Investments Analysis and Management Canadian 3rd Edition Cleary Solutions Manual

Investments Analysis and Management
Canadian 3rd Edition Cleary Solutions

Manual
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Cleary/Jones Investments: Analysis and Management, Third Canadian Edition
CHAPTER 9
Capital Market Theory
REVIEW QUESTIONS
9-1. The basic difference between graphs of the SML and the CML is the label on
the horizontal axis. For the CML, it is standard deviation while for the SML, it
is beta. Also, the CML is applicable to portfolios only while the SML applies
to individual securities and portfolios.
Level of Difficulty: Easy Topic: The Equilibrium Risk–Return
Trade-Off
9-2. In theory, the market portfolio (portfolio M) is the portfolio of all risky assets,
both financial and real, in their proper proportions. Such a portfolio would be
completely diversified; however, it is a risky portfolio. In equilibrium, all risky
assets must be in portfolio M because all investors are assumed to hold the
same risky portfolio.
Level of Difficulty: Medium Topic: The Market Portfolio
9-3. The major problem in testing capital market theory is that the theory is
formulated ex-ante, concerning what is expected to happen. The only data
we typically have are ex-post.
Level of Difficulty: Medium Topic: Introduction to Capital Market
Theory
9-4. Roll has argued that the CAPM is untestable because the market portfolio,
which consists of all risky assets, is unobservable.
Level of Difficulty: Medium Topic: Difficulties in Testing CAPM
9-5. The CML is drawn tangent to the Markowitz efficient frontier. When this is
done, it can be seen that the CML dominates the Markowitz efficient frontier.
The CML is a straight line tangent to the efficient frontier at point M, the
market portfolio, with an intercept of RF.
9-6. The CML is the trade-off between expected returns and risk for efficient
portfolios. The slope of the CML indicates the equilibrium price of risk in the
market.
Level of Difficulty: Medium Topic: The Capital Market Line
9-7. Most empirical work suggests that three to five factors influence security
returns and are priced into the market. For example, Roll and Ross identify
five systematic factors:
1. changes in expected inflation
Solutions Manual Chapter 9 – Capital Market Theory 9-1

Copyright © 2009 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
2. unanticipated changes in inflation

3. unanticipated changes in industrial production
4. unanticipated changes in the default-risk premium
5. unanticipated changes in the term structure of interest rates
Level of Difficulty: Medium Topic: Understanding the APT Model
9-8. A factor model makes no statement about equilibrium.

Level of Difficulty: Medium Topic: Arbitrage Pricing Theory
9-9. APT is not critically dependent on an underlying market portfolio. It

recognizes that several types of risk may affect security returns. The CAPM
on the other hand, predicts that only market risk influences expected returns.
9-10. The three factors included in Fama and French’s multifactor model are:
1. the expected return to a portfolio of small market capitalization

stocks less the return of a portfolio of large market capitalization
stocks,
2. the expected return to a portfolio of high book-to-market stocks less
the return of a portfolio of low book-to-market stocks; and
3. the expected return on the market index.
Level of Difficulty: Medium Topic: The Fama and French Studies
9-11.The CML (Capital Market Line) depicts the trade-off between expected return
and total risk (as measured by standard deviation), for efficient portfolios
consisting of the optimal portfolio of risky assets and risk-free assets. The
CML cannot be used for individual securities.
The SML (Security Market Line) is the graphical depiction of the CAPM,
which relates the expected return on an individual security or portfolio to its
market risk (as measured by beta).
Level of Difficulty: Medium Topic: The Equilibrium Risk–Return
Trade-Off
9-12. Lending possibilities change part of the Markowitz efficient frontier from an
arc to a straight line. The straight line extends from RF, the risk-free rate of
return, to M, the market portfolio. This new opportunity set, which dominates
the old Markowitz efficient frontier, provides investors with various
combinations of the risky asset, portfolio M, and the riskless asset.
Borrowing possibilities complete the transformation of the Markowitz

