A pension fund manager is considering three mutual funds.

The first is a stock fun, the second is

a long-term government and corporate bond fun, and the third is a T-bill money market fund
that yields a sure rate of 5.5% the probability distributions of the risky capital are

Tabulate and draw the investment opportunity set of the two risky funds. Use investment
proportions for the stock fund of 0% to 100% in increments of 20%. What expected return and
standard deviation does your graph show for minimum-variance portfolio

Draw a tangent at the risk-free rate to the opportunity set. What do your graph show for the
expected return and standard deviation of the optimal risky portfolio

What is the Sharpe ratio of the best feasible CAL?

Suppose now that your portfolio must yield an expected return of 12% and be efficient that is,
on the best feasible CAL
- What is the standard deviation of your portfolio
- What is the proportion invested in the T-bill fund and each of the two risky funds?
If you were to use only the two risky funds and still require an expected return 12%, what
would be the investment proportions of your portfolio? Compare its standard deviation to that
of the optimal portfolio in the previous problem. What do you conclude?

9. What must be the beta of a portfolio with E(rp) = 20%, if rf = 5% and E9rm) = 15%
E(rp) = rf + Bp [E(rm) – rf]
Excepted return = E(r)
Risk free rate return = rf
Beta of Security = B
Market rate of return = rm
20% = 5% + Bp [15% - 5%]
= 5% + Bp [10%]
20% - 5% = Bp [10%]
15% = Bp [10%]
15% / 10% = Bp
Bp = 1.5
Therefore, the beta of the portfolio is 1.5.
10. The market price of security is $40. Its expected rate of return is 13%. The risk-free rate is
7% and the market risk premium is 8%. What will the market price of security be if its beta
doubles? Assume the stock is expected to pay a constant dividend in perpetuity.
Risk free rate = 7%
Market risk premium = 8%
Current expected rate of return on equity = 13%
Current stock price = $40
CAPM = rs = Rrf + bi * (rm – Rrf) …..(1)
.13 = .07 + bi * .08
bi = .13 - .07 / .08
bi = 0.75
therefore, the current beta is .75
(expected return on equity after doubling the beta of the equity)
rs = Rrf + bi * (rm – Rrf)
rs = .07 + bi * 2) (.08)
rs = .07 + (.075 * 2) (.08)
rs = 19.00%

Price = perpetual dividend / cost of equity

$40 = perpetual dividend / .13
perpetual dividend = $40 * .13 = $5.20

price = perpetual dividend / cost of equity

price = $5.20 / .19
Price = $27.37
Price of the stock after doubling the beta will be $27.37
11. You are a consultant to a large manufacturing corporation considering a project with the
following net after-tax cash flows.
The projects beta is 1.7 assuming rf = 9% and E(rm) = 19% what is the net present value of the
project? What is the highest possible beta estimate for the project before NPV becomes
negative?
Expected return:
E(r) = rf B[E(rm) – rf]
E(r) = .09 + 1.7 (.19 - .09)
E(r) = .09 + 1.7 (.10)
E(r) = .09 + .17
E(r) = .26

NPV:
NPV = Σ Ct / (1 + r) ^t
= Co + C1 / (1 +r)^1 + C2 / (1+r)^2 + C3 / (1 +r)^3 … C10 / (1 + r)^10
Ct = cash flow
r = rate of return
t = number of periods
NPV = -20 + 10 / ( 1 + .26) ^2 + 10 / ( 1 + .26)^2 + 10 / ( 1 + .26)^3 + 10 / (1 + .26)^4 + 10 / (1 +
.26)^5 ….. 20 / ( 1 + .26) ^10
NPV = -20 + 7.94 + 6.3 + 5.00 + 3.97 + 3.15 + 2.15 + 1.98 + 1.57 + 1.25 + 1.98
NPV = $15.64

IRR:
Years
Cash flows in millions of dollars
IRR:

Years Cash flows in millions of dollars

0 -20

1 10

2 10

3 10

4 10

5 10

6 10

7 10

8 10

9 10

10 20

IRR 0.4955

Beta at 49.55% expected rate of return as follows:

E(r) = rf + B[E(rm) – rf]
.4955 = .09 + B (.19 - .09)
.4955 = .09 + .19 B - .09B
.4955 - .09 = .19B - .09B
.4055 = .19B - .09B
.4055 = .1B
B = .4055 /.1
B = 4.55
Therefore, the highest possible beta before the NPV becomes negative is 4.055
12. Consider the following table, which gives a security analysis expected return on two stocks
for two particular market returns:
a: what are the betas of the two stocks?

