Topic 3 In-Class Example

Capital Asset Pricing Model and Arbitrage Pricing Theory

Investment Theory and Portfolio Management

Example 1: You are interested in applying what you have just learned in class about the CAPM. Picking two
companies randomly (i.e. Chicken Little and Mighty Store), you want to figure out the return you should expect to
earn based on the two investments’ betas. The following information is collected from the Elm Street Journal.

Chicken Little beta 1.20

Mighty Store beta 0.78
Annualized T-bill return 4.50%
Annualized S&P 500 return 9.25%

Determine the returns of Chicken Little and Mighty Store (using the CAPM) based on their betas.

Example 2: Based on the Value Line report, you realized the four investments you held in your portfolio have the
following betas:

Investment Beta
Chicken Little 1.20
Mighty Store 0.78
Little Baby 0.00
Tiny Tot -0.60

How do you interpret each of the four investments’ betas?

Suppose the market’s return is expected to increase by 4%, how would you expect the returns of the four
investments to react?

Investment Theory -1- Topic 3 In-class Example

Example 3. Using the information from Example 2, you would like to determine the portfolio’s overall beta. In
addition to the information provided, you have also found the following information from your latest brokerage
statement.

Investment Value ($)

Chicken Little 22,000
Mighty Store 34,000
Little Baby 10,000
Tiny Tot 14,000

Determine the beta of the portfolio. Based on your calculation, what can you say about the “risk level” of the
portfolio?

Example 4: Flipping through the Elm Street Journal, you realized that the current market return (based on the
DJIA) is approximately 9.2% and the return of a 1-year T-bill is approximately 2.5%. With this information in hand,
you are interested in knowing if the following 5 investments are overpriced or underpriced:

Investment Beta Average Return (%)

1 0.9 12.0
2 1.3 13.0
3 0.5 11.0
4 1.1 12.5
5 1.0 12.0

Calculate the expected return for each of the investment (using the CAPM). Determine which of the investments are
overpriced and which are underpriced. In addition, calculate the alpha for each investment.

Investment Theory -2- Topic 3 In-class Example

Example 5: Using the data contained in the Excel spreadsheet, determine the betas for Disney and IBM. What do
the betas tell you about the two companies in terms of risk?

Example 6: Suppose you are given the market information from Example 4. In addition, you also know that Fine
Product Inc. has an average return of 11.2% and a beta of 1.2. Using the information provided and the CAPM, is the
company’s stock underpriced or overpriced?

Suppose you decide to use the 30-year T-bond as a proxy for the risk-free asset (but keep the DJIA as the proxy for
the market). How would that affect your conclusion if it has a return of 3.5%?

Suppose you decide to use the S&P 500 as the proxy for the market (but keep the 1-year T-bill as a proxy for the
risk-free asset). How would it affect your conclusion if it has a return of 10.5%?

Investment Theory -3- Topic 3 In-class Example

Example 7: A friend of yours had developed a two-factor APT model to help you determine the appropriate return
of a given investment. The two factors chosen for the model are predicted industrial production and inflation. The
following is the formula for the two-factor model:

E ( ri )  rrf   ip Fip   i Fi

where Fip and Fi are the predicted industrial production and inflation factors, respectively. You are interested in
applying the model to the following four stocks:

Predicted ip i
Return (%)
Stock 1 15 0.9 2.0
Stock 2 21 3.0 1.5
Stock 3 12 1.8 0.7
Stock 4 8 2.0 3.2

In addition, you know the risk-free rate is 8%, the predicted industrial production factor is 4%, and the predicted
inflation factor is –2%. Based on this information, can you determine which of the four stocks is correctly priced,
underpriced or overpriced?

Investment Theory -4- Topic 3 In-class Example