efficient frontier into a straight line extending from RF through M and beyond.
Investors can use borrowed funds to lever their portfolio position beyond

point M, increasing the expected return and risk beyond that available at
point M.
9-13. Under the CAPM, all investors hold the market portfolio because it is the
optimal risky portfolio. Because it produces the highest attainable return for
any given risk level, all rational investors will seek to be on the straight line
tangent to the efficient set at the steepest point, which is the market portfolio.
Level of Difficulty: Medium Topic: The Security Market Line
9-14. The slope of the CML is
(ERM – RF)/SDM
where ERM is the expected return on the market portfolio M, RF is the rate of
return on the risk-free asset, and SDM is the standard deviation of the returns
on the market portfolio.
The slope of the CML is the market price of risk for efficient portfolios; that is,
it indicates the equilibrium price of risk in the market. It shows the additional
return that the market demands for each percentage increase in a portfolio's
risk.
9-15. The CML extends from RF, the risk-free asset, through M, the market
portfolio of all risky securities (weighted by their respective market values).
This portfolio is efficient, and the CML consists of combinations of this
portfolio and the risk-free asset. All asset combinations on the CML are
efficient portfolios consisting of M and the risk-free asset.
9-16. The contribution of each security to the standard deviation of the market
portfolio depends on the size of its covariance with the market portfolio.
Therefore, investors consider the relevant measure of risk for a security to be
its covariance with the market portfolio.
9-17. Using some methodology (such as the dividend valuation model), to estimate
the expected returns for securities, investors can compare these expected
returns to the required returns obtained from the SML. Securities whose
expected returns plot above the SML are undervalued because they offer
more expected return than investors require. If they plot below the SML, they
are overvalued because they do not offer enough expected return for their
level of risk.

9-18. When a security is recognized by investors as undervalued, they will

purchase it because it offers more return than required, given its risk. This
demand will drive up the price of the security as more of it is purchased. The
return will be driven down until it reaches the level indicated by the SML as
appropriate for its degree of risk.
9-19. The CAPM is a useful model for estimating required returns. These required
returns can be used in conjunction with independently derived expected
returns to determine overvalued and undervalued securities. This model is
also useful in estimating the cost of equity capital for a security. And, as we
shall see in Chapter 22, the CAPM provides a basis for measuring portfolio
performance.
9-20. Investors decide where they want to be on the new efficient frontier (the
straight line dominating the Markowitz efficient frontier), based on their risk
preferences. If they are conservative, they will be on the lower end of the
line toward RF; if aggressive, they will be on the upper end, which represents
larger expected returns and larger risks.
Level of Difficulty: Easy Topic: The Capital Market Line
9-21. A diagram of the SML is simply an upward-sloping trade-off between expected

return on the vertical axis and risk (as measured by beta), on the horizontal axis.
In effect, this is a diagram of the whole concept of investing, which is, in fact, best
described simply as an upward-sloping trade-off between expected return and
risk.
(a) If the risk-free rate shifts upward, and nothing else changes, the
diagram would show a new upward-sloping line above the old line,
running parallel with it. The difference between the two vertical
intercepts would reflect the increase in the risk-free rate.
(b) In this case, the SML would rotate upward to the left to reflect a
greater trade-off. As investors become pessimistic, the line becomes
steeper (rotates upward to the left). As they become optimistic, the
line rotates downward to the right, approaching a horizontal line at
the extreme.
Level of Difficulty: Difficult Topic: The Security Market Line
9-22. APT, like the CAPM, does assume:
1. investors have homogeneous beliefs

2. investors are risk-averse utility maximizers
3. markets are perfect
4. returns are generated by a factor model

Unlike the CAPM, APT does not assume:
1. a single-period investment horizon

2. the absence of taxes
3. borrowing and lending at the risk-free rate RF
4. investors select portfolios on the basis of expected return and variance
9-23. A factor model is based on the view that there are underlying risk factors
that affect realized and expected security returns. These risk factors
represent broad economic forces and not company-specific characteristics
and, by definition, represent the element of surprise in the risk factor ― the
difference between the actual value for the factor and its expected value.
9-24. The factors in a factor model must possess three characteristics:
1. Each risk factor must have a pervasive influence on stock returns.