Ba = 2 – 32 / 5 – 20 = 2.00
Bd = 3.5 – 14 / 5 – 20 = .70

B: what is the expected rate of return on each stock if the market return is equally likely to be
5% or 20%?

E(rA) = .5 * (.02 + .32) = .17

E(rB) = .5 * (.035 + .14) = .0875

C: if the T-bill rate is 8% and the market return is equally likely to be 5% or 20% draw the sml for
this economy
E(r) = .5 (.2 + .05) = .125

The equation for the security market line is: E(r) = .08 + B (.125 - .08)

D: plot the two securities on the SML graph. What are the alphas of each?

The aggressive stock has a fair expected rate of return of:

E(rA) = .08 + 2.0(.125 - .08) = .17

The security analysts estimate of the expected rate of return is also .17. there the alpha for the
aggressive stock is zero, so the required return for the defensive stock is:
E(rD) = .08 + .7(.125 - .08) = .1115
The security analysts estimate of the expected return for D is only .875 so aD = actual expected
return – required return predicted by CAPM.

= .875 - .1115 = -.024

(points are plotted above)

E: what hurdle rate should be used for the management of aggressive firm for a project with
the risk characteristics of the defensive firm’s stock?

The hurdle rate is determined by the project beta, not by the firm’s beta. The correct discount
rate is therefore 11.5%, the fair rate of return on stock D.

13. This situation is not possible, portfolio A has a higher beta than portfolio B, but the
expected return for portfolio A is lower than the expected return for portfolio B. Therefore,
these two portfolios cannot exist in equilibrium.

14. This situation is possible if the CAPM is valid, the expected rate of return compensates only
for systematic risk, represented by beta, rather than for the standard deviation, which includes
nonsystematic risk. Therefore, portfolio A’s lower rate of return can be paired with a higher
standard deviation, as long as A’s beta is less than B’s.

15. Variability of portfolio A = (.16 - .1 / .12) = .5

the variability of portfolio of A is .5
the market portfolio is:
Variability of market portfolio = (.18 - .1 / .24) = .33
The variability of market portfolio is .33%
This proves that portfolio A will not provide a better risk tradeoff than the market portfolio.

16. This situation is not possible if the CAPM is valid, as it is seen that portfolio A dominates the
market portfolio. It has a higher expected return and lower standard deviation in comparison to
the market portfolio. The expected return of market is 18% with a high standard deviation of
24%, but that of portfolio A is 20% with standard deviation of 22%.

17. In this situation it, is not possible. Given the data the SML is E(r) = .1 + b(.18 - .1)
a portfolio with a beta of 1.5 should have an expected return of:
E(r) = .1 + 1.5 * (.18 - .1) = .22
The expected return for Portfolio A is .16 so that portfolio A plots below the SML and therefore
is an overpriced portfolio, and is inconsistent with the CAPM.
18. E(ra) = rf B[E(rm) – rf]
= .1 + .9 * (.18 -.1)
= .1 + .9 * .08
= .1 + .072
= .172
If the simple CAPM is valid, the given situation is not valid. The reason is the expected return on
the portfolio A is .16 but the required expected return is .172
The required expected return under CAPM should be .16. but it is higher than the expected
return, therefore the given situation is not valid.

19. reward to variability = E(rmarket) – rf / standard deviation

= .18 - .1 / .24
= .08 / .24
= .33
The reward-to-variability of the market portfolio is .33, and therefore it can be concluded that
the reward-to-variability of market portfolio is higher than the reward-to-variability of portfolio
A so the given situation is possible.

4. A successful firm like Microsoft has consistently generated large profits for the year. Is this a
violation of the emh?

An efficient market is not violated. The company M is continuously earning from its stocks, but
it is not apparent that those who bought its stock after its achievement have realized excess
returns. An efficient market hypotheses do not mean that the profitability can be forecasted by
records and accuracy. Moreover, a positive return depends on the prices of securities. Efficient
market hypotheses will be violated if the company M continues to earn profits. So, one cannot
predict that if a company is making large profit consistently from years, then same will be
continued in future also.

