Risk-Return, diversification, CAPM and beta

Q1. Suppose an asset has a Beta of 2 and market participants expect a return of 20% in
one year. Expected risk premium on the market is 5% and risk free rate is 7% . Is the asset
appropriately priced? If market participants expect that the price after one year is Rs. 120,
what is the current market price? What should be the current market price as per CAPM?

Ans: Expected return based on CAPM = r_f + beta * (r_m – r_f)

Risk premium is given, which means, r_m – r_f = 0.05

Expected return is thus: 0.07 + 2*0.05 = 0.17 = 17%

If market participants are expecting 20% in one year, they are expecting more than the expected
return based on the CAPM. This implies that the asset is underpriced relative to the CAPM price.

If the expected price after one year is 120, based on 20% return, the current market price (CMP)
will be:

CMP * (1.20) = 120

CMP = Rs. 100

Based on the CAPM, for the market price of Rs. 120 at the end of one year, the CMP should be:

CMP*(1.17) = 120

CMP = 102.56

Hence, based on the CAPM, the current market price should be Rs. 102.56 instead of Rs. 100.
The asset is not fairly priced.

Q2. Ozark Corporation, which has a market value of equity of $ 2 billion and a beta of
1.50, has announced that it will be acquiring a Casino, which has a market value of $ 1
billion, and a beta of 1.30. At the time of acquisition, both Ozark and the Casino are 100%
equity financed and both do not have any cash. The corporate tax rate is 40%.

a. Estimate the beta for Ozark after the acquisition, assuming that the entire acquisition is
financed by raising fresh equity of $ 1billion.

b. Assume that Ozark takes a debt of $ 1 billion to acquire the Casino. Estimate the levered
beta of Ozark after the acquisition.

Ans:
a) Identifying that currently both Ozark and the Casino do not have any debt or cash, therefore
their current levered beta and unlevered beta will be same. Alternatively, the understand that the
given betas are unlevered betas.

Beta will be weighted average 2/3 * 1.5 + 1/3* 1.3 = 1.43

Since there is still no debt, both unleverd and levered beta will be same

b) Now 1.43 is the unlevered beta, but there is a D/E ratio of 1/2, with a tax rate of 40%, so
levered beta = 1.46*(1+0.5*(1-0.4)) = 1.86

Q3. You have decided to invest all your wealth in two mutual funds: A and B. Their
returns and risks are given below:

E(r_A) = 15%, E(r_B) = 11%.

Var(r_A) = 4%, Var(r_B) = 3.2%.

Cov(r_A, r_B) = 0.025

You want your portfolio to yield a return of 12%. What portfolio of your wealth should
you invest in A and B? What is the standard deviation of the return on your portfolio?

Ans. Let w1 be the weight on mutual fund A. Weight on Mutual fund B, w2 = (1-w1).

Expected portfolio return = 0.15 * w1 + 0.11 * w2 = 0.12

Substitute w2 by (1-w1), and solve for w1. This will give w1 = 0.25 and w2 = 0.75

Hence, 25% of the wealth should be invested in mutual fund A, and 75% in B, to get an expected
return of 12%.

Variance of the above portfolio = w1^2 * var(r_A) + w2^2 * var (r_B) + 2 w1 w2 cov(r_A, r_B)
= 0.25^2 * 0.04 + 0.75^2 * 0.032 + 2 * 0.25 * 0.75 * 0.025 = 0.030

Q4. You are a consultant to a large manufacturing corporation that is considering a project
with the following net after-tax cash flows (in millions of dollars):

Years from Now After-tax cashflow

0 -40

1 − 10 15

The project’s beta is 1.8. Assuming that r_f = 8% and E(r_M ) = 16%, what is the net
present value of the project?
Ans: The appropriate discount rate for the project could be computed using the CAPM as:

r_f + beta (E(r_m) - r_f) = 0.08 + 1.8 (0.16-0.08) = 22.4%.

Using the discount rate, find the NPV as:

NPV = -40 + 15 / 0.224 (1 - 1/(1.224^10)] = 18.09

Q5. In the economy of Transylvania there are just three stocks, A, B and C. The market
portfolio, M, is the market value weighted index of these three stocks.

Market Expected
Beta
Asset Value Return E(r)
A 100 million 1.2 12%
B 100 million 0.75 8.50%
C 100 million ? ?

a. What is the expected return of the Risk-free asset (risk-free rate)?

b. What is the expected return of Market Portfolio M?

c. What is the beta and expected return of Asset C?

Ans: Rf + 1.2 (Rm-Rf) = 12% --- (1)

Rf + 0.75 (Rm-Rf) = 8.5% -- (2)

Subtracting Equation (2) from Equation (1) we get

Rm- Rf = 7.78%

Substituing the value of Rm-Rf in Equation 1 we get Rf = 2.67%

Expected return of market portfolio Rm = 10.44%

Beta of market portfolio is 1. Beta of market portfolio is a value weighted average of betas of
Assets A, B and C.

Therefore, Beta of Asset C = 1.05

Expected return of Asset C as per CAPM is 10.83%.

Further questions

Q1. Stock X has 3 units of systematic risk (market risk) and 2 units of unsystematic risk
(specific risk). Stock Y has 3 units of systematic risk and 4 units of unsystematic risk. If
Stock X is expected to generate an 8% return for investors, what is the expected returns of
Stock Y?

Ans: Since both the stocks have the same systematic risk, by CAPM, the expected return on
Stock X should be the same as the expected return on Stock Y because only the market risk gets
rewarded. Hence, the expected return on Stock Y is 8%.

