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FIN 312 - Investments

Homework 3 - Solutions
Chapter 5
9. From Table 5.3, we find that for the period 1927 – 2018, the mean excess return for
S&P 500 over 1-month T-bills is 8.34%.
E(r) = Risk-free rate + Risk premium = 3% + 8.34% = 11.34%

19. We use standard deviation as the volatility measure.

Then we would have Reward to variability ratio .

CFA 7. E(rX) = [0.2  (–20%)] + [0.5  18%] + [0.3  50%)] = 20%

E(rY) = [0.2  (–15%)] + [0.5  20%] + [0.3  10%)] = 10%

CFA 8. X2 = [0.2  (–.20 – .20)2] + [0.5  (.18 – .20)2] + [0.3  (.50 – .20)2] = .0592
X = 24.33%
Y = [0.2  (–.15 – .10)2] + [0.5  (.20 – .10)2] + [0.3  (.10 – .10)2] = .0175
Y = 13.23%

CFA 9. E(r) = (0.9  20%) + (0.1  10%) = 19%

Chapter 6
6.
a. Without doing any math, the severe recession is worse and the boom is better.
Thus, there appears to be a higher variance, yet the mean is probably the same
since the spread is equally larger on both the high and low side. The mean return,
however, should be higher since there is higher probability given to the higher
returns.

20. The expectation should be revised down (which would be sufficient answer).
More specifically, the expected rate of return on the stock will change by beta times the
unanticipated change in the market return: 1.2  (8% – 10%) = – 2.4%
Therefore, the expected rate of return on the stock should be revised to:
12% – 2.4% = 9.6%

CFA 1. E(rP) = (0.5 x 15) + (0.4 x 10) + (0.10 x 6) = 12.1%

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Chapter 7: relevant problems

3.
a. False.  = 0 implies E(r) = rf , not zero.

b. False. Investors require a risk premium for bearing systematic (i.e., market or
undiversifiable) risk.

c. False. You should invest 0.75 of your portfolio in the market portfolio, and the
remainder in T-bills. Then:
P = (0.75  1) + (0.25  0) = 0.75

9. E(rP) = rf + [E(rM) – rf]

20% = 5% + (15% – 5%)   = 15/10 = 1.5

10. From CAPM, if the beta of the security doubles, then so will its risk premium. The current
risk premium for the stock is: (13% - 7%) = 6%, so the new risk premium would be 12%, and
the new expected return for the security would be: 12% + 7% = 19%.

If the stock pays a constant dividend in perpetuity, then we know from the original data
that the dividend (D) must satisfy the equation for a perpetuity:
Price = Dividend/Discount rate
40 = D/0.13 -> D = 40 x 0.13 = $5.20
At the new discount rate of 19%, the stock would be worth: $5.20/0.19 = $27.37
The increase in stock risk has lowered the value of the stock by 31.58%

13. Not possible. Portfolio A has a higher beta than Portfolio B, but the expected return for
Portfolio A is lower.

14. Possible. If the CAPM is valid, the expected rate of return compensates only for
systematic (market) risk as measured by beta, rather than the standard deviation, which
includes nonsystematic risk. Thus, Portfolio A's lower expected rate of return can be paired
with a higher standard deviation, as long as Portfolio A's beta is lower than that of Portfolio
B.

15. Not possible. The reward-to-variability ratio for Portfolio A is better than that of the
market, which is not possible according to the CAPM, since the CAPM predicts that the market
portfolio is the most efficient portfolio. Using the numbers supplied:
SA =

SM =

These figures imply that Portfolio A provides a better risk-reward tradeoff than the market
portfolio.
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16. Not possible. Portfolio A clearly dominates the market portfolio. It has a lower standard
deviation with a higher expected return.