If the simple CAPM is valid, which of the situations in Problems 13–19 below are possible?
Explain. Consider each situation independently.
16. “if the business cycle is predictable, and stock has a positive beta, the stocks returns also
must be predictable.” respond

While positive beta stocks respond well to favorable new information about the
economy’s progress through the business cycle, the stock’s returns should be predictable and
should not show abnormal returns around already anticipated events. If a recovery, for
example, is already anticipated, the actual recovery is not news. The stock price should already
reflect the coming recovery. The level of the stock price will be unpredictable only when
responding to new information.
21. You know that firm XYZ is very poorly run. On a scale of 1 to 10, you would give it a score of
3. The market consensus evaluation is that the management score is only 2. Should you buy or
sell the stock?

Investors decide upon investing in stocks based on market information. Investors also consider
any private information obtained about stocks while investing. Firm XYZ is poorly run; the
investor should buy the stock, private information tells the investor that the firm is better to
run than the market believes. The current price of the stock reflects the market consensus on
the firm. This means that stock is undervalued in the market in comparison to the true value of
the stock based on more optimistic opinion of the company.

7. Some scholars contend that professional managers are incapable of outperforming the
market, others come to an opposite conclusion. Compare and contrast the assumptions about
the stock market that support (a) passive portfolio management and (b) active portfolio
management.

A: assumptions supporting passive management are informational efficiency

B: Primacy of diversification motives is that active management is supported by the opposite
assumptions, in particular, that pockets of market inefficiency exist.

21. A share of stock is now selling for $100. It will pay a dividend of $9 per share at the end of
the year. Its beta is 1. What do investors expect the stock to sell for at the end of the year?
E9r) = rf + B (rm – rf)
Expected return = E(r) = ?
Risk free rate of return rf = .08
Beta = B = 1.0
Market rate of return = rm = .18
E(r) = .08 + 1 (.18 - .08) = .18
E(r) = D1 / P0 + (P1 – P0) / P0
D1 = (
P0 – 100
E(r) = 18%
.18 = 9 / 100 + ( P1 – 100) / 100
.18 = 9 + P1 – 100 / 100
.18 * 100 = P1 – 91
18 = P1 – 91
P1 = 18 + 91
P1 = $109
Therefore, price of the stock at the end of the year is $109.00

22. I am buying a firm with an expected perpetual cash flow of $1,000 but am unsure of its risk.
If I think the beta of the firm is zero when the beta is 1, how much more will I offer for the firm
than it is truly worth?
PV = $1,000 / .08 = 12, 500 but if the beta is actually equal to 1 the investment should yield 18%
and the price paid for the firm should be PV = $1,000 / .18 = $5,555.56
The difference of $6944.44 is the amount that you will overpay if you erroneously assume that
the beta is zero rather than 1.

23. The stock has an expected return of 6%. What is its beta?
E(r) = rf + B[ E(r,) – rf]
.06 = .08 + B [.18 - .08]
.06 = .08 + B[.1]
-.02 = B[.1]
B = -.02 / .1 = -0.20
Therefore the beta of the stock is -.20
24. Two investment advisers are comparing performance. One averaged a 19% return and the
other a 16% return. However, the beta of the first adviser was 1.5, while that of the second was
1. a. Can you tell which adviser was a better selector of individual stocks (aside from the issue
of general movements in the market)?
b. If the T-bill rate were 6% and the market return during the period were 14%, which adviser
would be the superior stock selector?
c. What if the T-bill rate were 3% and the market return 15%?
A: It is impossible to decide which is a better selector as the addition information is not
provided. To decide the best one, risk-free rate, market return, and the abnormal return/alpha
are required.
B: the risk-free rate and market returns are 6% and 14% so to decide which advisor is a better
selector, it is required to find the alpha of both investments suggested by the advisers.
First advisor:
E(r1) = rf +B1[E(rm) – rf]
= .06 +.015 [.14 - .06]
= .06 + .015 [.08]
= 18%
(a)1 = average return – E(r)1
= 19% - 18%
= 1%
Second advisor:
= .06 + .01 [ .14 - .06]
= .06 + .01 [.08]
= .06 + .08
= .14
(a)2 = average return – E(r1)
= .16 - .14
= 2%
The alpha of investment suggested by the second adviser is 2% which is higher than that of
investment suggested by first adviser which is 1%. This states that the second adviser has high
abnormal return and is a superior stock selector.
C: The risk-free rate and market returns are 3% and 15% respectively. To decide which adviser is
a better selector, it is required to find the alpha of both investments suggested by the advisers.
Expected return of first adviser:
E(ra) = rf + B1[E(rm) – rf]
= .03 + .015 [.15 - .03]
= .21
(alpha)1 = average return – E(r1) of first adviser
= .19 - .21
= -.02%
Expected return of second adviser:
= .03 + .01 [.15 - .03]
= .15

