FINC311 Investments

Week 8 Tutorial

Lecturer: Huong Dang huong.dang@canterbury.ac.nz

Tutor: Zach Logan zal28@uclive.ac.nz
Question 1

Your personal opinion is that a security has an expected rate of return

of 0.11. It has a beta of 1.5. The risk-free rate is 0.05 and the market
expected rate of return is 0.09. According to the Capital Asset Pricing
Model, this security is
A. underpriced.
B. overpriced.
C. fairly priced.
D. cannot be determined from data provided.
E. none of the above.
Question 2

• A security has an expected rate of return of 0.10 and a beta of 1.1.

The market expected rate of return is 0.08 and the risk-free rate is
0.05. The alpha of the stock is
A. 1.7%.
B. -1.7%.
C. 8.3%.
D. 5.5%.
E. none of the above.
Chapter 9 Question 2 BKM
• The market price of a security is $50. Its expected rate of return is
14%. The risk-free rate is 6%, and the market risk premium is 8.5%.
What will be the market price of the security if its correlation
coefficient with the market portfolio doubles (and all other variables
remain unchanged)? Assume that the stock is expected to pay a
constant dividend in perpetuity.
Chapter 9 Question 4/5 BKM
• The T-Bill rate is 4% and market risk premium is 6%
Company $1 Discount Store Everything $5
Forecasted return 12% 11%
Standard deviation 8% 10%
Beta 1.5 1.0

• 4) What would be the fair return for each company, according to the
CAPM?
• 5) Characterize each company as under, over, or fairly priced
Chapter 9 Question 9 BKM
• Consider the following table, which gives a security analyst’s expected
return on two stocks in two particular scenarios for the rate of return
on the market
Market Return Aggressive Stock Defensive Stock
5% -2% 6%
25% 38% 12%

• a) What are the betas of the two stocks?

Chapter 9 Question 9 BKM
• Consider the following table, which gives a security analyst’s expected
return on two stocks in two particular scenarios for the rate of return
on the market
Market Return Aggressive Stock Defensive Stock
5% -2% 6%
25% 38% 12%

• b) What is the expected rate of return on each stock if the two

scenarios for the market return are equally likely?
Chapter 9 Question 9 BKM
• Consider the following table, which gives a security analyst’s expected
return on two stocks in two particular scenarios for the rate of return
on the market
Market Return Aggressive Stock Defensive Stock
5% -2% 6%
25% 38% 12%

• c) If the T-Bill rate is 6% and the market return is equally likely to be

5% or 25%, draw the SML for this economy
Chapter 9 Question 9 BKM
• Consider the following table, which gives a security analyst’s expected
return on two stocks in two particular scenarios for the rate of return
on the market
Market Return Aggressive Stock Defensive Stock
5% -2% 6%
25% 38% 12%

• d) Plot the two securities on the SML graph. What are the alphas of
each?
Chapter 9 Question 9 BKM
• Consider the following table, which gives a security analyst’s expected
return on two stocks in two particular scenarios for the rate of return
on the market
Market Return Aggressive Stock Defensive Stock
5% -2% 6%
25% 38% 12%

• e) What hurdle rate should be used by the management of the

aggressive firm for a project with the risk characteristics of the
defensive firm’s stock?
Chapter 9 Question 17 BKM
• Assume the risk-free rate is 6% and the expected return on the
market is 16%

• A share of stock sells for $50 today. It will pay a dividend of $6 per
share at the end of the year. Its beta is 1.2. What do investors expect
the stock to sell for at the end of the year?
Chapter 9 Question 19 BKM
• Assume the risk-free rate is 6% and the expected return on the
market is 16%

• A stock has an expected rate of return of 4%. What is its beta?