Corporate Finance 9th Edition Ross

Solutions Manual
Visit to download the full and correct content document: https://testbankdeal.com/dow
nload/corporate-finance-9th-edition-ross-solutions-manual/
Chapter12
Problem 1

For a large-company stock mutual fund, would you expect the betas to be positive or negative for

each of the factors in a Fama-French multifactor model?

Step-by-step solution

step 1 of 1

For a large-company stock fund, we would expect the beta for the market risk premium to be near one since large company returns account for a large part of the total market

return on a market-value basis. We would expect the betas for the SMB and HML risk factors to be low, and possibly negative, since large company stock returns are not highly

related to small company stock returns and large company stocks tend to be more oriented toward value stocks.

Problem 1ACQ

Systematic versus Unsystematic Risk Describe the difference between systematic risk and

unsystematic risk.

Step-by-step solution

step 1 of 1

Systematic risk is risk that cannot be diversified away through formation of a portfolio. Generally, systematic risk factors are those factors that affect a large number

of firms in the market, however, those factors will not necessarily affect all firms equally. Unsystematic risk is the type of risk that can be diversified away through

portfolio formation. Unsystematic risk factors are specific to the firm or industry. Surprises in these factors will affect t he returns of the firm in which you are interested,

but they will have no effect on the returns of firms in a different industry and perhaps little effect on other firms in the same industry.

Problem 1SQP

Factor Models A researcher has determined that a two-factor model is appropriate to determine

the return on a stock. The factors are the percentage change in GNP and an interest rate. GNP
is expected to grow by 3.5 percent, and the interest rate is expected to be 2.9 percent. A stock

has a beta of 1.2 on the percentage change in GNP and a beta of ‒.8 on the interest rate. If the

expected rate of return on the stock is 11 percent, what is the revised expected return on the

stock if GNP actually grows by 3.2 percent and interest rates are 3.4 percent?

Step-by-step solution

step 1 of 1

Since we have the expected return of the stock, the revised expected return can be determined using the innovation, or surprise, in the risk factors. So, the revised expected

return is:

R = 11% + 1.2(3.2% – 3.5%) – 0.8(3.4% – 2.9%)

R = 10.24%

Problem 2

The Fama-French factors and risk-free rates are available at Ken French’s Web site:

www.dartmouth.edu/~kfrench. Download the monthly factors and save the most recent 60 months for

each factor. The historical prices for each of the mutual funds can be found on various Web sites,

including finance.yahoo.com. Find the prices of each mutual fund for the same time as the

Fama–French factors and calculate the returns for each month. Be sure to include dividends. For

each mutual fund, estimate the multi- factor regression equation using the Fama-French factors.

How well do the regression estimates explain the variation in the return of each mutual fund?

Step-by-step solution

step 1 of 1
The following shows the results of the regression estimates for the period between January 2001 and December 2005. The actual answer to the case will change based on current

market returns.

Fidelity Magellan:

Regression Statistics
Multiple R 0.96923
R Square 0.93941
Adjusted R Square 0.93617
Standard Error 0.01265
Observations 60

ANOVA
df SS MS F Significance F
Regression 3 0.139004 0.046335 289.4198 4.74E-34
Residual 56 0.008965 0.00016
Total 59 0.14797

Coefficients Standard Error t Stat P-value

Intercept -0.00148 0.001665 -0.88867 0.37798
Mkt-RF 1.230512 0.04505 27.31433 4.7E-34
SMB -0.13006 0.082425 -1.57795 0.120209
HML -0.35628 0.086944 -4.09784 0.000136

Fidelity Low-Priced Stock Fund:

Regression Statistics
Multiple R 0.97008
R Square 0.94106
Adjusted R Square 0.93790
Standard Error 0.01177
Observations 60

ANOVA
df SS MS F Significance F
Regression 3 0.123813 0.041271 298.0359 2.19E-34
Residual 56 0.007755 0.000138
Total 59 0.131568
 Coefficients Standard Error t Stat P-value
Intercept 0.00157 0.001548 1.01372 0.315076
Mkt-RF 1.047432 0.041898 24.99949 4.63E-32
SMB 0.322687 0.076658 4.209435 9.36E-05
HML 0.082383 0.080861 1.018823 0.312668

Baron Small Cap Fund:

Regression Statistics
Multiple R 0.93283
R Square 0.87017
Adjusted R Square 0.86321
Standard Error 0.01874
Observations 60

ANOVA
df SS MS F Significance F
Regression 3 0.131768 0.043923 125.108 8.46E-25
Residual 56 0.01966 0.000351
Total 59 0.151429

Coefficients Standard Error t Stat P-value

Intercept 0.002124 0.002465 0.861594 0.392585
Mkt-RF 1.045257 0.066713 15.66805 3.97E-22
SMB 0.465691 0.122059 3.815284 0.000342
HML -0.26523 0.128752 -2.06004 0.044053

Problem 2ACQ

APT Consider the following statement: For the APT to be useful, the number of systematic risk

factors must be small. Do you agree or disagree with this statement? Why?

Step-by-step solution

step 1 of 1

Any return can be explained with a large enough number of systematic risk factors. However, for a factor model to be useful as a practical matter, the number of factors

that explain the returns on an asset must be relatively limited.

Problem 2SQP

Factor Models Suppose a three-factor model is appropriate to describe the returns of a stock.

Information about those three factors is presented in the following chart:

Factor β Expected ValueActual Value

GDP .0000479$13,275 $13,601
Inflation ‒1.30 3.9% 3.2%
Interest rates‒.67 5.2% 4.7%

a.What is the systematic risk of the stock return?

b.Suppose unexpected bad news about the firm was announced that causes the stock price to drop

by 2.6 percent. If the expected return on the stock is 10.8 percent, what is the total return

on this stock?

Step-by-step solution

step 1 of 2

a.If m is the systematic risk portion of return, then:

m = βGNPΔGNP + βInflationΔInflation + βrΔInterest rates

m = .0000479($13,601 – 13,275) – 1.30(3.20% – 3.90%) – .67(4.70% – 5.20%)

m = 2.81%

step 2 of 2

b.The unsystematic return is the return that occurs because of a firm specific factor such as the bad news about the company. So, the unsystematic return of the stock

is –2.6 percent. The total return is the expected return, plus the two components of unexpected return: the systematic risk portion of return and the unsy stematic portion.

So, the total return of the stock is:

R = + m + ε
R = 10.80% + 2.81% – 2.6%

R = 11.01%

Problem 3

What do you observe about the beta coefficients for the different mutual funds? Comment on any

similarities or differences.

Step-by-step solution

step 1 of 1

This answer will depend on the returns used by the students.

Problem 3ACQ

APT David McClemore, the CFO of Ultra Bread, has decided to use an APT model to estimate the required

return on the company’s stock. The risk factors he plans to use are the risk premium on the stock

market, the inflation rate, and the price of wheat. Because wheat is one of the biggest costs

Ultra Bread faces, he feels this is a significant risk factor for Ultra Bread. How would you evaluate

his choice of risk factors? Are there other risk factors you might suggest?

Step-by-step solution

step 1 of 1

The market risk premium and inflation rates are probably good choices. The price of wheat, while a risk factor for Ultra Products, is not a market risk factor and will

not likely be priced as a risk factor common to all stocks. In this case, wheat would be a firm specific risk factor, not a market risk factor. A better model would employ

macroeconomic risk factors such as interest rates, GDP, energy prices, and industrial production, among others.

Problem 3SQP
Factor Models Suppose a factor model is appropriate to describe the returns on a stock. The current

expected return on the stock is 10.5 percent. Information about those factors is presented in

the following chart:

Factor β Expected ValueActual Value

Growth in GNP 2.04 1.80% 2.6%
Inflation ‒1.15 4.3 4.8

a.What is the systematic risk of the stock return?

b.The firm announced that its market share had unexpectedly increased from 23 percent to 27 percent.

Investors know from past experience that the stock return will increase by .45 percent for every

1 percent increase in its market share. What is the unsystematic risk of the stock?

c.What is the total return on this stock?