(Alpha)2 = average return – E(r)1 of the second adviser

= .16 - .15
= .01
The alpha of investments suggested by the second adviser is 1% which is higher than the one
suggested by the first adviser which is -2%. Thus, states that the second advisor has higher
abnormal return and is a superior stock selector.

25. Suppose the yield on short-term government securities (perceived to be risk-free) is about
4%. Suppose also that the expected return required by the market for a portfolio with a beta of
1 is 12%. According to the capital asset pricing model:
a. What is the expected return on the market portfolio?

rs = Rrf + b1 (rm – Rrf)

= .04 + 1 * (.12 - .04)
= .12
therefore the expected return on market portfolio as per CAPM is 12%
b. What would be the expected return on a zero-beta stock?

rs = Rrf + b1 ( rm – Rrf)
= .04 + 0 (.12 - .04)
= .04 is the expected return
From the computation above the expected return on a stock will be equal to the risk-free rate if
the beta of the stock is 0.
c. Suppose you consider buying a share of stock at a price of $40. The stock is expected to pay a
dividend of $3 next year and to sell then for $41. The stock risk has been evaluated at β = –.5. Is
the stock overpriced or underpriced?

Underpriced stock: the stocks that are selling in the market below the price than what is
expected to be its intrinsic value
Overpriced stock: the stocks that sell in the market above the price than what is expected to be
its intrinsic value
The expected return of a stock with a beta -.5 is computed as follows
The risk-free rate of return is 4%
The expected market return is 12%
Rs = Rrf + b1 (rm – Rrf)
= .04 + (-.5)(.12 -.04)
=0

the actual rate of return of the stock is:

Actual return = dividend yield + capital gain yield
= D1 / P0 + ( P1 – P0) / P0
= 3 / 40 +(41 – 40) / 40
= .1
so the actual return on the stock is 10%
on conclusion, the stock will be called as undervalued if the return as per CAPM is lesser
compared to return as per dividend growth model or actual return. Here, the expected return,
according to CAPM model is lesser than the actual return that the investors are getting, so
therefore the stock is undervalued.

26. Based on current dividend yields and expected capital gains, the expected rates of return on
portfolios A and B are 11% and 14%, respectively. The beta of A is .8 while that of B is 1.5. The
T-bill rate is currently 6%, while the expected rate of return of the S&P 500 Index is 12%. The
standard deviation of portfolio A is 10% annually, while that of B is 31%, and that of the index is
20%.
a. If you currently hold a market-index portfolio, would you choose to add either of these
portfolios to your holdings? Explain.
Using the SML, the expected rate of return for any portfolio P is:
E(rP) = Rf + B [E(rM) – rf]
E(rA) = .06 + .8 (.12 - .06) = 10.8%
E(rB) = .06 + 1.5 (.12 - .06) = 15%
It can be seen that the expected return of portfolio A is 10.8% while that of portfolio B is 15%.
Return of portfolio A is less than that of the market index that is S&P 500 of 12%
It is known that the market index return based on the practical market portfolios, i.e., based on
the actual returns of the stocks in the portfolio. So, it is much more realistic. The portfolio
which is giving return higher than the market index is not feasible and cannot be relied upon.
Therefore, your portfolio A is more desirable b. If instead, you could invest only in bills and one
of these portfolios, which would you choose?
If the investor can make only investments in T-bills and one of the portfolios, the one with a
great slope of the CAL / reward to volatility ratio will be selected.
S = E(rp) – Rf / p = the reward to volatility ratio for the market index portfolio:
= .12 - .06 / .2
= .3 or 30%
Portfolio A:
Reward to volatility ratio = E(rp) – Rf / p
= .11 - .06 / .1
= .05 / .2
= .5 or 50%
Portfolio B:
Reward to volatility ratio = E(rp) – Rf / p
= .14 - .06 / .31
= .08 / .31
= .2581 or 25.81%
In conclusion, the reward-to-volatility ratio of portfolio A is .5 and for B is .2581. Therefore, it
can be said that the reward-to-volatility ratio of portfolio A is greater than that of Portfolio B

