ANSWER TUTORIAL CHAPTER 2—CAPITAL MARKET THEORY

MULTIPLE CHOICE

1. Which of the following is not an assumption of the Capital Market Theory?

a. All investors are Markowitz efficient investors.
b. All investors have homogeneous expectations.
c. There are no taxes or transaction costs in buying or selling assets.
d. All investments are indivisible so it is impossible to buy or sell fractional shares.
e. All investors have the same one period time horizon.

2. Which of the following statements about the risk-free asset is correct?

a. The risk-free asset is defined as an asset for which there is uncertainty regarding the
expected rate of return.
b. The standard deviation of return for the risk-free asset is equal to zero.
c. The standard deviation of return for the risk-free asset cannot be zero, since division by
zero is undefined.
d. Choices a and b
e. Choices a and c
3. What does WRF = 0.50 mean?
a. The investor can borrow money at the risk-free rate.
b. The investor can lend money at the current market rate.
c. The investor can borrow money at the current market rate.
d. The investor can borrow money at the prime rate of interest.
e. The investor can lend money at the prime rate of interest.
4. The market portfolio consists of all
a. New York Stock Exchange stocks.
b. High grade stocks and bonds.
c. Stocks and bonds.
d. U.S. and non-U.S. stocks and bonds.
e. Risky assets.

5. The separation theorem divides decisions on ____ from decisions on ____.

a. Lending, borrowing
b. Risk, return
c. Investing, financing
d. Risky assets, risk free assets
e. Buying stocks, buying bonds
 6. When identifying undervalued and overvalued assets, which of the following statements is false?
a. An asset is properly valued if its estimated rate of return is equal to its required rate of
return.
b. An asset is considered overvalued if its estimated rate of return is below its required rate
of return.
c. An asset is considered undervalued if its estimated rate of return is above its required rate
of return.
d. An asset is considered overvalued if its required rate of return is below its estimated
rate of return.
e. None of the above (that is, all are true statements)

7. The correlation coefficient between the market return and a risk-free asset would
a. be +¥.
b. be ¥.
c. be +1.
d. be 1.
e. be Zero.

8. As the number of securities in a portfolio increases, the amount of systematic risk

a. Remains constant.
b. Decreases.
c. Increases.
d. Changes.
e. None of the above

9. Theoretically, the correlation coefficient between a completely diversified portfolio and the market
portfolio should be
a. 1.0.
b. +1.0.
c. 0.0.
d. 0.5.
e. +0.5.

10. All portfolios on the capital market line are

a. Perfectly positively correlated.
b. Perfectly negatively correlated.
c. Unique from each other.
d. Weakly correlated.
e. Unrelated except that they contain the risk free asset.

11. Which of the following would most closely resemble the true market portfolio?
a. Stocks
b. Stocks and bonds
c. Stocks, bonds and foreign securities
d. Stocks, bonds, foreign securities and options
e. Stocks, bonds, foreign securities options and coins
12. A completely diversified portfolio would have a correlation with the market portfolio that is
a. Equal to zero because it has only unsystematic risk.
b. Equal to one because it has only systematic risk.
c. Less than zero because it has only systematic risk.
d. Less than one because it has only unsystematic risk.
e. Less than one because it has only systematic risk.

13. All of the following are assumptions of the Capital Asset Pricing Model (CAPM) except
a. Investors can borrow and lend any amount at the risk-free rate.
b. Investors all have homogeneous expectations regarding expected returns.
c. Investors can have different time horizons, daily, weekly, annual, or some other
period.
d. All investments are infinitely divisible.
e. Capital markets are in equilibrium.