Firm-specific events are not APT risk factors.
2. These risk factors must influence expected return, which means they
must have non-zero prices. This issue must be determined
empirically by statistically analyzing stock returns to see which
factors pervasively affect returns.
3. At the beginning of each period, the risk factors must be
unpredictable to the market as a whole.
9-25. A portfolio manager could design strategies that would expose them to one
or more types of these risk factors or that would "sterilize" a portfolio such
that its exposure to the unexpected change in the growth rate of profits
matched that of the market as a whole. Taking an active approach, a
portfolio manager who believes that he or she can forecast a factor
realization can build a portfolio that emphasizes or de-emphasizes that
factor. In doing this, the manager would select stocks that have exposures to
the remaining risk factors that are exactly proportional to the market. If the
manager is accurate with the forecast ― and remember that such a manager
must forecast the unexpected component of the risk factor ― he or she can
outperform the market for that period.
Level of Difficulty: Medium Topic: Using APT in Investment
Decisions
9-26. An arbitrage profit, in the context of the APT, refers to a situation where a
zero investment portfolio can be constructed that will yield a risk-free profit. If
arbitrage profits arise, relatively few investors can act to restore equilibrium.

9-27. We can evaluate how each security affects the standard deviation of the
market portfolio by evaluating the way it would change if the proportion
invested in a particular security changes. In effect, we take the partial
derivative of the standard deviation of the market portfolio with respect to the
proportion of portfolio funds invested in that particular security.
The result is that a security's contribution to the risk of the market portfolio is
given by:
Si,M /SM
where Si,M = the covariance between stock i and the market

portfolio.
9-28. The expected return on a stock is just that, an expected return based on
information available at the time the stock was purchased. At the end of the
year, the realized (actual) return on the stock may be quite a bit different than
the expected return (it could even be negative), due to unexpected events
that occurred during the year.
At the time the investor bought the stock and based on the information
available at that time, the investor expected that the stock would have a
positive return higher than the “guaranteed” return on the risk-free asset.
9-29. The difficulties involved in estimating a security's beta include deciding on

the number of observations and the length of the periods to use in calculating
the beta. The regression estimate of beta is only an estimate of the true
beta, and subject to error. Also, the beta is not perfectly stationary over time.
Level of Difficulty: Medium Topic: Estimating the Security Market
Line (SML)
9-30. The CAPM can be tested empirically by regressing the average return on
security i over some number of periods on security i's beta. This is usually
done for a large number of securities. The equation involved is:
Ri = a1 + a2bi
where Ri is the average return on security i over some number of periods and
bi is the estimated beta for security i.
The expected results of regressing average returns on beta are that a 1

should approximate the average risk-free rate during the period studied, and
a2 should approximate the average market risk premium during the period
studied (RM - RF).

Level of Difficulty: Medium Topic: Tests of the CAPM
9-31. Three reasons why two different analysts may derive different estimates of
beta for the same stock may be because they are using:
- Different time periods (e.g., 3 vs. 5 years)
- Different time intervals (e.g., weekly vs. monthly)
- Different choice of market proxies (e.g., S&P/TSX 60 vs. S&P/TSX
Composite)
Level of Difficulty: Medium Topic: Estimating Beta
9-32. Some assumptions underlying the Capital Asset Pricing Model (CAPM) are:
1. Investors are price takers
2. Investors have identical holding periods (single period)
3. Investors can borrow and lend at the risk-free rate
4. No taxes, no transaction costs
5. Investors are all rational and risk averse
6. Investors have homogeneous expectations
Level of Difficulty: Medium Topic: Assumptions of the Capital
Asset Pricing Model (CAPM)
PROBLEMS
9-1. (a) CML slope = (12-8)/20 = .2
(b) Scotia Canadian Balanced 8 + .2 (5) = 9%