27. Consider the following data for a one-factor economy. All portfolios are well diversified. A
10% 1.0 F40 Suppose another portfolio E is well diversified with a beta of 2/3 and expected a
return of 9%. Would an arbitrage opportunity exist? If so, what would the arbitrage strategy
be?
The expected return for portfolio F equals the risk-free rate since its beta equals o. for portfolio
A, the ratio of risk premium to beta is (.1 - .04)/1 = 6%. For portfolio E, the ratio is lower at: (.09
- .04) / .6 = 7.57%
Arbitrage opportunity exists, and profit can be earned in the following way. For instance, you
could create a new portfolio with a beta equal to 1, which is the same as that of portfolio A by
taking a short position in portfolio F and a long position in portfolio E which is done by
borrowing at the risk-free rate and investing the proceeds in portfolio E.
Expected return of portfolio G = .5 * .04 + 1.5 * .09
= 15.5%
When comparing Portfolio G to E, G has the same beta and higher return. Therefor, an
arbitrage opportunity exists by buying portfolio G and selling an equal amount of Portfolio E.
The profit for this arbitrage will be:
rG – rE = [.155% + (1 * F)] – [.09 + (.66 * F)] = 0%
28. Assume both portfolios A and B are well diversified, that E(r ) = 14% and E(r ) = 14.8%. If the
A B Page 226
economy has only one factor, and βA = 1 while βB = 1.1, what must be the risk-free rate?
Let risk free rate = x
Risk free rate = rf + beta *(market rate – rf)
X + 1 * (.14 – X) = X + 1.1 * (.148 – X)
.14 – X = .148 * 1.1 – 1.1X
.1X = .148 * 1.1 - .14 = 2.28
EXPECTED R
29. Assume a market index represents the common factor and all stocks in the economy have a
beta of 1. Firm-specific returns all have a standard deviation of 30%. Suppose an analyst studies
20 stocks and finds that one-half have an alpha of 3%, and one-half have an alpha of –3%. The
analyst then buys $1 million of an equally weighted portfolio of the positive-alpha stocks and
sells short $1 million of an equally weighted portfolio of the negative-alpha stocks.
a. What is the expected profit (in dollars), and what is the standard deviation of the analyst’s
profit?
Shorting equal amount of the ten negative-alpha stocks and investing the proceeds equally in
the ten positive-alpha stocks eliminates the market exposure and creates a zero investment
portfolio.
Using, $1,000,000 * [.03 (1.0 RM] - $1,000,000 * [(-.03) + (1.0 RM)]
= $1,000,000 * .06 = $60,000
The sensitivity of the payoff of this portfolio to the market fact is zero because the exposures of
the positive alpha and negative alpha stocks cancel out. Therefore, the systematic component
of total risk also is zero. The variance of the analyst's profit is not zero, however since this
portfolio is not well diversified. For N = 20 stocks the investor will have $100,000 position in
each stock. Net market exposure is zero, but the firm-specific risk has not been fully diversified.
The variance of dollar returns from the positions in the 20 firm is: 20 * [(100,000 * .3)2] =
18,000,000,000
The standard deviation of the dollar return is, therefore, $134,164
b. How does your answer change if the analyst examines 50 stocks instead of 20? 100 stocks?

If N=50 stocks, $40,000 is places in each position, and the variance of dollar return is:
50 * [(40,000 * .3)2] = 7,200,000,000
the standard deviation of dollar returns is $84,852
similarly if n = 100 stock, $20,000 is placed in each position and the variance of dollar return is
100 * [(20,000 * .30)2] = 3,600,000,000
the standard deviation of dollar return is $60,000