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This document contains the solution of Reilly-Brown Chapter 8

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Answers to Problems

1. Rate of SMLc

Return

SMLb

E(Rmc) .17

SMLc

E(Rmb) .15

E(Rmc) .12

RFRc=RFRb .09

RFRa .06

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.

= .10 + .04i

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

8-7

3.

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

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

-0.5 0.5 1.0

4. Student Exercise

5. Student Exercise

8-8

6. Student Exercise

7. Student Exercise

8. Student Exercise

9. Student Exercise

11(a).

COVi, m COVi, m

Bi and ri, m

2

m i m

then COVi,m = (ri,m)(i)( m)

For Intel:

.00479 .00479

Beta 1.597

(.055) 2 .0030

For Ford:

.00265

Beta .883

.0030

.00230

Beta .767

.0030

For Merck:

.00337

Beta 1.123

.0030

8-9

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

*AB

RM = .15 *Ford

.10 *Merck

RFR=.08

1.0 Beta

= .08 + .06i

8 - 10

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

1211.33 410

Var1 201.89 VarM 68.33

6 6

92.00

COV1, M 15.33

6

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.

COV1, M 15.33

B1 .2244

VarM 68.33

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.

8 - 11

15% Security Market Line (SML)

12% *Stock Y

10% *Market

9% *Stock Y

5%

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

where

rf = risk-free rate

i = beta for Security i

E(rM) = expected return on the market

Calculation of alphas:

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 ).

= 12% - 11.5% = 0.5%

8 - 12

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:

= 12% - 10.95% = 1.1%

= 9% - 9.1% = -00.1%

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)

= 16.5%

= 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

8 - 13

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.

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

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.

SMLTrue = 0.09 + x(0.18 – 0.09)

Using the S&P proxy:

E(Ra) = 0.07 + 0.09x(0.09)

= 0.07 + 0.0081

= 0.0781

8 - 14

Using the true market:

E(Ra) = 0.09 + 0.09x(0.09)

= 0.09 + 0.0081

= 0.0981

Using the S&P proxy:

E(Rb) = 0.07 + 1.0x0.09

= 0.16

E(Rb) = 0.09 + 1.0x0.09

= 0.18

Using the S&P proxy:

E(Rc) = 0.07 – 0.40x0.09

= 0.07 – 0.036

= 0.034

E(Rc) = 0.09 – 0.40x0.09

= 0.09 –0.036

= 0.054

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

E(Rd) = 0.09 + 1.1x0.09

= 0.09 +0.099

= 0.189

8 - 15

19. R

0.08

0.06

1.0 Beta

From a spreadsheet program, we find

m2 = 190.4

Using the proxy:

p = 187.4/190.4 = .984

t = 176.4/168 = 1.05

E(RR) = 0.08 + 0.984x(0.12 - 0.08)

= 0.08 + 0.0394

= .1194

E(RR) = 0.06 + 1.05x(0.12 – 0.06)

= 0.06 + 0.063

= 0.123

8 - 16

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