Step-by-step solution

step 1 of 3

a.If m is the systematic risk portion of return, then:

m = βGNPΔ%GNP + βrΔInterest rates

m = 2.04(2.6% – 1.8%) – 1.15(4.8% – 4.3%)

m = 1.06%

step 2 of 3

b.The unsystematic is the return that occurs because of a firm specific factor such as the increase in market share. If ε is the unsystematic risk portion of the return,

then:
ε = 0.45(27% – 23%)

ε = 1.80%

step 3 of 3

c.The total return is the expected return, plus the two components of unexpected return: the systematic risk portion of return and the unsystematic portion. So, the total

return of the stock is:

R = + m + ε

R = 10.50% + 1.06% + 1.80%

R = 13.36%

Problem 4

If the market is efficient, what value would you expect for alpha? Do your estimates support market

efficiency?

Step-by-step solution

step 1 of 1

If the market is efficient, all assets should have an alpha of zero. In this case, none of the three funds has a statisticall y significant positive alpha, so the evidence

provided here against market efficiency is limited.

Problem 4ACQ

Systematic and Usystematic Risk You own stock in the Lewis-Striden Drug Company. Suppose you had

expected the following events to occur last month:

a.The government would announce that real GNP had grown 1.2 percent during the previous quarter.

The returns of Lewis-Striden are positively related to real GNP.

b.The government would announce that inflation over the previous quarter was 3.7 percent. The

returns of Lewis-Striden are negatively related to inflation.

c.Interest rates would rise 2.5 percentage points. The returns of Lewis-Striden are negatively

related to interest rates.

d.The president of the firm would announce his retirement. The retirement would be effective six

months from the announcement day. The president is well liked: In general, he is considered an

asset to the firm.

e. Research data would conclusively prove the efficacy of an experimental drug. Completion of

the efficacy testing means the drug will be on the market soon.

Suppose the following events actually occurred:

a.The government announced that real GNP grew 2.3 percent during the previous quarter.

b.The government announced that inflation over the previous quarter was 3.7 percent.

c.Interest rates rose 2.1 percentage points.

d.The president of the firm died suddenly of a heart attack.

e.Research results in the efficacy testing were not as strong as expected. The drug must be tested

for another six months, and the efficacy results must be resubmit-ted to the FDA.

f.Lab researchers had a breakthrough with another drug.

g.A competitor announced that it will begin distribution and sale of a medicine that will compete

directly with one of Lewis-Striden’s top-selling products.

Discuss how each of the actual occurrences affects the return on your Lewis-Striden stock. Which

events represent systematic risk? Which events represent unsystematic risk?

Step-by-step solution

step 1 of 8

a.Real GNP was higher than anticipated. Since returns are positively related to the level of GNP, returns should rise based on this factor.

step 2 of 8

b.Inflation was exactly the amount anticipated. Since there was no surprise in this announcement, it will not affect Lewis-Striden returns.

step 3 of 8

c.Interest rates are lower than anticipated. Since returns are negatively related to interest rates, the lower than expected rate is good news. Returns should rise due

to interest rates.

step 4 of 8
 d.The President’s death is bad news. Although the president was expected to retire, his retirement would not be effective for six months. During that period he would

still contribute to the firm. His untimely death means that those contributions will not be made. Since he was generally considered an asset to the firm, his death will

cause returns to fall. However, since his departure was expected soon, the drop might not be very large.

step 5 of 8

e.The poor research results are also bad news. Since Lewis-Striden must continue to test the drug, it will not go into production as early as expected. The delay will

affect expected future earnings, and thus it will dampen returns now.

step 6 of 8

f.The research breakthrough is positive news for Lewis Striden. Since it was unexpected, it will cause returns to rise.

step 7 of 8

g.The competitor’s announcement is also unexpected, but it is not a welcome surprise. This announcement will lower the returns on Lewis-Striden.

step 8 of 8

The systematic factors in the list are real GNP, inflation, and interest rates. The unsystematic risk factors are the president’s ability to contribute to the firm, the

research results, and the competitor.

Problem 4SQP

Multifactor Models Suppose stock returns can be explained by the following three- factor model:

Ri. = RF+β1F1 + β2F2– β3F3

Assume there is no firm-specific risk. The information for each stock is presented here:

β1 β2 β3
Stock A1.45.80 .05
Stock B.73 1.25 –.20
Stock C.89 –.141.24

The risk premiums for the factors are 5.5 percent, 4.2 percent, and 4.9 percent, respectively.

If you create a portfolio with 20 percent invested in stock A, 20 percent invested in stock B,
and the remainder in stock C, what is the expression for the return on your portfolio? If the

risk-free rate is 5 percent, what is the expected return on your portfolio?