23. Using the CAPM: 6% = 8% + (18% – 8%)   = –2/10 = –0.2

24. We denote the first investment advisor 1, who has r1 = 19% and 1 = 1.5, and the second
investment advisor 2, as r2 = 16% and 2 = 1.0. In order to determine which investor was a better
selector of individual stocks, we look at the abnormal return, which is the ex-post alpha; that is,
the abnormal return is the difference between the actual return and that predicted by the SML.

a. Without information about the parameters of this equation (i.e., the risk-free rate
and the market rate of return), we cannot determine which investment adviser is
the better selector of individual stocks.

b. If r
f = 6% and rM = 14%, then (using alpha for the abnormal return):
α 1 = 19% – [6% + 1.5 (14% – 6%)] = 19% – 18% = 1%

α 2 = 16% – [6% + 1.0 (14% – 6%)] = 16% – 14% = 2%

Here, the second investment adviser has the larger abnormal return and thus
appears to be the better selector of individual stocks. By making better
predictions, the second adviser appears to have tilted his portfolio toward under-
priced stocks.

c. If r
f = 3% and r
M = 15%, then:

α 1 =19% – [3% + 1.5 (15% – 3%)] = 19% – 21% = –2%

α 2 = 16% – [3%+ 1.0 (15% – 3%)] = 16% – 15% = 1%

Here, not only does the second investment adviser appear to be a better stock
selector, but the first adviser's selections appear valueless (or worse).

CFA 6. d. The expect return on the market, rM:

E(r) = rf + [E(rM) –rf ] = rf + 1.0 [E(rM) –rf ] = E(rM)

Extra questions:
A. d
B. b
C. Hint: part a: Calculate reward to risk ratio; that is the slope of the SML
Slope of SML = Reward / Relevant risk = Expected risk premium / Beta
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= (0.14 – 0.06) / 1.1 = 0.0727

This reward to risk ratio must be the same for the market portfolio as well. So,
Market’s Reward / Relevant risk = [E(Rm) – Rf] / m = 0.0727. Beta of the market is 1, risk free
rate is 0.06,
So, E(Rm) – 0.06 = 0.0727. Thus E(Rm) = 0.1327 = 13.27%.

D.
First we ask, what does the market think the expected return of ABC stock is? The answer to
this question is CAPM model.
E(RABC) = Rf + ABC*(E(Rm) – Rf) = 0.08 + 1.25*(0.15 – 0.08) = 0.08 + 0.0875= 0.1675=16.75%
The stock is offering a return of 17%, which is higher than what everyone in the market is
expecting. Therefore, this is a good investment, it is undervalued.

E. Stock A has expected return of 25% and beta of 1.59. Stock B has expected return of 12%
and beta of 0.44. What is the risk free rate for these two stocks to be correctly priced?
If these two stocks are correctly priced, their reward to risk ratios are equal to each other. We
find the risk free rate this way:
(0.25 – Rf) / 1.59 = (0.12 – Rf) / 0.44
 0.44*(0.25 – Rf) = 1.59*(0.12– Rf)
 0.11 – 0.44Rf = 0.1908 – 1.59Rf
 1.59Rf – 0.44Rf = 0.1908 – 0.11
 1.15Rf = 0.0808
 Rf = 0.0808/1.15 = 0.07026 or 7.026%.

F. Beta of a stock is 1.3, expected return on the market is 10% and risk free rate is 5%. What is
the required rate of return (i.e., what should be the expected return) of this investment?
This is a simple CAPM problem:
E(Rstock) = 0.05 + 1.3*(0.1 – 0.05) = 0.115 = 11.5%

G. Expected return for Stock A is 10%, its beta is 2.5. Expected return for Stock B is 8%, its
beta is 2. If you have to pick one stock which one should you choose?
Reward to Risk Ratio for A: (0.1 – 0.05) / 2.5 = 0.02
Reward to Risk Ratio for B: (0.08 – 0.05) / 2 = 0.015. Stock A has a bigger Reward to Risk
ratio, so rationally we would choose Stock A.