IAC-FMAS

Assignment

PROBLEM 1. Answer the following problems.

1. A stock has had returns of 18.43 percent, 16.82 percent, 6.83 percent, 32.19 percent, and –19.87 percent over the past five years,
respectively. What was the holding period return for the stock?

(1.1843)(1.1682)(1.0683)(1.3219)(.8013)-1 = .5655 or 56.55%

2. You own a portfolio that has $1,900 invested in stock A and $2,300 invested in stock B. If the expected returns on these stocks are
10 percent and 15 percent, respectively, what is the expected return on the portfolio?

(1900x.10)+(2300x.15) = 535

3. You own a stock portfolio invested 25 percent in stock Q, 20 percent in stock R, 15 percent in stock S, and 40 percent in stock T.
The betas for these four stocks are .75, 1.90, 1.38, and 1.16, respectively. What is the portfolio beta?

(.25 x .75) + (.20 x 1.9) + (.15 x 1.38) + (.40 x 1.16) = 1.2385

4. You own a portfolio equally invested in a risk-free asset and two stocks. If one of the stocks has a beta of 1.85 and the total portfolio
is equally as risky as the market, what must the beta be for the other stock in your portfolio?

[1 – (1/3 x 0) + (1/3 x 1.85)] x 3 = 1.15

5. Stock Y has a beta of 1.35 and an expected return of 14 percent. Stock Z has a beta of .85 and an expected return of 11.5 percent. If
the risk-free rate is 5.5 percent and the market risk premium is 6.8 percent, are these stocks correctly priced?

CAPM Formula:
Stock Y Er = .055 + 1.35(.068)
= 0.1468, given Er is lower, therefore stock price must be decreased to increase Er

Stock Z Er = .055 + .85(.068)

= 0.1128, given Er is higher, therefore price must be increased to decrease Er

Reward to Risk Ratio:

Stock Y = (.14 - .055) / 1.35 = .06296 reward to risk ratio is too low, stock is overvalued
Stock Z = (.115 - .055) / .85 = .07058 reward to risk ratio is too high, stock is undervalued

6. You have $100,000 to invest in a portfolio containing stock X, stock Y, and a risk-free asset. You must invest all of your money. Your
goal is to create a portfolio that has an expected return of 10.7 percent and that has only 80 percent of the risk of the overall market. If
X has an expected return of 17.2 percent and a beta of 1.8, Y has an expected return of 8.75 percent and a beta of .5, and the risk-free
rate is 7 percent, how much money will you invest in stock X?

7. Security F has an expected return of 10 percent and a standard deviation of 26 percent per year. Security G has an expected return
of 17 percent and a standard deviation of 58 percent per year. The correlation coefficient between the two stocks is 1. If your portfolio is
invested 40 percent each in A and B and 20 percent in C,
a. what is the portfolio expected return?
b. The variance?
c. The standard deviation?
8. What is the expected return on a portfolio composed of 30 percent of security J and 70 percent of security K?

a. Erj = .1066 Erk = .0596

Erp = .30x .1066 + .70 x .0596
Erp = 7.37%

9. The market portfolio has an expected return of 12 percent and a standard deviation of 19 percent. The risk-free rate is 5 percent.
a. What is the expected return on a well-diversified portfolio with a standard deviation of 7 percent?
b. What is the standard deviation of a well-diversified portfolio with an expected return of 20 percent?

a. Erp = .05 + (.12-.05)/.19 x .07)

Erp = .07579 or 7.58%

b. .20 = .05 + (.12 - .05)/ .19 / x)

x = .4071 or 40.71%

10. SML Suppose you observe the following situation:

Assume these securities are correctly priced. Based on the CAPM, what is the expected return on the market? What is the risk-free
rate?

11. Which of the following common stock portfolios is best for a conservative, risk-averse investor? Explain briefly.
Portfolio A Portfolio B Portfolio C
Expected Return 19% 13% 16%
Risk Premium 13% 7% 10%
Standard Deviation of Return 20% 16% 12.5%
12. Parmacheenee Belle’s entire common stock portfolio ($500,000) is allotted to an index fund tracking the Standard & Poors 500
index. The expected rate of return on the index is 9.5% and the standard deviation is 18% per year. The one-year risk-free rate is 2.0%.

Now Ms. Belle receives a strongly favorable security analyst’s report on Mycronics Corp. The analyst projects a return of 25%.
Myroncis has a high volatility (40% annual standard deviation) but its correlation coefficient with the S&P 500 is only .3. Assume the
return in the analyst’s report is an unbiased forecast.

a. What is the beta of Myconics?

b. What is the required return of Myconics?
c. Is Myconics overpriced or underpriced? Why?

13. Assume that the risk-free rate of interest is 6% and the expected rate of return on the market is 16%. A share of stock sells for $50
today. It will pay a dividend of $6 per share at the end of the year. Its beta is 1.2. What do investors expect the stock to sell for at the
end of the year?

Er = .06 + 1.2 (.16-.06)

= .18

.18 = (.06 + P1 – 50) / P0

P1 = 53

14. Assume that you can borrow and lend at a riskless rate of 5% and that the tangency portfolio of risky assets has an expected return
of 13% and a standard deviation of return of 16%.

(a) What is the highest level of expected return that can be obtained if you are willing to take on a standard deviation of returns that is
at most equal to 24%?

.24 = .16x
x = 1.5
ErxCML = .05 + 1.5 (.13-.05)
= .17
(b) What is the fraction of your wealth (in percent) invested in the riskless asset in the portfolio you found in part (a) (the mean- variance
efficient portfolio with a standard deviation of 24%)? What is the fraction invested in the tangency portfolio of risky assets?

150% in the market and -50% in the risky asset

Problem 2. True or False. Write true if the statement is true otherwise write false.

a) Stocks with a beta of zero offer an expected rate of return of zero.

b) The CAPM implies that investors require a higher return to hold highly volatile securities.
c) You can construct a portfolio with a beta of 0.75 by investing 0.75 of the investment budget in bills and the remainder in the
market portfolio.
d) CAPM says that all risky assets must have positive risk premium.
e) The expected return on an investment with a beta of 2.0 is twice as high as the expected return on the market.
f) If a stock lies below the security market line, it is undervalued.
g) According to James Tobin Separation Theorem, the role of risk aversion is confined in the second stage only.

1. Stocks with a beta of zero offer an expected rate of return of zero.

False. Excess return will be zero when beta is zero

2. The CAPM implies that investors require a higher return to hold highly volatile securities.
False. The CAPM is independent of this and is only determined by the risk premium

3. You can construct a portfolio with a beta of 0.75 by investing 0.75 of the investment budget in bills and the remainder in the market
portfolio.
False. Invest 0.75 in the market

4. CAPM says that all risky assets must have positive risk premium.
True. If a stock lies below the SML, it is undervalued and investors get a reward lower than their risk.

5. The expected return on an investment with a beta of 2.0 is twice as high as the expected return on the market.
False because the risk-free rate is not 0.

6. If a stock lies below the security market line, it is undervalued.

True.

7. According to James Tobin Separation Theorem, the role of risk aversion is confined in the second stage only.
True.