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1.
RA = .01 + .80 RM + A
M = 0.20, A = .10 (A is the residual standard deviation).
The volatility of the return for stock A is
2A = .802 (2M )+ 2 = 0.0356, and A = .0356 = .1887
2.
The alphas of A and B are given by:
A = (E[rA] rf ) A (E[rM] rf) = 0.04 0.5 0.05 = 0.015
B = (E[rB] rf ) B (E[rM] rf) = 0.06 1.5 0.05 = 0.015
To find the variance of P, first find A and B.
Recall that the R2 is defined as the explained variance divided by the total variance:
Var[P + P(rM rf)] / Var[(rP rf)].
R2 = 2i 2M /2i
A = ( 2A 2M / R2 )= (0.52 0.22 /0.95) = .1026 = 10.26%
B = ( 2B 2M / R2 )= (1.52 0.22 /0.95) = .3078 = 30.78%
Cov(rA,rB) = A B 2M = 0.5 1.5 0.22 = 0.03
Var(rP) = wA2 A2 + wB2 B2 + 2 wA wB Cov(rA,rB)
= 0.72 0.0105 + 0.32 0.0947 + 2(0.7)(0.3) (0.03) = 0.0263
3.
RA = 3% + .7RM + A;
RB = -2% + 1.2RM + B;
M = 20%;
Rsq(A)=.20; Rsq(B)=.12;
a) The standard deviation of each stock can be derived from the following equation
for R2:
i2 2M Explained variance
R =
= Total variance
i2
2
i
Therefore:
=
2
A
A2 M2
R A2
0.7 2 .20 2
=
= 0.098
0.20
A = 31.30%
1.2 2 .20 2
= 0.48
0.12
B = 69.28%
B2 =
AB =
Cov (rA , rB )
A B
0.0336
= 0.155
31.30% 69.28%
d) The non-zero alphas from the regressions are inconsistent with the CAPM. The
question is whether the alpha estimates reflect sampling errors or real mispricing. To
test the hypothesis of whether the intercepts (3% for A, and 2% for B) are
significantly different from zero, we would need to compute t-values for each
intercept.
4.
avg ret
std dev
beta
alpha
R2
General
Electric
0.154
0.236
IBM
0.147
0.294
Pepsi
0.153
0.168
Apple
0.307
0.625
Johnson
0.163
0.180
3M
0.128
0.134
Kellogg
0.112
0.216
Bank of
America
0.180
0.219
Fedex
0.160
0.216
DELL
0.471
0.703
Portfolio
0.198
0.156
1.328
0.042
0.864
0.678
0.069
0.146
0.381
0.092
0.150
0.673
0.230
0.031
0.492
0.096
0.222
0.199
0.077
0.059
0.237
0.058
0.033
0.500
0.112
0.141
0.629
0.085
0.212
1.285
0.362
0.091
0.640
0.122
0.471
Intercept
RM-rf
Coefficients
0.122
0.640
Standard
Error
0.028
0.170
t Stat
4.30
3.77
The R2 of a well-diversified portfolio should be higher than the R2 of an individual stock (the market can explain more of its total variance). This
should be true on average. However, in this case, there is a stock with a higher R2.
An R2 of 80% is unusually high for a regression of the SML type, when the data in question describe a single stock. It is much more usual for the
R2 of a single stock to be around 20-30%.