Q2. A regression of monthly returns of Infosys against monthly returns of NSE 500 index
(market index) generated the following output:

Return of Infosys = 1.47% + 1.45 Return on Market

An analyst has correctly estimated that the stock did 21.7% better than expected annually
during the period of regression. What is the annualized risk-free rate that the analyst used
to come up with this estimate?

Ans: Annual overperformance: 21.7%,

Monthly overperformance = (1+21.7%)^(1/12) – 1= 1.650%

Using CAPM:

1.65% = 1.47% - Rf* (1- 1.45)

Find out the montly R_f = 0.40%, which means an annualized R_f = (1+0.40)^12 – 1 = 4.91%
[Or If reporting APR then annualized R_f = (0.40*12)% = 4.8%]

Q3. If two stocks are similar in cashflows, growth and have the same beta coefficients and
standard errors. Which one would you pick if stock A has 75% as R 2 and stock B has 25%
as R 2 ?

Ans: For a diversified investor, returns to equity is only from the market risk. The specific risk is
diversifiable, and is hence unrewarded. If you (diversiifed investor) pick Stock A with 75% R2,
then you can eliminate the stock specific risk of 25%. If you pick Stock B with 75% specific risk,
you can eliminate that 75% also by diversification. So as a diversified investor, if the betas are
the same, it doesn’t matter if the stock has high R2 or low R2.
If instead, you were an undiversified investor, then holding a stock with low R2 means that you
remain exposed to both the firm-specific as well as the market risk. You will not be able to
eliminate the firm specific risk. The rewards are always for only the market risk, and hence
holding Stock B will imply that you will only be rewarded for the market risk (25%). The
remaining 75% which comes from firm-risk will move the value of your portfolio with no
expected returns. Thus, if you are an undiversified investor, better to invest in a firm that is
diversified company.

Q4. If you find Jensen’s alpha for every stock listed on NSE, what should the average
Jensen’s alpha be?

Ans: It should be zero, because if the Jensen’s alpha is non-zero, say positive, it means on an
average, the market beats itself by that positive value of Jensen’s alpha. This is not possible. In
general, there will be some stocks in the market which will make positive Jensen’s alpha, but
others, which will have negative Jensen’s alpha. And on average, the positive values will cancel
the negative values, and you will be left with only zero.

Q5. Does a positive Jensen’s alpha reflect the good performance of management?

Ans: No. A positive Jensen’s alpha only indicates that the stock did better than the expected
average return based on the CAPM model during the regression period. The positive Jensen’s
alpha could be an industry wide phenomenon or could be a firm specific phenomenon.

Q6. What is the Standard deviation of a very large equally weighted portfolio of stocks
within an industry in which all stocks have standard deviation of 40% and the average
correlation between any two stocks is 60%?

Ans. For a very large equally weighted portfolio, the individual variances drop because of lower
and lower weights. Hence, the standard deviation of such a portfolio will be equal to the square
root of average covariance. The average covariance is:
SQRT(0.6 * 0.4*0.4) = 31%.

Q7. Stock A has expected return 10% and standard deviation 15%, and stock B has
expected return 12% and standard deviation 13%. Then, no investor will buy stock A.
True of False?

Ans: False. The correlation structure between Stock A and other securities in the market may
make it useful as part of a diversified portfolio.

Q8. Diversification means that the equally weighted portfolio is optimal?

Ans: False. The optimal diversification depends on the return and risk of each security, as well as
the correlation structure between securities.

Q9. Stock 1 and 2 have the same beta of 0.8. But stock 1’s return has a standard deviation
of 40% and stock 2 has a standard deviation of 60%. How would you compare the risk of
these two stocks? Which one do you think should have the higher expected returns?
Explain briefly.

Ans: The two stocks have the same beta. This implies that both have the same systematic risk.
Since the standard deviation of Stock 2 is higher than Stock 1, this implies that Stock 2 has
higher total risk. Which means that the firm-specific risk of stock 2 is dominant.

Under CAPM, investors are well diversified and hold the market portfolio. The idiosyncratic
risks of the stocks within the portfolio cancel out. Therefore, investors are only rewarded for the
systematic risk (undiversifiable risk). The expected return on a stock (typically the opportunity
cost of capital investors will use to discount cash flows) depends on the beta of the stock,
following the CAPM equation. Since Stock 1 and 2 have the same beta, they should have the
same expected return.

Q10. ABC Limited has market value of equity of 300 million. They had a bank loan of INR
50 million. The company had also issued bonds with a face value of INR 100 and a coupon
rate of 5%, paid annually. There were 5 years left to maturity and there are 1 million
bonds outstanding. The pre-tax cost of debt for the company was 8%. What is the levered
beta for ABC limited if the levered beta for the sector is 1.5 and the sector has an average
debt ratio of 20% in market value terms? Assume that the cash ratio of both the sector and
ABC Limited is similar, and tax rate = 30%.

Ans: Find out the present value of bonds, and determine the debt to equity ratio. Plug the
numbers into the levered beta computation

Levered beta for ABC: 1.688

Bonds

Q1. Of the two bonds which is more sensitive to changes in interest rates?

‘A’ : 8% coupon, 3 year bond, Face Value 100 and YTM = 10%

‘B’ : 2-year zero coupon bond, Face Value 1000 and YTM = 10%

Ans Mod. Durations for A = 2.52 and B= 1.81; A is more sensitive