14. The Efficient Frontier refers to a set of portfolios that

a. Have the highest expected return for a given level of risk.
b. Have the lowest risk for a given level of return.
c. Are dominant to all other portfolios.
d. a, b, and c above are correct.
e. None of the answers above are correct.
15. If an individual owns only one security the most appropriate measure of risk is:
a. Standard deviation
b. Correlation
c. Beta
d. Covariance
e. All of the above are equally important
16. Calculate the expected return for A Industries which has a beta of 1.75 when the risk free rate is 0.03
and you expect the market return to be 0.11.
a. 11.13%
b. 14.97%
c. 16.25%
d. 22.25%
e. 17.0%
k = 0.03 + 1.75 (0.11  0.03) = 0.17

17. Calculate the expected return for B Services which has a beta of 0.83 when the risk free rate is 0.05
and you expect the market return to be 0.12.
a. 14.96%
b. 16.15%
c. 10.81%
d. 17.00%
e. 15.25%
k = 0.05 + 0.83 (0.12  0.05) = 0.1081
 USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S)

Rates of Return
Year RA Computer Market Index
1 13 17
2 9 15
3 11 6
4 10 8
5 11 10
6 6 12

NARREND

18. Compute the beta for RA Computer using the historic returns presented above.
a. 0.7715
b. 1.2195
c. 1.3893
d. 1.1023
e. 0.7715

(1) (2) (3) (4) (5) (6) (7) (8)

RA Market RA Market (6) ´ (7)
Year RA Market (RE(R))2 (RE(R))2 RE(R) RE(R)
1 13 17 44.44 32.11 6.67 5.67 37.78
2 9 15 7.11 13.44 2.67 3.67 9.78
3 11 6 300.44 28.44 17.33 5.33 92.44
4 10 8 13.44 11.11 3.67 3.33 12.22
5 11 10 21.78 1.78 4.67 1.33 6.22
6 6 12 0.11 0.44 0.33 0.67 0.22
Total 38 68 387.33 87.33 121.33
Average 6.3333 11.33333
Variance 77.47 17.47
Std. Dev. 8.80 4.18
Covariance 24.27
Correlation 0.66
Beta 1.3893
alpha 9.41221
Exp Ret on mkt 12
Exp ret on stock 7.259542

COVRA,MI = 121.33 ¸ 5 = 24.27

MI2 = 87.33 ¸ 5 = 17.47 \ MI = 4.18

Beta for RA is (RA) = COVRA,MI ¸ MI2 = 24.27 ¸ 17.47 = 1.3893

RA2 = 387.33 ¸ 5 = 77.47 \ RA = 8.8

 USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S) 19 TILL 21

You expect the risk-free rate (RFR) to be 3 percent and the market return to be 8 percent. You also
have the following information about three stocks.

CURRENT EXPECTED EXPECTED

STOCK BETA PRICE PRICE DIVIDEND
X 1.25 $20 $23 $1.25
Y 1.50 $27 $29 $0.25
Z 0.90 $35 $38 $1.00

NARREND

19. What are the expected (required) rates of return for the three stocks (in the order X, Y, Z)?
a. 16.50%, 5.50%, 22.00%
b. 9.25%, 10.5%, 7.5%
c. 21.25%, 8.33%, 11.43%
d. 6.20%, 2.20%, 8.20%
e. 15.00%, 3.50%, 7.30%

STOCK REQUIRED ESTIMATED EVALUATION

X .03 + 1.25(.08  .03) = 9.25% undervalued

Y .03 + 1.50(.08  .03) = 10.5% overvalued

Z .03 + 0.9(.08  .03) = 7.5% undervalued

20. What are the estimated rates of return for the three stocks (in the order X, Y, Z)?
a. 21.25%, 8.33%, 11.43%
b. 6.20%, 2.20%, 8.20%
c. 16.50%, 5.50%, 22.00%
d. 9.25%, 10.5%, 7.5%
e. 15.00%, 3.50%, 7.30%

STOCK REQUIRED ESTIMATED EVALUATION

X .03 + 1.25(.08  .03) = 9.25% undervalued

Y .03 + 1.50(.08  .03) = 10.5% overvalued

Z .03 + 0.9(.08  .03) = 7.5% undervalued

21.What is your investment strategy concerning the three stocks?
a. Buy X and Y, sell Z.
b. Sell X, Y and Z.
c. Sell X and Z, buy Y.
d. Buy X, Y and Z.
e. Buy X and Z, sell Y.

