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Investments Professor: Young Ho Eom

Exercises (APT)
1. The following is a scenario for three stocks constructed by the security analysts of Pf Inc. Scenario Rate of Return (%) Price ($) Recession Average Boom Stock A 10 -15 20 30 Stock B 15 25 10 -10 Stock C 50 12 15 12 (a) Construct an arbitrage portfolio using three stocks. (b) How might these prices change when equilibrium is restored? Given an example where a change in Stock C price is su cient to restore equilibrium, s assuming the dollar payos to Stock C remain the same. 2. Assume that stock market returns have the market index as a common factor, and that all stocks in the economy have a beta of 1 on the market index. Firmspecic returns all have a standard deviation of 30%. Suppose that an analyst studies 20 stocks and nds that one-half have an alpha of 2% and the other half an alpha of 2%. Suppose the analyst buys $1 million of an equally weighted portfolio of the positive alpha stocks and shorts $1 million an equally weighted portfolio of the negative alpha stocks. (a) What is the expected prot (in dollars) and standard deviation of the analyst prot? s (b) How does your answer change if the analyst examines 50 stocks instead of 20 stocks? 100 stocks? 3. (BKM 11) Assume that security return are generated by the single-index model, Ri =
i

i RM

+ ei

where Ri is the excess return for security i and RM is the market excess return. s The risk-free rate is 2%. Suppose also that there are three securities A, B and C, characterized by the following data:

Security E (Ri ) i A 0.8 10% B 1.0 12% C 1.2 14% (a) If

(ei ) 25% 10% 20%

= 20%, calculate the variance of returns of securities A, B, and C.

(b) Now assume that there are an innite number of assets with return characteristics identical to those of A, B, and C, respectively. If one forms a well-diversied portfolio of type A securities, what will be the mean and variance of the portfolio excess returns? What about portfolios composed s only of type B or C stocks? (c) Is there an arbitrage opportunity in this market? What is it? Analyze the opportunity graphically. 4. Consider the following multifactor (APT) model of security returns for a particular stock.(BKM 11) Factor Factor Beta Factor Risk Premium In ation 1.2 6% Industrial production 0.5 6 Oil prices 0.3 3 (a) If T-bills currently oer a 6% yield, nd the expected rate of return on this stock if the market views the stock as fairly priced. (b) Suppose that the market expected the values for the three macro factors given in column 1 below, but that the actual value turn out as given in column2. Calculate the revised expectation for the rate of return on the stock one the surprisesbecome known. Factor Expected Rate of Change Actual Rate of Change In ation 5% 4% Industrial production 3 6 Oil prices 2 0 5. The following annual excess rates of return were obtained for nine individual stocks and market index:(BKM Ch13)

STOCK EXCESS RETURNS (%)

YEAR 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00 12.00
MarketIndex

29.65 - 11.91 14.73 27.68 5.18 25.97 10.64 1.02 18.82 23.92 - 41.61 - 6.64

A 33.88 - 49.87 65.14 14.64 15.67 - 32.17 - 31.55 - 23.79 - 4.59 - 8.03 78.22 4.75

B - 25.20 24.70 - 25.04 - 38.64 61.93 44.94 - 74.65 47.02 28.69 48.61 - 85.02 42.95

C 36.48 - 25.11 18.91 - 23.31 63.95 - 19.56 50.18 - 42.28 - 0.54 23.65 - 0.79 - 48.60

D E F G H I 452.89 - 39.89 39.67 74.57 40.22 90.19 - 54.39 44.92 - 54.33 - 79.76 - 71.58 - 26.64 - 39.86 - 3.91 - 5.69 26.73 14.49 18.14 - 0.72 - 3.21 92.39 - 3.82 13.74 0.09 - 32.82 44.26 - 42.96 101.67 24.24 8.98 69.42 90.43 76.72 1.72 77.22 72.38 74.52 15.38 21.96 - 43.95 - 13.40 28.95 28.61 - 17.64 28.83 98.01 28.12 39.41 2.32 42.36 18.93 - 2.45 37.65 94.67 26.26 - 3.65 23.31 15.36 80.59 52.51 - 68.70 - 85.71 - 45.64 2.27 - 72.47 - 80.26 26.27 13.24 - 34.34 - 54.47 - 1.50 - 24.46

Suppose that in addition to the market factor, a second factor is considered. The values of this factor for years 1 to 12 were as follows:
YEAR 1.00 2.00 3.00 4.00 5.00 6.00 7.00 8.00 9.00 10.00 11.00 12.00

% changes in Factor value

- 9.84 6.46 16.12 - 16.51 17.82 - 13.31 - 3.52 8.43 8.23 7.06 - 15.74 2.03

1. (a) Perform the rst-pass regressions as did Chen, Roll and Ross and tabulate the relevant summary statistics. (Hint: Use a multiple regression as in a standard spreadsheet package. Estimate the betas of the 12 stocks on the two factors.) (b) Specify the hypothesis for a test of a second-pass regression for the two factor SML. (c) Do the data suggest a two-factor economy? (d) Can you identify a factor portfolio for the second factor?