Step-by-step solution

step 1 of 1

The beta for a particular risk factor in a portfolio is the weighted average of the betas of the assets. This is true whether the betas are from a single factor model or

a multi-factor model. So, the betas of the portfolio are:

F1 = .20(1.45) + .20(0.73) + .60(0.89)

F1 = 0.97

F2 = .20(0.80) + .20(1.25) + .60(–0.14)

F2 = 0.33

F3 = .20(0.05) + .20(–0.20) + .60(1.24)

F3 = 0.71

So, the expression for the return of the portfolio is:

Ri = 5% + 0.97F1 + 0.33F2 – 0.71F3

Which means the return of the portfolio is:

Ri = 5% + 0.97(5.50%) + 0.33(4.20%) – 0.71(4.90%)

Ri = 8.21%

Intermediate

Problem 5

Which fund has performed best considering its risk? Why?

Step-by-step solution
step 1 of 1

Once adjusting for risk, we cannot say any of these three funds performed better since all three alphas are not significantly different from zero at any reasonable level

of confidence.

Problem 5ACQ

Market Model versus APT What are the differences between a k-factor model and the market model?

Step-by-step solution

step 1 of 1

The main difference is that the market model assumes that only one factor, usually a stock market aggregate, is enough to exp lain stock returns, while a k-factor model

relies on k factors to explain returns.

Problem 5SQP

Multifactor Models Suppose stock returns can be explained by a two-factor model. The firm-specific

risks for all stocks are independent. The following table shows the information for two diversified

portfolios:

β 1 β2 E(R)
Portfolio A .85 1.15 16%
Portfolio B1.45–.25 12

If the risk-free rate is 4 percent, what are the risk premiums for each factor in this model?

Step-by-step solution

step 1 of 1

We can express the multifactor model for each portfolio as:

E(R P ) = RF + β1F1 + β2F2

where F1 and F2 are the respective risk premiums for each factor. Expressing the return equation for each portfolio, we get:
16% = 4% + 0.85 F1 + 1.15F2

12% = 4% + 1.45 F1 – 0.25F2

We can solve the system of two equations with two unknowns. Multiplying each equation by the respective F2 factor for the other equation, we get:

4.00% = 1.0% + .2125 F1 + 0.2875F2

13.8% = 4.6% + 1.6675 F1 – 0.2875F2

Summing the equations and solving F1 for gives us:

17.8% = 5.6% + 1.88 F1

F1 = 6.49%

And now, using the equation for portfolio A, we can solve for F2, which is:

16% = 4% + 0.85(6.490%) + 1.15 F2

F2 = 5.64%

Problem 6ACQ

APT In contrast to the CAPM, the APT does not indicate which factors are expected to determine

the risk premium of an asset. How can we determine which factors should be included? For example,

one risk factor suggested is the company size. Why might this be an important risk factor in an

APT model?

Step-by-step solution

step 1 of 1

The fact that APT does not give any guidance about the factors that influence stock returns is a commonly-cited criticism. However, in choosing factors, we should choose

factors that have an economically valid reason for potentially affecting stock returns. For example, a smaller company has more risk than a large company. Therefore, the

size of a company can affect the returns of the company stock.

Problem 6SQP

Market Model The following three stocks are available in the market:

E(R) β
Stock A10.5%1.20
Stock B 13.0 .98
Stock C 15.7 1.37
Market 14.2 1.00

Assume the market model is valid.

a.Write the market model equation for each stock.

b.What is the return on a portfolio with weights of 30 percent stock A, 45 percent stock B, and

25 percent stock C ?

c.Suppose the return on the market is 15 percent and there are no unsystematic surprises in the

returns. What is the return on each stock? What is the return on the portfolio? .

