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CHAPTER 8

Answers to Problems

1. Rate of SMLc
Return
SMLb
E(Rmc) .17
SMLc
E(Rmb) .15

E(Rmc) .12

RFRc=RFRb .09

RFRa .06

1.0 Systematic Risk (Beta)

In (b), a change in risk-free rate, with other things being equal, would result in a new
SMLb, which would intercept with the vertical axis at the new risk-free rate (.09) and
would be parallel in the original SMLa.

In (c), this indicates that not only did the risk-free rate change from .06 to .09, but the
market risk premium per unit of risk [E(Rm) - Rf] also changed from .06 (.12 - .06) to
.08 (.17 - .09). Therefore, the new SMLc will have an intercept at .09 and a different
slope so it will no longer be parallel to SMLa.

2. E(Ri) = RFR + i(RM - RFR)

= .10 + i(.14 - .10)

= .10 + .04i

Stock Beta (Required Return) E(Ri) = .10 + .04i


U 85 .10 + .04(.85) = .10 + .034 = .134
N 1.25 .10 + .04(1.25)= .10 + .05 = .150
D -.20 .10 + .04(-.20) = .10 - .008 = .092

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3.

Current Expected Expected


Stock Price Price Dividend Estimated Return
24  22  0.75
U 22 24 0.75  .1250
22

N 48 51 2.00 51  48  2.00
 .1042
48

D 37 40 1.25 40  37  1.25
 .1149
37

Stock Beta Required Estimated Evaluation


U .85 .134 .1250 Overvalued
N 1.25 .150 .1042 Overvalued
D -.20 .092 .1149 Undervalued

If you believe the appropriateness of these estimated returns, you would buy stocks D
and sell stocks U and N.

E(R)

N
14% U
*U’
* N’
*D’
D

-0.2 .085 1.25


-0.5 0.5 1.0

4. Student Exercise

5. Student Exercise

8-8
6. Student Exercise

7. Student Exercise

8. Student Exercise

9. Student Exercise

10. Student Exercise

11(a).
COVi, m COVi, m
Bi  and ri, m 
 2
m  i  m 
then COVi,m = (ri,m)(i)( m)

For Intel:

COV i,m = (.72)(.1210)(.0550) = .00479

.00479 .00479
Beta    1.597
(.055) 2 .0030

For Ford:

COV i,m = (.33)(.1460)(.0550) = .00265

.00265
Beta   .883
.0030

For Anheuser Busch:

COV i,m = (.55)(.0760)(.0550) = .00230

.00230
Beta   .767
.0030

For Merck:

COV i,m = (.60)(.1020)(.0550) = .00337

.00337
Beta   1.123
.0030
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11(b). E(Ri) = RFR + Bi(RM - RFR)
= .08 + Bi(.15 - .08)
= .08 + .07Bi
Stock Beta E(Ri) = .08 + .07Bi
Intel 1.597 .08 + .1118 = .1918
Ford .883 .08 + .0618 = .1418
Anheuser Busch .767 .08 + .0537 = .1337
Merck 1.123 .08 + .0786 = .1586

11(c). .20 *Intel


*AB

RM = .15 *Ford

.10 *Merck
RFR=.08

1.0 Beta

12. E(Ri) = RFR + i (RM - RFR)

= .068 + i (.14 - .08)

= .08 + .06i

12(a). E(RA) = .08 + .06(1.72) = .08 + .1050 = .1850 = 18.50%

12(b). E(RB) = .08 + .06(1.14) = .08 + .0684 = .1484 = 14.84%

12(c). E(RC) = .08 + .06(0.76) = .08 + .0456 = .1256 = 12.56%

12(d). E(RD) = .08 + .06(0.44) = .08 + .0264 = .1064 = 10.64%

12(e). E(RE) = .08 + .06(0.03) = .08 + .0018 = .0818 = 8.18%

12(f). E(RF) = .08 + .06(-0.79) = .08 - .0474 = .0326 = 3.26%

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13. Anita General (R1 - E(R1) x
Year (R1) Index (RM) R1 - E(R1) RM - E(RM) RM - E(RM)
1 37 15 27.33 6 163.98
2 9 13 -.67 4 -2.68
3 -11 14 -20.67 5 -103.35
4 8 -9 -1.67 -18 30.06
5 11 12 1.33 3 3.99
6 4 9 -5.67 0 0.00
 = 58  = 54  = 92.00

E(R1) = 9.67 E(M) = 9

1211.33 410
Var1   201.89 VarM   68.33
6 6

 1  201.89  14.21  M  68.33  8.27

92.00
COV1, M   15.33
6

13(a). The correlation coefficient can be computed as follows:

COV1, M 15.33 15.33


r1, M     .13
 1 M (14.21)(8.27) 117.52

13(b). The standard deviations are: 14.21% for Anita Computer and 8.27% for index,
respectively.

13(c). Beta for Anita Computer is computed as follows:

COV1, M 15.33
B1    .2244
VarM 68.33

14. CFA Examination II (1995)


14(a). The security market line (SML) shows the required return for a given level of systematic
risk. The SML is described by a line drawn from the risk-free rate: expected return is 5
percent, where beta equals 0 through the market return; expected return is 10 percent,
where beta equal 1.0.

