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1.
iandii.Thestandarddeviationisnonnegative.
11.
a.
Theholdingperiodreturnsforthethreescenariosare:
Boom:
(3525+1)/25=0.44=44.00%
Normal:
(2525+0.50)/25=0.02=2.00%
Recession: (1025+0.25)/25=0.59=59.00%
E(HPR)=[(1/3)44%]+[(1/3)2%]+[(1/3)(59.00%)]=4.33%
2(HPR)=[(1/3)(44(4.33))]2+[(1/3)(2(4.33))]2+(1/3)[(59(4.33))]2
=1788.22
= 1788.22 =42.29%
b.
E(r)=(0.54.33%)+(0.54%)=0.165%
=0.542.29%=21.145%
13.
a.
Meanofportfolio=(1y)rf+yrP=rf+(rPrf)y=6+9y
Iftheexpectedrateofreturnfortheportfoliois12%,then,solvingfory:
12=6+9yy=
12 6
=0.667
9
Therefore,inordertoachieveanexpectedrateofreturnof12%,theclient
mustinvest66.7%oftotalfundsintheriskyportfolioand33.3%inTbills.
b.
Security
TBills
StockA
StockB
StockC
c.
Investment
Proportions
33.3%
0.66727%=
18.0%
0.66733%=
22.0%
0.66740%=
26.7%
P=0.66725%=16.7%peryear
14.
a.
Portfoliostandarddeviation=P=y25%
Iftheclientwantsastandarddeviationof20%,then:
y=(20%/25%)=0.80=80.0%intheriskyportfolio.
15.
b.
Expectedrateofreturn=6+9y=6+(0.809)=13.20%
a.
SlopeoftheCML=
b.
Myfundallowsaninvestortoachieveahigherexpectedrateofreturnforany
givenstandarddeviationthanwouldapassivestrategy,i.e.,ahigherexpected
returnforanygivenlevelofrisk.
14 6
=0.333
24
28.
Average Rate of Return, Standard Deviation
and Reward-to-Variability Ratio of the Risk Premiums
for Small Common Stocks over One Month Bills
for 1926-2003 and Various Sub-Periods
1926-1943
1944-1963
1964-1983
1984-2003
1926-2003
Risk Premium(%)
Mean
SD
18.40
60.00
17.84
29.86
13.61
35.30
9.08
25.69
14.64
38.72
a.
b.
7.15
14.74
2.76
9.08
8.46
SD
29.07
18.38
17.29
16.79
20.80
Reward-toVariability Ratio
0.3066
0.5975
0.3855
0.3535
0.3780
Reward-toVariability Ratio
0.2460
0.8018
0.1596
0.5408
0.4071
Fortheentireperiod(19262003),smallstockshadalowerrewardto
variabilityratio(0.3780)thanlargestocks(0.4071).However,intwoofthe
foursubperiods,smallstocksperformedbetterthanlargestocks.
Ingeneral,yes.
CHAPTER6:EFFICIENTDIVERSIFICATION
1.
E(rP)=(0.516%)+(0.410%)+(0.106%)=12.6%
13.
Year
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Average:
Std. deviation:
Annualized %
Large Stocks
L-t T-Bonds
6.46
15.29
32.00
32.68
18.40
23.96
5.34
-2.65
16.86
8.40
31.34
19.49
-3.20
7.13
30.66
18.39
7.71
7.79
9.87
15.48
1.29
-7.18
37.71
31.67
23.07
-0.81
33.17
15.08
28.58
13.52
21.04
-8.74
-9.10
20.27
-11.89
4.21
-22.10
16.79
28.69
2.38
14.30
11.66
17.12
11.61
Large Stocks
Large Stocks
L-t T-Bonds
L-t T-Bonds
1
0.284892829
Portfolio Proportions
ABC
XYZ
0.00
1.00
0.10
0.90
0.20
0.80
0.30
0.70
0.40
0.60
0.50
0.50
0.60
0.40
0.70
0.30
0.80
0.20
0.90
0.10
1.00
0.00
0.2485
0.7515
Mean
11.66
11.92
12.19
12.45
12.71
12.98
13.24
13.50
13.77
14.03
14.30
12.31
Portfolio
Std.Dev.
11.61
11.06
10.78
10.78
11.08
11.63
12.42
13.40
14.53
15.78
17.12
10.74
18.
Theprobabilitydistributionis:
Probability
0.6
0.4
RateofReturn
100%
50%
Expectedreturn=(0.6100%)+0.4(50%)=40%
Variance=[0.6(10040)2]+[0.4(5040)2]=5400
Standarddeviation= 5400 =73.48%
19.
20.
a.