PHN Canadian Equity 8 + .2 (10) = 10%
AGF Canadian Growth Equity 8 + .2 (17) = 11.4%
Altamira Special Growth 8 + .2 (16) = 11.2%
RBC Precious Metals 8 + .2 (26) = 13.2%
(c) The rank order is the same as in (b), which is from low risk to high
risk.
(d) Altamira Special Growth does because it has the same risk as
measured by the standard deviation.
9-2. (a) From the SML:
Stock 1 8 + .9(4) = 11.6%

2 8 + 1.3(4) = 13.2%
3 8 + .5(4) = 10.0%
4 8 + 1.1(4) = 12.4%
5 8 + 1.0(4) = 12.0%
(b) This is the SML, with the formula

Ri = 8 + 4bi
(c) Stocks 1, 3, and 4 are undervalued because each has an expected

return greater than its required return as given by the SML. Stock 2
is overvalued while stock 5 is correctly priced.
(d) The slope of the SML, or (12-8) = 4.

9-3. (a) ER = (.6) (3) + (.4) (10) = 5.8% SD = .4(21) = 8.4%
(b) ER = (-.5) (3) + (1.5) (10) = 13.5% SD = 1.5(21) = 31.5%
(c) ER = (0) (3) + (1.0) (10) = 10% SD = 21%

9-4. E(Ri) = 3.0 + (10.0-3.0)Bi = 3.0 + 7.0Bi
A 3 + 7(.62) = 7.34% < 9% undervalued

B 3 + 7(1.16) = 11.12% < 10% undervalued
C 3 + 7(0.49) = 6.43% < 9% undervalued
D 3 + 7(0.76) = 8.32% > 8% overvalued
E 3 + 7(0.76) = 8.32% < 18% undervalued
F 3 + 7(0.82) = 8.74% > 7% overvalued
9-5. If Teck Cominco Ltd. is in equilibrium, the relationship is:
11 = RF + [E(RM – RF)] ß
11 = 4 + [E(RM – 4)] 0.96
Therefore,
(a) the slope of the SML must be [E(RM – 4)] or approximately (11-
4)/0.96 = 7.29% in order for the relationship to hold on both sides.
(b) the expected return on the market is 7.29% + 4% or 11.29%

(approximately).
9-6. (a) In order to calculate the beta for each stock, it is necessary to
calculate each of the covariances with the market using the
correlation coefficient for the stock with the market, the standard
deviation of the stock, and the standard deviation of the market.

Stock A cov = (.8)(25)(21) = 420
beta = 420/(21)2 = 0.95
Stock B cov = (.6)(30)(21) = 378
beta = 378/(21)2 = 0.86
(b) From the SML, Ri = 8 + (12-8)Bi
Stock A = 8 + (12-8)(0.95) = 11.8%

Stock B = 8 + (12-8)(0.86) = 11.44%
9-7. RF ≈ 2 + 2 ≈ 4% or RF = [(1.02) (1.02)] – 1 = 4.04%
K = 4 + 8β = 4 + 8 (1.04) = 4 + 11.2 = 15.2%

Or K = 4.04 + 8 (1.4) = 15.24%
9-8. a) E (RA) = .10(40) + .20(30) + .50(10) + .20(-20) = 11.00%

 A = .10(40 − 11) 2 + .20(30 − 11) 2 + .50(10 − 11) 2 + .20(−20 − 11) 2
= 84.1 + 72.2 + 0.5 + 192.2 = 349 = 18.68%
b) E (RM) = .10(20) + .20(15) + .50(8) + .20(-5) = 8.00%
 M = .10(20 − 8) 2 + .20(15 − 8) 2 + .50(8 − 8) 2 + .20(−5 − 8) 2

