MANM524: Principles of Finance and Investment

Seminar 5: Capital Asset Pricing Model

Question 1. The standard deviation of the return on the market index is estimated as 20%. If
stock A’s standard deviation is 30% and its correlation of returns with the market index is
0.8, what is stock A’s beta? Interpret the meaning of the beta.
Suggested answer:
Co v i , M ρi , M σ i σ M ρ i, M σ i 0.80 ×0.30
β i= 2
= = = =1.2
σ M
σ M σM σM 0.20

It implies that if market index return increases (decreases) 1%, stock A’s return will increases
(decreases) by 1.2%.
Question 2. The following figure contains information based on analyst's forecasts for three
stocks. Assume a risk-free rate of 7% and a market return of 15%. Compute the forecasted
and required return on each stock, determine whether each stock is undervalued,
overvalued, or properly valued, and outline an appropriate trading strategy.
Forecast Data
Stock Pi ,t E(P¿ ¿i , t+1)¿ E(D ¿¿ i, t+1)¿ βi
A 25 27 1.00 1.0
B 40 45 2.00 0.8
C 15 17 0.50 1.2

Suggested answer:
Forecasted and required returns computations are shown in the following table.

Forecasted vs. Required Returns

Stock Forecasted Return Required Return
E(D¿¿ i , t+1)−Pt E ( R ) =Rf + βi ( E ( R M )−R f )
Rt +1=E (P¿¿ i, t+ 1)+ ×100 % ¿ ¿ i
Pt
A 27−25+ 1 0.07+ 1.0× ( 0.15−0.07 )=15 %
×100 %=12.0 %
25
B 45−40+2 0.07+ 0.8 × ( 0.15−0.07 ) =13.4 %
×100 %=17.5 %
40
C 17−15+ 0.5 0.07+ 1.2× ( 0.15−0.07 )=16.6 %
×100 %=16.6 %
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Stock A is overvalued. It is forecasted to earn 12%, but based on its systematic risk, it should
earn 15%. It plots below the SML.
Stock B is undervalued. It is forecasted to earn 17.5%, but based on its systematic risk, it
should earn 13.4%. It plots above the SML.

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Stock C is properly valued. It is forecasted to earn 16.6%, but based on its systematic risk, it
should earn 16.6%. It plots on the SML.
Question 3. Suppose the current risk-free rate is 7.6%. XYZ’s stock has a beta of 1.7 and an
expected return of 16.7%. (Assume the CAPM is true).
i. What is the risk premium on the market?
ii. UVW’s stock has a beta of 0.8. What is the expected return on the UVW stock?
iii. Suppose you have invested £10,000 in both XYZ and UVW, and the beta of the portfolio is
1.07. How much did you invest in each stock? What is the expected return on the portfolio?
Suggested answer:
i.

According to the Capital Asset Pricing Model: E ( Ri ) =Rf + βi ( E ( R M )−R f )

E ( R XYZ ) =Rf + β XYZ ( E ( R M )−R f ) =7.6 % +1.7 × ( E ( R M ) −Rf )=16.7 %

0.167−0.076
E ( R M )−R f = =0.0535=5.35 %
1.7
The expected market risk premium is 5.35%.
ii.

E ( RUVW ) =Rf + βUVW ( E ( R M ) −Rf )=7.6 % +0.8 ×5.35 %=11.88 %

iii.
The beta of a portfolio is the weighted average of the betas of the individual securities in the
portfolio. The beta of XYZ is 1.7, the beta of UVW is 0.8, and the beta of a portfolio
consisting of both XYZ and UVW is 1.07. Therefore:
β P =w XYZ × β XYZ +w UVW × βUVW =w XYZ ×1.7 + ( 1−w XYZ ) ×0.8=1.07

w XYZ =0.3

w UVW =0.7

E ( Ri ) =w 1 × R1 + w2 × R2=w XYZ × R XYZ +w UVW × R UVW =0.3 × 0.167+0.7 × 0.1188=13.33 %

Question 4. What are the differences between the Security Market Line (SML) and the
Capital Market Line (CML)?
Suggested answer:
SML and CML are quite different.
E ( R M )−R f
CML : E ( RP )=R f +σ P
σM

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 CAPM : E ( Ri )=R f + β i ( E ( R M )−R f )

The CML uses total risk σ P on the x-axis. Hence, only efficient portfolios will plot on the CML.
On the other hand, the SML uses beta β i (systematic risk) on the x-axis. So, in a CAPM world,
all properly priced securities and portfolios of securities will plot on the SML.
CML shows the efficient set of portfolios formed from both risky assets and the riskless
asset. Each point on the line represents an entire portfolio. Point M is a portfolio composed
entirely of risky assets. Every other point on the line represents a portfolio of the securities
in M combined with the riskless asset. The CML relates the expected return on a portfolio
and the standard deviation of a portfolio. Individual securities do not lie along the CML. The
SML relates expected return to beta. SML holds both for all individual securities and for all
possible portfolios, whereas CML holds only for efficient portfolios.

Question 5. Statistics for three stocks, A, B, and C, are shown in the following tables.
Standard Deviations of Returns
Stock A B C
Standard Deviation (%) 40 20 40

Correlation Matrix of Returns

Stock A B C
A 1.00 0.90 0.50
B 1.00 0.10
C 1.00

Using only the information provided in the tables, and given a choice between a portfolio
made up of equal amounts of stocks A and B or a portfolio made up of equal amounts of
stocks B and C, which portfolio would you recommend? Justify your choice.