Step-by-step solution

step 1 of 3

a.The market model is specified by:

R = + β(RM – ) + ε

so applying that to each Stock:

Stock A:
R A = + βA(RM – ) + εA

R A = 10.5% + 1.2(RM – 14.2%) + εA

Stock B:

R B = + βB(RM – ) + εB

R B = 13.0% + 0.98(RM – 14.2%) + εB

Stock C:

R C = + βC(RM – ) + εC

R C = 15.7% + 1.37(RM – 14.2%) + εC

step 2 of 3

b.Since we don't have the actual market return or unsystematic risk, we will get a formula with those values as unknowns:

R P = .30RA + .45RB + .25RC

R P = .30[10.5% + 1.2(RM – 14.2%) + εA] + .45[13.0% + 0.98(RM – 14.2%) + εB]

+ .25[15.7% + 1.37(R M – 14.2%) + εC]

R P = .30(10.5%) + .45(13%) + .25(15.7%) + [.30(1.2) + .45(.98) + .25(1.37)](RM – 14.2%)

+ .30ε A + .45εB + .25εC

R P = 12.925% + 1.1435(RM – 14.2%) + .30εA + .45εB + .25εC

step 3 of 3

c.Using the market model, if the return on the market is 15 percent and the systematic risk is zero, the return for each individual stock is:

R A = 10.5% + 1.20(15% – 14.2%)

R A = 11.46%

R B = 13% + 0.98(15% – 14.2%)

R B = 13.78%
R C = 15.70% + 1.37(15% – 14.2%)

R C = 16.80%

To calculate the return on the portfolio, we can use the equation from part b, so:

R P = 12.925% + 1.1435(15% – 14.2%)

R P = 13.84%

Alternatively, to find the portfolio return, we can use the return of each asset and its portfolio weight, or:

R P = X1R1 + X2R2 + X3R3

R P = .30(11.46%) + .45(13.78%) + .25(16.80%)

R P = 13.84%

Problem 7ACQ

CAPM versus APT What is the relationship between the one-factor model and the CAPM?

Step-by-step solution

step 1 of 1

Assuming the market portfolio is properly scaled, it can be shown that the one-factor model is identical to the CAPM.

Problem 7SQP

Portfolio Risk You are forming an equally weighted portfolio of stocks. Many stocks have the same

beta of .84 for factor 1 and the same beta of 1.69 for factor 2. All stocks also have the same

expected return of 11 percent. Assume a two-factor model describes the return on each of these

stocks.

a.Write the equation of the returns on your portfolio if you place only five stocks in it.
b.Write the equation of the returns on your portfolio if you place in it a very large number of

stocks that all have the same expected returns and the same betas.

Step-by-step solution

step 1 of 2

a.Since five stocks have the same expected returns and the same betas, the portfolio also has the same expected return and beta. However, the unsystematic risks might

be different, so the expected return of the portfolio is:

= 11% + 0.84F1 + 1.69F2 + (1/5)(ε1 + ε2 + ε3 + ε4 + ε5)

step 2 of 2

b.Consider the expected return equation of a portfolio of five assets we calculated in part a. Since we now have a very large number of stocks in the portfolio, as:

N → ∞, → 0

But, the ε js are infinite, so:

(1/N)(ε 1 + ε2 + ε3 + ε4 +…..+ εN) → 0

Thus:

= 11% + 0.84F1 + 1.69F2

Challenge

Problem 8ACQ

Factor Models How can the return on a portfolio be expressed in terms of a factor model?

Step-by-step solution

step 1 of 1
It is the weighted average of expected returns plus the weighted average of each security's beta times a factor F plus the weighted average of the unsystematic risks of

the individual securities.

Problem 8SQP

APT There are two stock markets, each driven by the same common force, F, with an expected value

of zero and standard deviation of 10 percent. There are many securities in each market; thus,

you can invest in as many stocks as you wish. Due to restrictions, however, you can invest in

only one of the two markets. The expected return on every security in both markets is 10 percent.

The returns for each security, i, in the first market are generated by the relationship:

R1i= .10 + 1.5F + ϵ1i,.

where e1 is the term that measures the surprises in the returns of stock i in market l. These

surprises are normally distributed; their mean is zero. The returns on security j in the second

market are generated by the relationship:

R2j = .10 + .5F + ϵ2j

where ϵ2j is the term that measures the surprises in the returns of stock j in market 2. These

surprises are normally distributed; their mean is zero. The standard deviation ϵ1i,.of and ϵ2j

for any two stocks, i and j, is 20 percent.

a.If the correlation between the surprises in the returns of any two stocks in the first market

is zero, and if the correlation between the surprises in the returns of any two stocks in the

second market is zero, in which market would a risk-averse person prefer to invest? (Note: The
correlation between ϵ1j and ϵ2j. for any i and j is zero, and the correlation between ϵ2j. and