= 14.4 + 9.8 + 0 + 33.8 = 58 = 7.62%
COVA,M = .10(.40 - .11) (.20 - .08) + .20(.30 - .11) (.15 - .08) + .50(.10 -
.11) (.08 -.08) + .20(-.20 - .11) ) (-.05 - .08) = .00348 + .00266 + 0 +
.00806 = .0142
Cov A, Mkt .0142

A = = = 2.45
 2
M .0058
c) RA = 4 + 2.45 (8 – 4) = 4 + 9.8 = 13.8%
Since the expected return estimated in part (a) is 11% < required return of
13.8%, A is overvalued, and it lies below the SML.
9-9. RF + .8 RM - .8 RF = 10 ---------------- .2RF + .8RM = 10 (1)

RF + 1.1 RM – 1.1 RF = 12 -------------- -.1 RF + 1.1 RM = 12 (2)
(1) + (2) .3RF - .3 RM = -2

.3(RF – RM) = -2
RM – RF = 6.67
RF + .8 (6.67) = 10
RF = 10 – 5.34 = 4.66
RM = (RM – RF) + RF = 6.67 + 4.66 = 11.33%

9-10. a) E (RM) – RF = (0.16 – 0.05) = 0.44

σm 0.25
b) It is the market price of risk
c) E (RM) – RF = 16% – 5% = 11%

Level of Difficulty: Medium Topic: Capital Market Line
9-11. a) βp = 0.25 (0.32) + 0.25 (1.4) + 0.25 (0.69) + 0.25 (1.11) = 0.88
b) βp = 0.5 (0.32) + 0.25 (1.4) + 0.15 (0.69) + 0.10 (1.11) = 0.7245

9-12. a) βa = ρa, mkt σa = (0.3) (19.46) = 0.3243

σmkt 18
βb = ρb, mkt σb = (0.7) (12.77) = 0.4966

σmkt 18
b) The required returns according to CAPM are:

Ra = 3 + 0.3243 (8 – 3) = 3 + 1.6215 = 4.6215 %
Since the estimated expected return of 9% > required rate of return, A is
currently undervalued.
Rb = 3 + 0.4966 (8 –3) = 3 + 2.483 = 5.483%

This is < estimated expected return of 7%, which suggests that B is
currently undervalued.
c) βp = Waβa + Wbβb = (0.7) (0.3243) + (0.3) (0.4966) = 0.37599
Rp = 3 + 0.37599 (8 – 3) = 3 + 1.87995 = 4.87995%
E (Rp) =
= 0.7(9) + 0.3(7)

= 8.4%
The estimated expected return of 8.4% exceeds this required rate of

return of 4.88%, which suggests that the portfolio is currently undervalued.
9-13. k = 5 + .9[11-5] = 10.4

Level of Difficulty: Easy Topic: The Security Market Line
9-14. k = 5 + .8[12-5] = 10.6

9-15. k = 5 + 1.5[7] = 15.5

9-16. a. One would expect RIM to have a higher beta than the Royal Bank. The Royal
Bank is a very large, stable firm and its basic business should not be very
sensitive to market shocks. One would also expect the beta of the Royal Bank
to be closer to 1.0 than RIM. The Royal Bank is a very large firm and therefore
a more substantial component of the S&P/TSX than RIM and, therefore, the
correlation between the Royal Bank and the Market should be closer to 1. RIM,
in contrast, operates in a more volatile industry and the basic business is much
more sensitive to economy-wide shocks.
b. Using Excel: Tools → Data Analysis → Covariance
The Variance-Covariance Matrix:
RIM RY TSX
returns returns returns
RIM
returns 0.021771
RY
returns 0.003307 0.001405
TSX
returns 0.001497 0.000455 0.000719
The diagonal terms are the variances and the off-diagonal terms are the
covariances.
Beta:
Royal 0.28784314
RIM 1.861960
c. i) Using the monthly returns of the portfolio, the beta is 1.0752941.