Suggested answer:
Since we do not have any information about expected returns, we focus exclusively on
reducing variability. Stocks A and C have equal standard deviations, but the correlation of
Stock B with Stock C (0.10) is less than that of Stock A with Stock B (0.90). Therefore, a
portfolio comprised of Stocks B and C will have lower total risk than a portfolio comprised of
Stocks A and B.

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Question 6. ABC’s current portfolio of £2 million is invested as follows:
Summary of ABC’s Current Portfolio
Value (£) Weight (%) Expected Annual Return (%) Annual Standard Deviation (%)
Short-term bonds 200,000 10 4.6 1.6
Large-cap stocks 600,000 30 12.4 19.5
Small-cap stocks 1,200,000 60 16.0 29.9
Total portfolio 2,000,000 100 13.8 23.1

ABC soon expects to receive an additional £2 million and plans to invest the entire amount
in an index fund that best complements the current portfolio. DEF is evaluating the four
index funds shown in the following table for their ability to produce a portfolio that will
meet two criteria relative to the current portfolio: (1) maintain or enhance expected return
and (2) maintain or reduce volatility.

Each fund is invested in an asset class that is not substantially represented in the current
portfolio.

Index Fund Characteristics

Index Fund Expected Annual Return Expected Annual Standard Correlation of Returns with Current
Deviation Portfolio
Fund A 15% 25% 0.80
Fund B 11% 22% 0.60
Fund C 16% 25% 0.90
Fund D 14% 22% 0.65

Which fund should DEF recommend to ABC? Justify your choice by describing how your
chosen fund best meets both of DEF’s criteria. No calculations are required.
Suggested answer:

Fund D represents the single best addition to complement ABC's current portfolio, given his
selection criteria. First, Fund D’s expected return (14.0%) has the potential to increase the
portfolio’s return somewhat. Second, Fund D’s relatively low correlation with his current
portfolio (+0.65) indicates that Fund D will provide greater diversification benefits than any
of the other alternatives except Fund B. The result of adding Fund D should be a portfolio
with approximately the same expected return and somewhat lower volatility compared to
the original portfolio.

The other three funds have shortcomings in terms of either expected return enhancement
or volatility reduction through diversification benefits. Fund A offers the potential for
increasing the portfolio’s return but is too highly correlated to provide substantial volatility
reduction benefits through diversification. Fund B provides substantial volatility reduction
through diversification benefits but is expected to generate a return well below the current
portfolio’s return. Fund C has the greatest potential to increase the portfolio’s return but is
too highly correlated with the current portfolio to provide substantial volatility reduction
benefits through diversification.
Question 7. The Arbitrage Pricing Theory (APT) itself does not provide guidance concerning
the factors that one might expect to determine risk premiums. How should researchers

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decide which factors to investigate? Why, for example, is industrial production a reasonable
factor to test for a risk premium?
Suggested answer:
The Arbitrage Pricing Theory (APT) factors must correlate with major sources of uncertainty,
i.e., sources of uncertainty that are of concern to many investors. Researchers should
investigate factors that correlate with uncertainty in consumption and investment
opportunities. GDP, the inflation rate, and interest rates are among the factors that can be
expected to determine risk premiums. In particular, industrial production (IP) is a good
indicator of changes in the business cycle. Thus, IP is a candidate for a factor that is highly
correlated with uncertainties that have to do with investment and consumption
opportunities in the economy.

Question 8. If the APT is to be a useful theory, the number of systematic factors in the
economy must be small. Why?
Suggested answer:
Any pattern of returns can be “explained” if we are free to choose an indefinitely large
number of explanatory factors. If a theory of asset pricing is to have value, it must explain
returns using a reasonably limited number of explanatory variables (i.e., systematic factors).

Question 9. Suppose that there are two independent economic factors, F1 and F2. The risk-
free rate is 6%, and all stocks have independent firm-specific components with a standard
deviation of 45%. Portfolios A and B are both well-diversified with the following properties:
Portfolio Beta on F 1 Beta on F 2 Expected Return
A 1.5 2.0 31%
B 2.2 -0.2 27%
What is the expected return–beta relationship in this economy?
Suggested answer:

E ( R P )=R f + β F 1 [ E ( R 1 )−R f ] + β F 2 [ E ( R 2 )−R f ]

We need to find the Risk Premium (RP) for each of the two factors:

R P1=[ E ( R1 ) −Rf ] and R P2=[ E ( R 2) −Rf ]

In order to do so, we solve the following system of two equations with two unknowns:

31 %=Rf + β F 1 [ E ( R1 )−R f ]+ β F 2 [ E ( R2 )−R f ] =6 %+ ( 1.5 × R P1 ) +(2.0 × R P 2)

27 %=R f + β F 1 [ E ( R 1) −Rf ] + β F 2 [ E ( R2 ) −Rf ]=6 % + ( 2.2 × R P1 ) +(−0.2× R P2)

Solving simultaneous equations using the “Solver” Add-in with Excel https://www.youtube.com/watch?v=_EIdjKVRd_U

The solution to this set of equations is:

R P1=10 % and R P2=5 %

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Thus, the expected return-beta relationship is:

E ( R P )=R f + β F 1 [ E ( R 1 )−R f ] + β F 2 [ E ( R 2 )−R f ]=6 %+ β F 1 × 10 %+ β F 2 × 5 %