ϵ2j j for any i and j is zero.)

b.If the correlation between ϵ1j and ϵ1j. in the first market is .9 and the correlation between

ϵ2j and ϵ2j in the second market is zero, in which market would a risk-averse person prefer to

invest?

c.If the correlation between ϵ1j and ϵ1j in the first market is zero and the correlation between

ϵ2j and ϵ2j in the second market is.5,in which market would a risk-averse person prefer to invest?

d.In general, what is the relationship between the correlations of the disturbances in the two

markets that would make a risk-averse person equally willing to invest in either of the two markets?

Step-by-step solution

step 1 of 4

To determine which investment an investor would prefer, you must compute the variance of portfolios created by many stocks from either market. Because you know that

diversification is good, it is reasonable to assume that once an investor has chosen the market in which she will invest, she will buy many stocks in that market.

Known:

E F = 0 and σ = 0.10

E ε = 0 and Sεi = 0.20 for all i

If we assume the stocks in the portfolio are equally-weighted, the weight of each stock is , that is:
X i = for all i

If a portfolio is composed of N stocks each forming 1/N proportion of the portfolio, the return on the portfolio is 1/N times the sum of the returns on the N stocks. To

find the variance of the respective portfolios in the 2 markets, we need to use the definition of variance from Statistics:

Var(x) = E[x – E(x)] 2

In our case:

Var(R P) = E[RP – E(RP)]2

Note however, to use this, first we must find R P and E(RP). So, using the assumption about equal weights and then substituting in the known equation for Ri:

R P =

R P = (0.10 + βF + εi)

R P = 0.10 + βF +

Also, recall from Statistics a property of expected value, that is:

If:

where a is a constant, and , , and are random variables, then:

and
E( a) = a

Now use the above to find E(R P):

E(R P) = E

E(R P) = 0.10 + βE(F) +

E(R P) = 0.10 + β(0) +

E(R P) = 0.10

Next, substitute both of these results into the original equation for variance:

Var(R P) = E[RP – E(RP)]2

Var(R P) = E

Var(R P) = E

Var(R P) = E

Var(R P) =

Finally, since we can have as many stocks in each market as we want, in the limit, as N → ∞,

→ 0, so we get:

Var(R P) = β2σ2 + Cov(εi,εj )

and, since:
Cov(ε i,εj) = σiσjρ(εi,εj)

and the problem states that σ 1 = σ2 = 0.10, so:

Var(R P) = β2σ2 + σ1σ2ρ(εi,εj)

Var(R P) = β2(0.01) + 0.04ρ(εi,εj)

So now, summarize what we have so far:

R 1i = 0.10 + 1.5F + ε1i

R 2i = 0.10 + 0.5F + ε2i

E(R 1P) = E(R2P) = 0.10

Var(R 1P) = 0.0225 + 0.04ρ(ε1i,ε1j)

Var(R 2P) = 0.0025 + 0.04ρ(ε2i,ε2j)

Finally we can begin answering the questions a, b, &c for various values of the correlations:

a.Substitute ρ(ε 1i,ε1j) = ρ(ε2i,ε2j) = 0 into the respective variance formulas:

Var(R 1P) = 0.0225

Var(R 2P) = 0.0025

Since Var(R 1P) > Var(R2P), and expected returns are equal, a risk averse investor will prefer to invest in the second market.

step 2 of 4

b.If we assume ρ(ε 1i,ε1j) = 0.9, and ρ(ε2i,ε2j) = 0, the variance of each portfolio is:

Var(R 1P) = 0.0225 + 0.04ρ(ε1i,ε1j)

Var(R 1P) = 0.0225 + 0.04(0.9)

Var(R 1P) = 0.0585

Var(R 2P) = 0.0025 + 0.04ρ(ε2i,ε2j)

Var(R 2P) = 0.0025 + 0.04(0)

Var(R 2P) = 0.0025

Since Var(R 1P) > Var(R2P), and expected returns are equal, a risk averse investor will prefer to invest in the second market.

step 3 of 4

c.If we assume ρ(ε 1i,ε1j) = 0, and ρ(ε2i,ε2j) = .5, the variance of each portfolio is:

Var(R 1P) = 0.0225 + 0.04ρ(ε1i,ε1j)

Var(R 1P) = 0.0225 + 0.04(0)

Var(R 1P) = 0.0225

Var(R 2P) = 0.0025 + 0.04ρ(ε2i,ε2j)

Var(R 2P) = 0.0025 + 0.04(0.5)

Var( R2P) = 0.0225

Since Var(R 1P) = Var(R2P), and expected returns are equal, a risk averse investor will be indifferent between the two markets.

step 4 of 4

d.Since the expected returns are equal, indifference implies that the variances of the portfolios in the two markets are also equal. So, set the variance equations e qual,

and solve for the correlation of one market in terms of the other:

Var(R 1P) = Var(R2P)

0.0225 + 0.04ρ(ε 1i,ε1j) = 0.0025 + 0.04ρ(ε2i,ε2j)

ρ(ε 2i,ε2j) = ρ(ε1i,ε1j) + 0.5

Therefore, for any set of correlations that have this relationship (as found in part c), a risk adverse investor will be indifferent between the two markets

Problem 9ACQ

Data Mining What is data mining? Why might it overstate the relation between some stock attribute

and returns?

Step-by-step solution
step 1 of 1

Choosing variables because they have been shown to be related to returns is data mining. The relation found between some attribute and returns can be accidental, thus overstated.

For example, the occurrence of sunburns and ice cream consumption are related; however, sunburns do not necessarily cause ice cream consumption, or vice versa. For a factor

to truly be related to asset returns, there should be sound economic reasoning for the relationship, not just a statistical one.

Problem 9SQP

APT Assume that the following market model adequately describes the return- generating behavior

of risky assets:

Rit = αi. + βi RMt, + ϵit

Here:

R it = The return on the ith asset at time t.

RMt = The return on a portfolio containing all risky assets in some proportion at time t.

RMt and ϵitare statistically independent.

Short selling (i.e., negative positions) is allowed in the market. You are given the following

information:

AssetβiE(Ri)Var(ϵi)
A .7 8.41% .0100
B 1.212.06 .0144
C 1.513.95 .0225

The variance of the market is .0121, and there are no transaction costs.

a.Calculate the standard deviation of returns for each asset.

b.Calculate the variance of return of three portfolios containing an infinite number of asset

types A, B, or C, respectively.

c.Assume the risk-free rate is 3.3 percent and the expected return on the market is 10.6 percent.

Which asset will not be held by rational investors?

d.What equilibrium state will emerge such that no arbitrage opportunities exist? Why?

Step-by-step solution

step 1 of 4

a.In order to find standard deviation, σ, you must first find the Variance, since σ = . Recall from Statistics a property of Variance:

If:

where a is a constant, and , , and are random variables, then:

and:

Var( a) = 0

The problem states that return-generation can be described by:

R i,t = αi + βi(RM) + εi,t

Realize that R i,t, RM, and εi,t are random variables, and αi and βi are constants. Then, applying the above properties to this model, we get:

Var(R i) = Var(RM) + Var(εi)

and now we can find the standard deviation for each asset:

= 0.72(0.0121) + 0.01 = 0.015929

= = .1262 or 12.62%

= 1.22(0.0121) + 0.0144 = 0.031824

= = .1784 or 17.84%

= 1.52(0.0121) + 0.0225 = 0.049725

= = .2230 or 22.30%

step 2 of 4

b. From the above formula for variance, note that as N → ∞, → 0, so you get:

Var(R i) = Var(RM )

So, the variances for the assets are:

= 0.72(.0121) = 0.005929

= 1.22(.0121) = 0.017424

= 1.52(.0121) = 0.027225

step 3 of 4

c.We can use the model:

= RF + βi( – RF)
which is the CAPM (or APT Model when there is one factor and that factor is the Market). So, the expected return of each asset is:

= 3.3% + 0.7(10.6% – 3.3%) = 8.41%

= 3.3% + 1.2(10.6% – 3.3%) = 12.06%

= 3.3% + 1.5(10.6% – 3.3%) = 14.25%

We can compare these results for expected asset returns as per CAPM or APT with the expected returns given in the table. This shows that assets A&B are accurately priced,

but asset C is overpriced (the model shows the return should be higher). Thus, rational investors will not hold asset C.

step 4 of 4

d. If short selling is allowed, rational investors will sell short asset C, causing the price of asset C to decrease until no arbitrage opportunity exists. In other w ords,

the price of asset C should decrease until the return becomes 14.25 percent.

