Home work week 5

Problem 1. Ex-post Alpha. Stock A has a beta of 2.0. The equity market
return over a 1 year period was 10%. The risk-free rate is 6.00%. The price of
stock A went from $50 at the beginning of the period to $64 at the end of the
year. No dividends were paid.
(a) Using the CAPM model, what is the expected return of the stock?
(b) What is actual return of the stock?
(c) Using the CAPM model, what is the alpha of the stock?
(d) Your colleague says The alpha of a stock is the actual return of a stock minus
the return of the market. I think the alpha of the stock is 18%. Do you
agree? Why?
(e) Your colleague then says the alpha after adjusting for beta is just the

actual returnbetamarket return . So the alpha for this stock is 28%-2*10%

or 8%. Is this correct? Why?
Problem 2. Beta / Ex-post. Expected return. A colleague of yours at work
makes the following remarks:
According to CAPM, a stock with a beta of 2.0 will go up twice as much as the
market. If the market goes up 10% in a year the stock with a beta of 2.0 should
go up 20%.
(a) Is this statement true? Why or why not?
Your colleague then says The beta of a stock is meant to capture how much
market risk a stock has. A stock with a beta of 2.0 must have twice the market
risk. The market component of the variance of a stock with a beta of 2.0 is
2

which is 4.0* M

so the standard deviation must be 2.0*

M .

Therefore, the stock should be twice as volatile as the market. If the stock is
twice as volatile as the market then the return must be twice that of the
market.
(b) How many of the five statements do you agree with? Point out any flaws.
Your colleague then says to forget about the risk argument. Ill make it easy for
you. The security characteristic line (SCL) is graph of the return of a stock
versus the return on the market. The slope of this line (SCL) is the same number
as the beta in CAPM. The slope of this line will be two for a stock with a beta of
2.0. So if the market moves 10% the change along the X-axis is 10% so the
change in the y-axis must be 20%. The return of the stock must be 20%.
(c) How many of the last five sentences do you agree with? Point out any flaws.

The colleague then says Im right if youre looking at the returns over 1 day
because the risk-free rate for 1 day is very small. A risk free rate of 3.65% is
really 3.65% for 1 year. The risk free rate for 1 day in this case is only about 1
basis point which you can ignore compared to the market. If the market goes up
2% in one day, a stock with a beta of 2.0 will double and go up about 4%. You
can pretty much ignore the risk free rate for one day.
(d) How many of the last five sentences do you agree with? Point out any flaws.

Problem 3. Ex-ante alpha. Stock B has a beta of 1.5. The risk-free rate is
4.0%. The market risk premium is 8.0%. The price of stock B today is $60. After
doing some fundamental analysis, you come up with a forecast of the stock Bs
share price of $70 at the end of the year. It is expected that $2 in dividends will
be paid during the year.
(a) According to the CAPM, what is the expected return of the stock?
(b) According to your fundamental analysis, what is the forecasted return of the
stock?
(c) What is the projected alpha of the stock?
(d) Is the stock overpriced or underpriced?
(e) Should you buy or sell the stock? Why?
Problem 4. Abnormal return (alpha). You are asked to estimate the illegal
profits (or ill gotten gains) to determine penalties in an insider trading case.
The court considers abnormal return around the event as the source of the illegal
profits. The abnormal return is defined as the alpha in the CAPM model.
The trader found out that company A was going to launch a takeover attempt of
company B. The takeover attempt had not yet been announced to the public.
She bought 100,000 shares of company B at a price of $20. The next day the
takeover attempt is announced. On that day the U.S. government defaults on its
debt and the stock market is down 8%. The stock price of company B closes at
$19.80. The beta of stock B is 1.5. The risk free rate is 7.30% (annual basis).
(a) What are the traders gains or losses?
(b) Are there any illegal profits? If so, calculate.
(c) The trader claims there are no profits so there should not be any penalties
assessed. Comment on this statement.
Problem 5. Expected return / capital budgeting. You are analyzing the
expected cash flows of a project. The company is 100% equity financed and
uses the expected return on equity to discount cash flows when analyzing new
projects. The beta of the equity is 0.75. The risk free rate is 5.0%. The
expected return on the market is 13%.
The cash flows of the project are:

Cash flow

Year 1
$10,000

Year 2
$12,000

Year 3
$15,000

Year 4
$17,000

Year 5
$21,000

(a) According to the CAPM, what is the expected rate of return of the equity?
(b) Given these cash flows, what is the present value of the project?
Problem 6. Diversification of firm specific risk / Well diversified
portfolio / APT. The arbitrage pricing theory depends on well diversified
portfolios which eliminate firm specific risk and only contain market risk. You are
analyzing how quickly diversification eliminates firm specific risk in equally
weighted portfolios with varying number of stocks. Assume the firm specific risk
of every stock is equal to 50%. By definition, the firm specific risk of any stock is
independent (correlation =0) of the firm specific risk of any other stock.
(a) What is the firm specific risk of a portfolio which contains two stocks with a
weight of 50% in each stock?
(b) What is the firm specific risk of a portfolio which contains three stocks with a
weight of 33.33% in each stock?
(c) What is the firm specific risk of a portfolio which contains n stocks with a
weight of (1/n) in each stock?
(d) What is the firm specific risk of a portfolio which contains 20 stocks with a
weight of (1/20=5%) in each stock?
(e) What is the firm specific risk of a portfolio which contains 50 stocks with a
weight of (1/50=2%) in each stock?
(f) How many stocks does it take to cause a firm specific risk reduction of 50%
(that is a portfolio standard deviation of 25%)?
(g) How many stocks does it take to cause a firm specific risk reduction of 75%
(that is a portfolio standard deviation of 12.5%)?
(h) How many stocks does it take to cause a firm specific risk reduction of 90%
(that is a portfolio standard deviation of 5%)?
(i) How many stocks do you need to achieve a firm specific risk reduction of 90%
if the firm specific risk of an individual stock is changed to 20% instead of the
50% assumed earlier(this will mean getting the portfolio standard deviation
down to 2%)?
Problem 7. Portfolio arbitrage / APT. You identify 100 stocks that each has
an alpha of 4% and a beta of 0.9. Each stock also has a firm specific risk of 50%.
You buy $100 million of an equally weighted portfolio of the 100 stocks. You
want to short an amount of a market portfolio to hedge (eliminate) the market
risk of your stocks and isolate the alpha.
(a)What value of the market portfolio is needed to hedge the long portfolio of
100 stocks?
(b)What is the firm specific risk of the long portfolio of the long portfolio of 100
stocks?

(c) What is the firm specific risk of the long portfolio and short portfolio
combined position?
(d)Incorporating alpha and firm specific risk, what is the 95% confidence interval
of the dollar profits of the strategy?
The client says he would prefer you own fewer stocks. He says he wants the
strategy to be more aggressive. He feels having 100 stocks makes it feel more
like an index fund. He wants you to hold 25 stocks instead.
(e)What is the new firm specific risk of the 25 stock long portfolio and short
portfolio combined position?
(f) Incorporating alpha and firm specific risk, what is the 95% confidence interval
of the dollar profits of the strategy?
(g)Do you prefer the 25 stock strategy or the 100 stock strategy? Why?
Problem 8. Fama French expected returns. Use the Fama-French-Carhart 4
factor framework to answer the following questions.

Stock
Stock
Stock
Stock

A
B
C
D

Market
specific
Beta Capitalization
1.0
$20 billion
1.5
$20 billion
1.0
$50 billion
1.0
$20 billion

Price-to
Book ratio
1.5
1.5
1.5
0.8

Return over Firmlast 12 months

5.0%
20%
5.0%
20%
5.0%
20%
5.0%
20%

Risk

Stock E
1.0
$20 billion 1.5
2.0%
20%
Stock F
1.0
$20 billion 1.5
5.0%
30%
(a)Which stocks have a higher expected return than the expected return of stock
A?
(b)Which stocks have a lower expected return than the expected return of stock
A?
(c) Which stocks have the same expected return as the expected return of stock
A?
Problem 9. Fama French perspectives.
(a) What are the two common explanations or perspectives on the size effect
and book to value effect?
Problem 10. Efficient Market Hypothesis. For each statement below say
whether it supports or contradicts the efficient market hypothesis. If it
contradicts the efficient market hypothesis state the lowest form (weak, semistrong, or strong) that it contradicts.

(a)Company A decides on September 18th to acquire company B but does not

announce their intentions to the public until September 21 st. The stock price
of company B rises 25% on September 21st.
(b)A strategy of buying stocks that have had strong returns over the previous 12
months tends to beat the S&P 500.
(c) Equity index funds tend to beat most actively managed stock funds.
(d)Buying stocks with high book to price and small size outperform the S&P 500.
Problem 11. EMH evidence.
(a)Give an example supporting the case for the efficient market hypothesis.
(b)Give an example contradicting the case for the efficient market
hypothesis.