RIM Royal Bank S&P Portfolio

2008-1-1 0.031189 –0.02292 0.006772 0.004133
2008-2-1 –0.08609 0.010294 –0.01563 –0.0379
2008-3-1 0.030383 –0.02556 0.008132 0.002409
2008-4-1 0.083864 0.002679 –0.00193 0.043272
2008-5-1 0.036533 0.008132 0.020411 0.022333
2008-6-1 0.021278 0.010465 0.023403 0.015872
2008-7-1 –0.0593 –0.04128 –0.00913 –0.05029
2008-8-1 0.013679 0.013129 –0.02931 0.013404
2008-9-1 0.020096 0.018472 0.009739 0.019284
2008-10-1 –0.25941 0.018743 –0.06901 –0.12034
2008-11-1 –0.0506 –0.03378 –0.07979 –0.04219
2008-12-1 –0.10103 –0.07245 –0.06163 –0.08674
Royal
RIM Bank Index Portfolio
RIM 0.008527
Royal
0.000227 0.000849
Bank
Index 0.002374 0.000367 0.001275
Portfolio 0.004377 0.000538 0.001371 0.002457
ii) Using the equation for the beta of a portfolio, the beta is 1.0752941.
iii) As expected, the two betas are identical.
9-17. Spreadsheet exercise
Preparing for Your Professional Exams

CFA Practice Questions
9-1. B
9-2. B β = (.0288) / (.2000)2 = 0.72

9-3. B k = 7 + (11 – 7) (.9) = 10.6% > expected return of 10% - so, its
overvalued.
9-4. C Required return = 5 + (15 – 5) (1.5) = 20%, so 18% is underperforming.

CFA Curriculum and Sample Exam Questions (©CFA Institute)

9-1. B Using the CAPM approach: 4% + 1.3(9%) = 15.7%
Level of Difficulty: Medium Topic: Introduction to the Capital Market
Theory
9-2. D
9-3. C
9-4. A
Level of Difficulty: Easy Topic: The Capital Market Line
9-5. With RM the return on the market portfolio, we have

E(Rp) = wE(RM) + (1 – w)RF
17 = 13w + 5(1 – w) = 8w + 5
12 = 8w
w = 1.5
Thus 1 – 1.5 = –0.5 of initial wealth goes into the risk-free asset. The negative
sign indicates borrowing: –0.5 ($1 million) = –$500,000, so the investor borrows
$500,000.
Level of Difficulty: Medium Topic: The Equilibrium Risk–Return Trade-Off
9-6. The surprise in a factor equals actual value minus expected value. For the
interest rate factor, the surprise was 2 percent; for the GDP factor, the surprise
was –3 percent.
R = Expected return – 1.5 (Interest rate surprise) + 2 (GDP surprise) +

Company-specific surprise
= 11% – 1.5(2%) + 2(–3%) + 3%
= 5%
9-7. Portfolio inflation sensitivity is the weight on Manumatic stock multiplied by its
inflation sensitivity, plus the weight on Nextech stock multiplied by its inflation
sensitivity: 0.5(–1) + 0.5(2) = 0.5. So a 1 percent interest rate surprise increase in
inflation is expected to produce a 50 basis point increase in the portfolio’s return.
Level of Difficulty: Difficult Topic: Arbitrage Pricing Theory

Legal Notice
Copyright
Copyright © 2009 by John Wiley & Sons Canada, Ltd. or related companies. All rights
reserved.
The data contained in these files are protected by copyright. This manual is furnished
under licence and may be used only in accordance with the terms of such licence.
The material provided herein may not be downloaded, reproduced, stored in a retrieval
system, modified, made available on a network, used to create derivative works, or
transmitted in any form or by any means, electronic, mechanical, photocopying,
recording, scanning, or otherwise without the prior written permission of John Wiley &
Sons Canada, Ltd.


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Investments Analysis and Management

Canadian 3rd Edition Cleary Solutions

1. changes in expected inflation

Solutions Manual Chapter 9 – Capital Market Theory 9-1

2. unanticipated changes in inflation

9-8. A factor model makes no statement about equilibrium.