Problem 10ACQ

Factor Selection What is wrong with measuring the performance of a U.S. growth stock manager

against a benchmark composed of British stocks?

Step-by-step solution

step 1 of 1

Using a benchmark composed of English stocks is wrong because the stocks included are not of the same style as those in a U.S. growth stock fund.

Problem 10SQP

APT Assume that the returns on individual securities are generated by the following two-factor

model:

Rit = E(Rit) +βijF1t+βi2F2t

Here:

Rit is the return on security i at time t.

F1t and F2t are market factors with zero expectation and zero covariance. In addition, assume

that there is a capital market for four securities, and the capital market for these four assets

is perfect in the sense that there are no transaction costs and short sales (i.e., negative

positions) are permitted. The characteristics of the four securities follow:

Securityβ 1β2E(R)
1 1.01.5 20%
2 .52.0 20
3 1.0 .5 10
4 1.5.75 10

a.Construct a portfolio containing (long or short) securities 1 and 2, with a return that does

not depend on the market factor, F1t, in any way. (Hint: Such a portfolio will have β1 = 0.)

Compute the expected return and β 2 coefficient for this portfolio.

b.Following the procedure in (a), construct a portfolio containing securities 3 and 4 with a return

that does not depend on the market factor, F1t. Compute the expected return and β2 coefficient

for this portfolio.

c.There is a risk-free asset with an expected return equal to 5 percent, β1 = 0, and β2 = 0.

Describe a possible arbitrage opportunity in such detail that an investor could implement it.
d.What effect would the existence of these kinds of arbitrage opportunities have on the capital

markets for these securities in the short run and long run? Graph your analysis.

Step-by-step solution

step 1 of 4

a.Let:

X 1 = the proportion of Security 1 in the portfolio and

X 2 = the proportion of Security 2 in the portfolio

and note that since the weights must sum to 1.0,

X 1 = 1 – X2

Recall from Chapter 10 that the beta for a portfolio (or in this case the beta for a factor) is the weighted average of the security betas, so

β P1 = X1β11 + X2β21

β P1 = X1β11 + (1 – X1)β21

Now, apply the condition given in the hint that the return of the portfolio does not depend on F1. This means that the portfolio beta for that factor will be 0, so:

β P1 = 0 = X1β11 + (1 – X1)β21

β P1 = 0 = X1(1.0) + (1 – X1)(0.5)

and solving for X 1 and X2:

X 1 = – 1

X 2 = 2

Thus, sell short Security 1 and buy Security 2.

To find the expected return on that portfolio, use

R P = X1R1 + X2R2

so applying the above:

E(R P) = –1(20%) + 2(20%)

E(R P) = 20%

β P1 = –1(1) + 2(0.5)

β P1 = 0

step 2 of 4

b.Following the same logic as in part a, we have

β P2 = 0 = X3β31 + (1 – X3)β41

β P2 = 0 = X3(1) + (1 – X3)(1.5)

and

X 3 = 3

X 4 = –2

Thus, sell short Security 4 and buy Security 3. Then,

E(R P2) = 3(10%) + (–2)(10%)

E(R P2) = 10%

β P2 = 3(0.5) – 2(0.75)

β P2 = 0

Note that since both β P1 and βP2 are 0, this is a risk free portfolio!

step 3 of 4

c.The portfolio in part b provides a risk free return of 10%, which is higher than the 5% return provided by the risk free security. To take advantage of this opportunity,

borrow at the risk free rate of 5% and invest the funds in a portfolio built by selling short security four and buying security three with weights (3,–2) as in part b.

step 4 of 4

d.First assume that the risk free security will not change. The price of security four (that everyone is trying to sell short) will decrease, and the price of security

three (that everyone is trying to buy) will increase. Hence the return of security four will increase and the return of security three will decrease.

The alternative is that the prices of securities three and four will remain the same, and the price of the risk-free security drops until its return is 10%.

Finally, a combined movement of all security prices is also possible. The prices of security four and the risk-free security will decrease and the price of security three

will increase until the opportunity disappears.