Tutorial Solutions

As part of efforts to provide feedback on your learning progress, I provide an indicative difficulty
level of questions, measured as the passing rate (e.g., easy questions have higher passing rates).
This is based on the students’ performance in the previous years. For example, a level “B” multiple
choice question means about 70% students passed this question; a level “B” problem solving
question means on average students got about 70% of total marks. You can use it to assess your
performance.
Keep in mind that questions in the Problem Set are highly selective, so the Problem Set on average
is more difficult than the final exam paper.

Difficulty level Passing rate Indicator

Easy >80% A
Moderate 60 – 80% B
Difficult 40 – 60% C
Very difficult 25 – 40% D
Extremely difficult <25% E

1. Which of the following statements is/are correct?

I. Any risky assets have some idiosyncratic risks.
II. Risk averse investors don’t hold too risky assets.
III. Alpha is a reward for holding systematic risks.

A. I
B. II
C. III
D. None of the above

Difficulty level: C

Answer: (D)
I: Well diversified portfolios have systematic risks only.
II. Risk averse investors invest positively in optimal risky portfolio, unless her risk aversion is
infinite.
III. Alpha refers to the risk premium not captured by known systematic risk factors.

2. Portfolio diversification theory and CAPM suggest ________

A. investors are indifferent to frontier portfolios because all of them are fully diversified.
B. all assets share the same security characteristic line.
C. all assets share the same capital market line.
D. all assets share the same security market line.
E. all assets share the same capital allocation line.
Difficulty level: C
Answer: (D)
A: Portfolio frontier is not the indifference curve.
B: SCL is the fitted line from a regression. Different assets have different SCL.
C: Individual securities, often with some idiosyncratic risk, are not on CML.
D: Correct, as implied by CAPM.
E: Only some assets, not all assets, are located on CAL.

3. You invest $600 in security A with a beta of 1.5 and $400 in security B with a beta of .90. The
beta of this portfolio is _________.

A. 1.14
B. 1.2
C. 1.26
D. 1.5

Difficulty level: B
Answer: (C)

4. You consider buying a share of stock at a price of $25. The stock is expected to pay a dividend
of $1.50 next year and your advisory service tells you that you can expect to sell the stock in one
year for $28. The stock's beta is 1.1, rf is 6% and E[rm] = 16%. What is the stock's abnormal return?
A. 1%
B. 2%
C. -1%
D. -2%

Difficulty level: B

Answer: (A)

Required return = 6% + (16% - 6%)(1.1) = 17%

Abnormal return = 18% - 17% = 1%
5. A stock's alpha measures the stock's ____________________.
A. expected return
B. abnormal return
C. excess return
D. residual return

Difficulty level: B

Answer: (B)

6. Which of the following statements are true?

I. CAPM is not testable because the model is wrong.
II. CAPM is not testable because the true market portfolio is not observable.
III. You create a portfolio by investing equal amount in four mutually uncorrelated stocks that have
the same standard deviation σ. Your portfolio has a standard deviation of ½ σ.
IV. You create a portfolio by investing equal amount in four mutually uncorrelated stocks that have
the same standard deviation σ. Your portfolio has a standard deviation of ¼ σ.

A. I only
B. II and III only
C. II and IV only
D. I and III only
Difficulty level: C

Answer: (B)

III. variance of this portfolio = 0.25 𝜎 +0.25 𝜎 0.25 𝜎 0.25 𝜎 0.25𝜎

7. X has an expected return of 16% and a beta of 1.0. Y has an expected of 12% and a beta of 0.25.
The risk free rate is 8%, According to CAPM, which of the follow statements are true?
I. Both X and Y are fairly priced.
II. If X is correctly priced, Y is underpriced.
III. If Y is correctly priced, X is overpriced.
IV. Both X and Y are overpriced.

A. I only
B. II only
C. II and III only
D. IV only
Difficulty level: C

Answer: (C)
8. The SML is valid for _______________ and the CML is valid for ______________.
A. only individual assets; well diversified portfolios only
B. only well diversified portfolios; only individual assets
C. both well diversified portfolios and individual assets; well diversified portfolios only
D. both well diversified portfolios and individual assets; both well diversified portfolios and
individual assets
Difficulty level: B

Answer: (C)

9. Suppose two factors are identified for the U.S. economy: the growth rate of industrial production,
IP, and the inflation rate, IR. IP is expected to be 4% and IR 6%. A stock with a beta of 1.0 on IP
and 0.4 on IR currently is expected to provide a rate of return of 14%. If industrial production
actually grows by 5%, while inflation rate turns out to be 7%, what is your best guess for the rate
of return on the stock?
Difficulty level: C

E(ro) – rf = alpha+ betaIP *[E(IP)-rf] + betaIR *[E(IR)-rf]

where ro is the original rate of return.
substitute the numbers:
14-rf = alpha+ 1.0(4-rf) + 0.4(6-rf) -----------------(1)

E(rn) – rf = alpha+ betaIP *[E(IP)-rf] + betaIR *[E(IR)-rf]

where rn is your new guess of the rate of return.
Plug in the numbers:
E(rn)-rf = alpha+ 1.0(5-rf) + 0.4(7-rf)…………………….(2)

Use (2) minus (1) => you cancel out alpha and rf.
Rearrange and you have:
E(rn) =14 + 1.0(1)+0.4(1) = 15.4%

10.