Theriskofthediversifiedportfolioconsistsprimarilyofsystematicrisk.Beta
measuressystematicrisk,whichistheslopeofthesecuritycharacteristicline
(SCL).Thetwofiguresdepictthestocks'SCLs.StockB'sSCLissteeper,and
henceStockB'ssystematicriskisgreater.TheslopeoftheSCL,andhencethe
systematicrisk,ofStockAislower.Thus,forthisinvestor,stockBistheriskiest.
b.
Theundiversifiedinvestorisexposedprimarilytofirmspecificrisk.StockA
hashigherfirmspecificriskbecausethedeviationsoftheobservationsfromthe
SCLarelargerforStockAthanforStockB.Deviationsaremeasuredbythe
verticaldistanceofeachobservationfromtheSCL.StockAisthereforeriskiest
tothisinvestor.
Monthlyratesofreturn,excessreturnsandmeansforthefiveyearperiodMay
2000throughApril2005areshowninthetableonthenextpage.Thecalculation
ofbetaforGMisshownonthefollowingpage.
Month
May-00
Jun-00
Jul-00
Aug-00
Sep-00
Oct-00
Nov-00
Dec-00
Jan-01
Feb-01
Mar-01
Apr-01
May-01
Jun-01
Jul-01
Aug-01
Sep-01
Oct-01
Nov-01
Dec-01
Jan-02
Feb-02
Mar-02
Apr-02
May-02
Jun-02
Jul-02
Aug-02
Sep-02
Oct-02
Nov-02
Dec-02
Jan-03
Feb-03
Mar-03
Apr-03
May-03
Jun-03
Jul-03
Aug-03
Sep-03
Oct-03
Nov-03
Dec-03
Jan-04
Feb-04
Mar-04
Apr-04
May-04
Jun-04
Jul-04
Aug-04
Sep-04
Oct-04
Nov-04
Dec-04
Jan-05
Feb-05
T-bills
0.50
0.49
0.51
0.52
0.52
0.52
0.53
0.50
0.44
0.42
0.38
0.33
0.31
0.30
0.30
0.29
0.22
0.18
0.16
0.14
0.14
0.15
0.15
0.15
0.15
0.14
0.14
0.14
0.14
0.13
0.10
0.10
0.10
0.10
0.10
0.10
0.09
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.08
0.09
0.11
0.11
0.13
0.14
0.15
0.18
0.19
0.20
0.22
Excess Returns
GM
S&P500
-25.07
-2.69
-18.28
1.91
-2.45
-2.15
22.42
5.55
-7.66
-5.86
-4.95
-1.02
-20.85
-8.54
2.41
-0.09
4.98
3.02
-1.13
-9.65
-3.14
-6.80
5.38
7.35
3.50
0.20
12.80
-2.80
-1.46
-1.37
-14.20
-6.70
-21.87
-8.40
-3.87
1.63
20.12
7.36
-2.36
0.61
5.09
-1.70
3.45
-2.22
13.95
3.52
5.97
-6.29
-3.26
-1.05
-14.14
-7.39
-13.05
-8.04
2.68
0.35
-18.86
-11.14
-14.66
8.51
19.29
5.60
-7.25
-6.13
-1.54
-2.84
-7.15
-1.80
-0.54
0.74
7.13
8.01
-2.09
5.00
1.82
1.05
3.90
1.55
9.72
1.71
-0.49
-1.27
4.17
5.42
0.18
0.63
24.75
5.00
-7.04
1.65
-3.22
1.14
-1.89
-1.72
0.28
-1.76
-4.37
1.12
2.54
1.69
-7.52
-3.54
-4.37
0.10
2.69
0.80
-9.40
1.25
-0.07
3.68
3.62
3.06
-8.31
-2.73
-3.37
1.68
Mar-05
Apr-05
Average:
-17.56
-12.15
-1.58
-1.91
-3.65
-0.31
0.23
0.24
0.21
-17.79
-12.38
-1.79
-2.15
-3.88
-0.51
COVARIANCE MATRIX:
GM
GM
107.9826597
S&P500
26.78817906
S&P500
20.24856691
Intercept
S&P500
1
58
59
Coefficients
-1.10680279
1.322966666
SS
MS
2126.392076 2126.392076
4352.567507 75.04426736
6478.959583
F
28.33517004
Std Error
1.125626727
0.248534103
P-value
0.329555203
1.72383E-06
t Stat
-0.983276927
5.323079
Significance
F
1.72383E-06
CHAPTER7:CAPITALASSETPRICING
ANDARBITRAGEPRICINGTHEORY
1.
a,candd.
2.
a.