9-9. APT is not critically dependent on an underlying market portfolio. It

1. the expected return to a portfolio of small market capitalization

Borrowing possibilities complete the transformation of the Markowitz

Solutions Manual Chapter 9 – Capital Market Theory 9-2

9-14. The slope of the CML is

Solutions Manual Chapter 9 – Capital Market Theory 9-3

9-18. When a security is recognized by investors as undervalued, they will

9-21. A diagram of the SML is simply an upward-sloping trade-off between expected

9-22. APT, like the CAPM, does assume:

1. investors have homogeneous beliefs

Solutions Manual Chapter 9 – Capital Market Theory 9-4

Unlike the CAPM, APT does not assume:

1. a single-period investment horizon

9-24. The factors in a factor model must possess three characteristics:

1. Each risk factor must have a pervasive influence on stock returns.

Solutions Manual Chapter 9 – Capital Market Theory 9-5

where Si,M = the covariance between stock i and the market

9-29. The difficulties involved in estimating a security's beta include deciding on

The expected results of regressing average returns on beta are that a 1

Solutions Manual Chapter 9 – Capital Market Theory 9-6

Level of Difficulty: Medium Topic: Tests of the CAPM

(b) Scotia Canadian Balanced 8 + .2 (5) = 9%

9-2. (a) From the SML:

Stock 1 8 + .9(4) = 11.6%

(b) This is the SML, with the formula

Solutions Manual Chapter 9 – Capital Market Theory 9-7

(c) Stocks 1, 3, and 4 are undervalued because each has an expected

(d) The slope of the SML, or (12-8) = 4.

9-3. (a) ER = (.6) (3) + (.4) (10) = 5.8% SD = .4(21) = 8.4%

(b) ER = (-.5) (3) + (1.5) (10) = 13.5% SD = 1.5(21) = 31.5%

(c) ER = (0) (3) + (1.0) (10) = 10% SD = 21%

9-4. E(Ri) = 3.0 + (10.0-3.0)Bi = 3.0 + 7.0Bi

A 3 + 7(.62) = 7.34% < 9% undervalued

9-5. If Teck Cominco Ltd. is in equilibrium, the relationship is:

11 = 4 + [E(RM – 4)] 0.96

(b) the expected return on the market is 7.29% + 4% or 11.29%

Solutions Manual Chapter 9 – Capital Market Theory 9-8

Stock A cov = (.8)(25)(21) = 420

beta = 420/(21)2 = 0.95

Stock B cov = (.6)(30)(21) = 378

beta = 378/(21)2 = 0.86

(b) From the SML, Ri = 8 + (12-8)Bi

Stock A = 8 + (12-8)(0.95) = 11.8%

9-7. RF ≈ 2 + 2 ≈ 4% or RF = [(1.02) (1.02)] – 1 = 4.04%

K = 4 + 8β = 4 + 8 (1.04) = 4 + 11.2 = 15.2%

9-8. a) E (RA) = .10(40) + .20(30) + .50(10) + .20(-20) = 11.00%

b) E (RM) = .10(20) + .20(15) + .50(8) + .20(-5) = 8.00%

 M = .10(20 − 8) 2 + .20(15 − 8) 2 + .50(8 − 8) 2 + .20(−5 − 8) 2

Cov A, Mkt .0142

c) RA = 4 + 2.45 (8 – 4) = 4 + 9.8 = 13.8%

9-9. RF + .8 RM - .8 RF = 10 ---------------- .2RF + .8RM = 10 (1)

Solutions Manual Chapter 9 – Capital Market Theory 9-9

RF + 1.1 RM – 1.1 RF = 12 -------------- -.1 RF + 1.1 RM = 12 (2)

(1) + (2) .3RF - .3 RM = -2

RM = (RM – RF) + RF = 6.67 + 4.66 = 11.33%

9-10. a) E (RM) – RF = (0.16 – 0.05) = 0.44

b) It is the market price of risk

c) E (RM) – RF = 16% – 5% = 11%