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CAPM Recap Exercises 2023 Solution

This document provides exercises to practice concepts from CAPM lectures. It includes 4 questions about stocks' alphas and betas given market data, calculating required rates of return for investment projects, computing alphas and betas for stocks in a data set, and solving end of chapter problems related to CAPM. The assistant provides step-by-step workings and conclusions for each sub-question.

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Mirela Kafalieva
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61 views

CAPM Recap Exercises 2023 Solution

This document provides exercises to practice concepts from CAPM lectures. It includes 4 questions about stocks' alphas and betas given market data, calculating required rates of return for investment projects, computing alphas and betas for stocks in a data set, and solving end of chapter problems related to CAPM. The assistant provides step-by-step workings and conclusions for each sub-question.

Uploaded by

Mirela Kafalieva
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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CAPM

To follow up on the CAPM lectures, we solve a set of relevant


exercises.
1. Stock A has an expected return of 4.2% and a risk of
β = 0.8, while stock B has an expected return of 8% and a
risk of β = 1.25. The expected return on the market is 5%
and the risk-free rate is 1%.
I What is the alpha of each stock? Plot the SML and each
stock’s risk-return point on one graph. Show the alphas
graphically.
Answer
E (rA ) = 0.01 + 0.8(0.05 − 0.01) = 0.042
αA = 0.042 − 0.042 = 0
E (rB ) = 0.01 + 1.25(0.05 − 0.01) = 0.06
αB = 0.08 − 0.06 = 0.02
2. The risk-free rate is 1% and the expected return on the
market portfolio is 7%. A firm considers an investment project
that is expected to have a beta of 0.9.
I What is the required rate of return on the project?
I If the expected IRR of the project is 7%, should it be
accepted?
Answer

E (r ) = 0.01 + 0.9(0.07 − 0.01) = 0.064

The expected return is smaller than the IRR for the


investment project. Accept.
3. The excel file ”Data stocks” contains data on the risk-free
rate, the market portfolio and on four stocks (Bank of
America, Apple, Amazon, and Nike):
I Compute alpha and beta values for the four stocks.
I What is the beta value of a portfolio that invests 25% in
each stock?
Answer
Bank of America Apple Amazon Nike
α -0.66 1.06 1.32 0.86
β 1.62 0.96 1.08 0.70

βp = 0.25 ∗ 1.62 + 0.25 ∗ 0.96 + 0.25 ∗ 1.08 + 0.25 ∗ 0.7 = 1.09


4. Solve the following end of chapter problems from chap. 9:
problem 3 and 10-15.
Answer
3.a. False. Stocks with β = 0 have expected return equal to rf .
3.b. False. Total volatility includes idiosyncratic risk, which is not
compensated according to CAPM.
3.c. False. The investment would have a beta of
0.75 ∗ 0 + 0.25 ∗ 1 = 0.25.
10.
Portfolio Expected return Beta
A 20% 1.4
B 25% 1.2

Answer
Not possible. A has higher beta, but lower expected return.
11
Portfolio Expected return Standard deviation
A 30% 35%
B 40% 25%

Answer
Possible. There is no compensation for idiosyncratic risk in CAPM. If
beta for A is lower than beta for B, this is possible.
12
Portfolio Expected return Standard deviation
Risk-free 10% 0%
Market 18% 24%
A 16% 12%

Answer
Not possible. The market is the most efficient portfolio under CAPM.
0.16 − 0.10 0.18 − 0.10
SA = = 0.5 SM = = 0.33
0.12 0.24
13
Portfolio Expected return Standard deviation
Risk-free 10% 0%
Market 18% 24%
A 20% 22%

Answer
Not possible. The market is the most efficient portfolio under CAPM. A
has both higher expected return and lower standard deviation.
14
Portfolio Expected return Beta
Risk-free 10% 0
Market 18% 1
A 16% 1.5

Answer
Not possible. CAPM predicts

E (rA ) = 0.1 + 1.5 ∗ (0.18 − 0.1) = 0.22 6= 0.16


15
Portfolio Expected return Beta
Risk-free 10% 0
Market 18% 1
A 16% 0.9

Answer
Not possible. CAPM predicts

E (rA ) = 0.1 + 0.9 ∗ (0.18 − 0.1) = 0.172 6= 0.16

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