E(rX)=5%+0.8(14%5%)=12.2%
X=14%12.2%=1.8%
E(rY)=5%+1.5(14%5%)=18.5%
Y=17%18.5%=1.5%
b.
i.Foraninvestorwhowantstoaddthisstocktoawelldiversifiedequity
portfolio,KayshouldrecommendStockXbecauseofitspositivealpha,while
StockYhasanegativealpha.Ingraphicalterms,StockXsexpected
return/riskprofileplotsabovetheSML,whileStockYsprofileplotsbelow
theSML.Also,dependingontheindividualriskpreferencesofKaysclients,
StockXslowerbetamayhaveabeneficialimpactonoverallportfoliorisk.
ii.Foraninvestorwhowantstoholdthisstockasasinglestockportfolio,
KayshouldrecommendStockY,becauseithashigherforecastedreturnand
lowerstandarddeviationthanStockX.StockYsSharperatiois:
(0.170.05)/0.25=0.48
StockXsSharperatioisonly:
(0.140.05)/0.36=0.25
ThemarketindexhasanevenmoreattractiveSharperatio:
(0.140.05)/0.15=0.60
However,giventhechoicebetweenStockXandY,Yissuperior.Whena
stockisheldinisolation,standarddeviationistherelevantriskmeasure.For
assetsheldinisolation,betaasameasureofriskisirrelevant.Although
holdingasingleassetinisolationisnottypicallyarecommendedinvestment
strategy,someinvestorsmayholdwhatisessentiallyasingleassetportfolio
(e.g.,thestockoftheiremployercompany).Forsuchinvestors,therelevance
ofstandarddeviationversusbetaisanimportantissue.
3.
a.
b.
Thebetaisthesensitivityofthestock'sreturntothemarketreturn.Callthe
aggressivestockAandthedefensivestockD.Thenbetaisthechangeinthe
stockreturnperunitchangeinthemarketreturn.Wecomputeeachstock's
betabycalculatingthedifferenceinitsreturnacrossthetwoscenariosdivided
bythedifferenceinmarketreturn.
A
1 33
2.00
4 20
6 10
0.25
4 20
[Note:Part(b)ofthisproblemshouldread:Whatistheexpectedreturnon
eachstockifthemarketreturnisequallylikelytobe4%or20%?]
Withthetwoscenariosequallikely,theexpectedrateofreturnisanaverage
ofthetwopossibleoutcomes:
E(rA)=0.5(1%+33%)=17.0%
E(rD)=0.5(6%+10%)=8.0%
c.TheSMLisdeterminedbythefollowing:Tbillrate=6%withabetaequaltozero,
betaforthemarketis1.0,andtheexpectedrateofreturnforthemarketis:
0.5(20%+4%)=12.0%
Theequationforthesecuritymarketlineis:
E(r)=6%+(12%6%)
Seethefollowinggraph.
E(r)
SML
18.0%
17.0%
M
12.0%
8.0%
7.5%
6.0%
.25
d.
1.0
2.0
Theaggressivestockhasafairexpectedrateofreturnof:
E(rA)=6%+2.0(12%6%)=18.0%
Thesecurityanalystsestimateoftheexpectedrateofreturnis17%.Thus
thealphafortheaggressivestockis:
A=actualexpectedreturnrequiredreturnpredictedbyCAPM
=17%18%=1.0%
Similarly,therequiredreturnforthedefensivestockis:
E(rD)=6%+0.25(12%6%)=7.5%
ThesecurityanalystsestimateoftheexpectedreturnforDis8%,andhence:
D=8%7.5%=0.50%
Thepointsforeachstockareplottedonthegraphabove.
e.
Thehurdlerateisdeterminedbytheprojectbeta(i.e.,0..25)notbythefirms
beta.Thecorrectdiscountrateistherefore7.50%,thefairrateofreturnon
stockD.
10
22.
a.
Sincethemarketportfolio,bydefinition,hasabetaof1.0,itsexpectedrate
ofreturnis12%.
b.
=0meansthestockhasnosystematicrisk.Hence,theportfolio's
expectedrateofreturnistheriskfreerate,5%.
c.
UsingtheSML,thefairrateofreturnforastockwith=0.5is:
E(r)=5%+(0.5)(12%5%)=1.5%
Theexpectedrateofreturn,usingtheexpectedpriceanddividendfornextyear:
E(r)=($44/$40)1=0.10=10%
Becausetheexpectedreturnexceedsthefairreturn,thestockmustbe
underpriced.
23.
a.
BoththeCAPMandAPTrequireameanvarianceefficientmarket
portfolio.Thisstatementisincorrect.TheCAPMrequiresthemean
varianceefficientportfolio,butAPTdoesnot.
b.
TheCAPMassumesthatonespecificfactorexplainssecurityreturnsbut
APTdoesnot.Thisstatementiscorrect.
11
12
13