STOCK REQUIRED ESTIMATED EVALUATION

X .03 + 1.25(.08  .03) = 9.25% undervalued

Y .03 + 1.50(.08  .03) = 10.5% overvalued

Z .03 + 0.9(.08  .03) = 7.5% undervalued

22. Recently you have received a tip that the stock of Bubbly Incorporated is going to rise from $57 to $61
per share over the next year. You know that the annual return on the S&P 500 has been 9.25% and the
90-day T-bill rate has been yielding 3.75% per year over the past 10 years. If beta for Bubbly is 0.85,
will you purchase the stock?
a. Yes, because it is overvalued.
b. No, because it is overvalued.
c. No, because it is undervalued.
d. Yes, because it is undervalued.
e. Yes, because the expected return equals the estimated return.
Expected Return = 3.75 + (0.85)(9.25  3.75) = 8.425%
Estimated Return = (61  57) ¸ 57 = 7.0175%

Estimated Return < Expected Return

\ Stock is overvalued and should be sold.

23. Your broker has advised you that he believes that the stock of Brat Inc. is going to rise from $20 to
$22.15 per share over the next year. You know that the annual return on the S&P 500 has been 11.25%
and the 90-day T-bill rate has been yielding 4.75% per year over the past 10 years. If beta for Brat is
1.25, will you purchase the stock?
a. Yes, because it is overvalued
b. No, because it is overvalued
c. No, because it is undervalued
d. Yes, because it is undervalued
e. Yes, because the expected return equals the estimated return

Expected Return = 4.75 + (1.25)(11.25  4.75) = 12.875%

Estimated Return = (22.15  20) ¸ 20 = 10.75%

Estimated Return < Expected Return

\Stock is overvalued and should be sold.
 SE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S) 24 TILL 30

Return Proxy True

Period of Radtron Specific Index General Index
(Percent) (Percent) (Percent)
1 10 12 15
2 12 10 13
3 10 8 8
4 4 10 0

NARREND

24. The average True return is

a. 1%
b. 2%
c. 3%
d. 4%
e. 5%
R (True) = (15 + 13  8 + 0)/4 = 20/4 = 5%

25. The average Proxy return is

a. 1%
b. 2%
c. 3%
d. 4%
e. 5%
R (Radtron) = (10 + 12  10  4)/4 = 8/4 = 2%

26. The average return for Radtron is

a. 1%
b. 2%
c. 3%
d. 4%
e. 5%
R (Proxy) = (12 + 10  8  10)/4 = 4/4 = 1%

27. The covariance between Radtron and the Proxy Index is

a. 57.30
b. 86.50
c. 88.00
d. 92.50
e. 107.90
(10  2) (12  1) = 88
(12  2) (10  1) = 90
(10  2) (8  1) = 108
(4  2) (10  1) = 66
352/4 = 88.00
28. The covariance between Radtron and the True Index is
a. 57.30
b. 86.50
c. 88.00
d. 92.50
e. 107.90
(10  2) (15  5) = 80
(12  2) (13  5) = 80
(10  2) (8  5) = 156
(4  2) (0  5) = 30
346/4 = 86.50

29. What is the beta for Radtron using the Proxy Index?
a. 0.87
b. 0.97
c. 1.02
d. 1.15
e. 1.28
(12  1)2 = 121 (15  5)2 = 100
(10  1)2 = 81 (13  5)2 = 64
(8  1)2 = 81 (8  5)2 = 169
(10  1)2 = 121 (0  5)2 = 25
404/4 = 101 358/4 = 89.50

88 ¸ 101 = 0.87

30. What is the beta for Radtron using the True Index?
a. 0.87
b. 0.97
c. 1.02
d. 1.15
e. 1.28
(12  1)2 = 121 (15  5)2 = 100
(10  1)2 = 81 (13  5)2 = 64
(8  1)2 = 81 (8  5)2 = 169
(10  1)2 = 121 (0  5)2 = 25
404/4 = 101 358/4 = 89.50

86.5 ¸ 89.5 = 0.97

31. An investor wishes to construct a portfolio consisting of a 70% allocation to a stock index and a 30%
allocation to a risk free asset. The return on the risk-free asset is 4.5% and the expected return on the
stock index is 12%. Calculate the expected return on the portfolio.
a. 8.25%
b. 16.50%
c. 17.50%
d. 9.75%
e. 14.38%
E(R) = 0.3(4.5) + 0.7(12) = 9.75%

32. A stock has a beta of the stock is 1.25. The risk free rate is 5% and the return on the market is 6%. The
estimated return for the stock is 14%. According to the CAPM you should
a. Sell because it is overvalued.
b. Sell because it is undervalued.
c. Buy because it overvalued.
d. Buy because it is undervalued.
e. Short because it is undervalued.
E(R) = 5 + 1.25(6  5) = 7.25%. The stock is undervalued.

