior perfor ance in both cases.

Pro*+e( 1&- - "1

Page 22 of 23

#raw the security a. *1+ $&$ L 5.5- $ *"+ $z L 5.5: using each index. Ret!rn of Ra,er Per"o, 1 " . 0 9 =Per/ent > "C 1" -1" .1= "5 $

arket line for each of the following conditionsH

*proxy+ L 5.1" *true+ L 5.19

b. rader !ire has the following results for the last six periods. /alculate and co pare the betas Pro6@ S5e/"f"/ In,e6 =Per/ent > 1" 15 -C 10 "9 Tr!e Genera+ In,e6 =Per/ent > 19 1. -1"-

: -9 If the current period return for the Solution:

-15 5 arket is 1" percent and for $ader is 11 percent , are superior

results being obtained for either index beta@

5.55.5: 1.5
"

(eta

1)=*>< L /ov i, 8* + &ro a spreadsheet progra , we find /ov i, L 1-=.0 " L 1C5.0 Dsing the proxyH p L 1-=.081C5.0 L .C-0 Dsing the true indexH t L 1=:.081:- L 1.59 1)=/>< Dsing the proxyH E*$$+ L 5.5- I 5.C-0x*5.1" - 5.5-+ - - ""

Page 23 of 23

L 5.5- I 5.5.C0 L .11C0 Dsing the true arketH E*$$+ L 5.5: I 1.59x*5.1" Q 5.5:+ L 5.5: I 5.5:. L 5.1". $ader6s perfor ance would be inferior co pared to either.

- - ".