Difficulty level: C

Substituting the portfolio returns and betas in the mean-beta relationship, we obtain two
equations in the unknowns, the risk-free rate (rf) and the factor return (F):

12.0% = rf + 1  (F – rf )
 13.1% = rf + 1.2  (F – rf )
From the first equation we find that F = 12%. Substituting this value for F into the second
equation, we get:
13.1% = rf + 1.2  (12% – rf )  rf = 6.5%

11. Which of the following statements is/are correct?

I. The expected return of a stock with a beta of 0.5 is half of the expected market return.
II. Zero beta assets don’t exist in the markets.
III. CAPM implies that all risky assets must have positive risk premium.
A. I only.
B. II only.
C. III only.
D. I and III.
E. None of the above.

Difficulty level: D
Answer: (E)
I. CAPM says E(ri) - rf = 𝛽 [E(rM) – rf] = 0.5*[E(rM) – rf].
So E(ri) = 0.5*E(rM) + 0.5*rf
III: Note there exist negative beta assets.

12. Consider the CAPM. The risk-free rate is 5%, and the expected return on the market is 15%.
What is the beta on a stock with an expected return of 17%?

A. .5
B. .7
C. 1
D. 1.2
Difficulty level: B

Answer: (D)
17% = 5% + [15% - 5%]βs;
βs = 1.2
13.

Difficulty level: C

Answer:
Under the CAPM, the only risk that investors are compensated for bearing is the risk that
cannot be diversified away (i.e., systematic risk). Because systematic risk (measured by
beta) is equal to 1.0 for each of the two portfolios, an investor would expect the same rate
of return from each portfolio. Moreover, since both portfolios are well diversified, it does
not matter whether the specific risk of the individual securities is high or low. The firm-
specific risk has been diversified away from both portfolios.

14.

Difficulty level: C

a. Since the market portfolio, by definition, has a beta of 1.0, its expected rate of
return is 14%.

b. β= 0 means the stock has no systematic risk. Hence, the portfolio's expected rate
of return is the risk-free rate, 4%.

c. Using the CAPM, the implied fair return for a stock with β = –0.5 is:
E(r) = 4% + (–0.5) (14% – 4%) = -1%
The expected rate of return, using the expected price and dividend for next year:
 E(r) = ($31 + $4)/$30 – 1 = 16.7%
Because the expected return exceeds the fair return, the stock must be
underpriced.

15. Following graphs are scatter diagrams from a single factor model. Interpret their alpha, beta,
idiosyncratic risk, and total variance.

Difficulty level: C
16. Semitool Corp. has an expected excess return of 6% for next year. However, for every
unexpected 1% change in the market, Semitool's return responds by a factor of 1.2. Suppose it
turns out that the economy and the stock market do better than expected by 1.5% and Semitool's
products experience more rapid growth than anticipated, pushing up the stock price by another 1%.
Based on this information, what was Semitool's actual excess return?

Difficulty level: B

A. 7%
B. 8.5%
C. 8.8%
D. 9.25%

Answer: (C)
Single index model: 6% + (1.5%)(1.2) + 1% = 8.8%

17. Consider two well-diversified portfolios, P and Q, in a single-index model, assuming their
alphas are zero. Which of the following statements is/are correct?
I. P and Q are positively correlated as they share the same risk factor.
II. The higher beta portfolio has a higher expected return.
III. The more volatile portfolio has a higher expected return.

A. II only
B. II and III
C. I and II
D. I, II, and III
E. None of the above
Difficulty level: C
Answer: (A)
I. Note betas of P and Q could be positive, 0, or negative, so P and Q could be negatively
correlated.
III. A portfolio can be volatile even if its beta is negative, but its expected return is low.

18.

Difficulty level: C

a. The risk of the diversified portfolio consists primarily of systematic risk. Beta
measures systematic risk, which is the slope of the security characteristic line (SCL).
The two figures depict the stocks' SCLs. Stock B's SCL is steeper, and hence Stock B's
systematic risk is greater. The slope of the SCL, and hence the systematic risk, of
Stock A is lower. Thus, for this investor, stock B is the riskiest.

b. The undiversified investor is exposed primarily to firm-specific risk. Stock A has

higher firm-specific risk because the deviations of the observations from the SCL
are larger for Stock A than for Stock B. Deviations are measured by the vertical
distance of each observation from the SCL. Stock A is therefore riskiest to this
investor.