33. Consider a risky asset that has a standard deviation of returns of 15. Calculate the correlation between
the risky asset and a risk free asset.
a. 1.0
b. 0.0
c. 1.0
d. 0.5
e. 0.5
The correlation between a risky asset and a risk-free asset is always zero.

34. The expected return for a stock, calculated using the CAPM, is 10.5%. The market return is 9.5% and
the beta of the stock is 1.50. Calculate the implied risk-free rate.
a. 7.50%
b. 13.91%
c. 17.50%
d. 21.88%
e. 14.38%
10.5 = X + 1.5(9.5  X). X = 7.5%.
 USE THE FOLLOWING INFORMATION FOR THE NEXT PROBLEM(S) 35 TILL 37

Stock Beta Current Price Expected Price Expected Dividend

X 0.8 $12.50 $13.10 $0.80
Y 1.1 $ 8.25 $ 9.76 $0.20
Z 2.1 $25.70 $30.04 $0.00

NARREND

35. What are the expected returns for stocks X, Y, and Z for the next period based on the above prices and
dividends?

X Y Z
I. 4.8% 18.3% 16.9%
II. 10.7% 17.5% 14.4%
III. 11.2% 20.7% 16.9%
IV. 12.3% 22.5% 22.3%
V. 13.1% 24.3% 18.2%

a. I
b. II
c. III
d. IV
e. V
Expected return for X = (13.10 + 0.80  12.50)/12.50 = .112 or 11.2%
Expected return for Y = (9.76 + 0.20  8.25)/8.25 = .207 or 20.7%
Expected return for Z = (30.04 + 0.00  25.70)/25.70 = 16.9%

36. If the expected return on the market is 11.5% and the risk-free rate of return is 4.5%, then what are the
required rates of return for stocks X, Y, and Z based on the CAPM?

X Y Z
I. 4.8% 18.3% 16.9%
II. 7.2% 20.7% 22.3%
III. 10.7% 17.5% 14.4%
IV. 10.1% 12.2% 19.2%
V. 11.1% 12.2% 21.3%

a. I
b. II
c. III
d. IV
e. V
Required return for X = .045 + 0.8(.115  .045) = .101
Required return for Y = .045 + 1.1(.115  .045) = .122
Required return for Z = .045 + 2.1(.115  .045) = .192
37. Which of the following statements is correct?
a. Stocks X, Y, and Z are undervalued.
b. Stocks X, Y and Z are overvalued.
c. Stocks X and Y are overvalued and stock Z is undervalued.
d. Stocks X and Y are undervalued and stock Z is overvalued.
e. Stocks X, Y, and Z are all properly valued.
Stocks X and Y are undervalued because the expected returns are greater than the required returns
based on the CAPM. Stock Z is overvalued because the expected return is less than the required return
based on the CAPM.

38. Assume the risk-free rate is 4.5% and the expected return on the market is 11%. You anticipate Stock
XYZ to sell for $28 at the end of next year and pay a dividend of $2. The stock is currently selling for
$26.50 with a beta of 1.2. You currently hold stock XYZ in a well-diversified portfolio. Assuming you
have money to invest, you should:
a. Buy stock XYZ.
b. Sell stock XYZ.
c. Do nothing because it is properly valued.
d. Invest your money in the risk-free rate of return.
e. Both b and d above.
The expected return for stock XYZ is (28.00  26.50 + 2.00)/26.50 = 0.132.
The required return based on the CAPM is .045 + 1.2(.11  .045) = 0.123.
The expected return for next period is greater than the required return based on the CAPM.