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15% Security Market Line (SML)

12% *Stock Y
10% *Market
9% *Stock Y

5%

.5 .7 1.0 1.3 1.5 2.0 Beta()

14(b). The expected risk-return relationship of individual securities may deviate from that
suggested by the SML, and that difference is the asset’s alpha. Alpha is the difference
between the expected (estimated) rate of return for a stock and its required rate of return
based on its systematic risk Alpha is computed as

ALPHA () = E(ri) - [rf + (E(rM) - rf)]

where

E(ri) = expected return on Security i


rf = risk-free rate
i = beta for Security i
E(rM) = expected return on the market

Calculation of alphas:

Stock X: = 12% - [5% + 1.3% (10% - 5%)] = 0.5%


Stock Y: = 9% - [5% + 0.7%(10% - 5%)] = 0.5%

In this instance, the alphas are equal and both are positive, so one does not dominate the
other.

Another approach is to calculate a required return for each stock and then subtract that
required return from a given expected return. The formula for required return (k) is

k = rf + i (rM - rf ).

Calculations of required returns:

Stock X: k = 5% + 1.3(10% - 5%) = 11.5%


= 12% - 11.5% = 0.5%

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Stock Y: k = 5% + 0.7(10% - 5%) = 8.5%
= 9% - 8.5% = 0.5%

14(c). By increasing the risk-free rate from 5 percent to 7 percent and leaving all other factors
unchanged, the slope of the SML flattens and the expected return per unit of incremental
risk becomes less. Using the formula for alpha, the alpha of Stock X increases to 1.1
percent and the alpha of Stock Y falls to -0.1 percent. In this situation, the expected
return (12.0 percent) of Stock X exceeds its required return (10.9 percent) based on the
CAPM. Therefore, Stock X’s alpha (1.1 percent) is positive. For Stock Y, its expected
return (9.0 percent) is below its required return (9.1 percent) based on the CAPM.
Therefore, Stock Y’s alpha (-0.1 percent) is negative. Stock X is preferable to Stock Y
under these circumstances.
Calculations of revised alphas:

Stock X = 12% - [7% + 1.3 (10% - 7%]


= 12% - 10.95% = 1.1%

Stock Y = 9% - [7% + 0.7(10% - 7%)]


= 9% - 9.1% = -00.1%

15. CFA Examination II (1998)


15(a). Security Market Line
i. Fair-value plot. The following template shows, using the CAPM, the expected
return, ER, of Stock A and Stock B on the SML. The points are consistent with
the following equations:
ER on stock = Risk-free rate + Beta x (Market return – Risk-free rate)

ER for A = 4.5% + 1.2(14.5% - 4.5%)


= 16.5%

ER for B = 4.5% + 0.8(14.5% - 4.5%)


= 12.5%

ii. Analyst estimate plot. Using the analyst’s estimates, Stock A plots below the
SML and Stock B, above the SML.

*Stock A
14.5% *Stock B

4.5%

0.8 1.2
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15(b). Over vs. Undervalue
Stock A is overvalued because it should provide a 16.5% return according to the CAPM
whereas the analyst has estimated only a 16.0% return.
Stock B is undervalued because it should provide a 12.5% return according to the
CAPM whereas the analyst has estimated a 14% return.

16. Rproxy = 1.2; Rtrue = 1.6

The beta for using the proxy is given by Cov(i,proxy)/Var(proxy). Given the data,

proxy = 256.7/205.2 = 1.251


true = 187.6/109.3 = 1.716.

The proxy is not mean-variance efficient, as it is dominated by the true market portfolio.

17.
R

.18
.16

.09
.07

1.0 Beta

It would be more difficult to show superior performance relative to the true market index.

18. SMLS&P = 0.07 + x(0.16 – 0.07)


SMLTrue = 0.09 + x(0.18 – 0.09)

18(a). Ra = 0.11, a = 0.09


Using the S&P proxy:
E(Ra) = 0.07 + 0.09x(0.09)
= 0.07 + 0.0081
= 0.0781

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Using the true market:
E(Ra) = 0.09 + 0.09x(0.09)
= 0.09 + 0.0081
= 0.0981

A would be superior in either case.

18(b). Rb = .14, b = 1.00


Using the S&P proxy:
E(Rb) = 0.07 + 1.0x0.09
= 0.16

Using the true market:


E(Rb) = 0.09 + 1.0x0.09
= 0.18

Inferior performance in both cases.

18(c). Rc = 0.12 c = -0.4


Using the S&P proxy:
E(Rc) = 0.07 – 0.40x0.09
= 0.07 – 0.036
= 0.034

Using the true market:


E(Rc) = 0.09 – 0.40x0.09
= 0.09 –0.036
= 0.054

Superior performance in both cases.


18(d). Rd = 0.20 d = 1.10
Using the market proxy:
E(Rd) = 0.07 + 1.1x0.09
= 0.07 + 0.99
= 0.169

Using the true market:


E(Rd) = 0.09 + 1.1x0.09
= 0.09 +0.099
= 0.189

Superior performance in both cases.

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19. R

0.08
0.06

1.0 Beta

19(b).  = Cov i,m/(m)2


From a spreadsheet program, we find

Cov i,m = 187.4


m2 = 190.4
Using the proxy:
p = 187.4/190.4 = .984

Using the true index:


t = 176.4/168 = 1.05

19(c). Using the proxy:


E(RR) = 0.08 + 0.984x(0.12 - 0.08)
= 0.08 + 0.0394
= .1194

Using the true market:


E(RR) = 0.06 + 1.05x(0.12 – 0.06)
= 0.06 + 0.063
= 0.123

Rader’s performance would be inferior compared to either.

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