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Homework #7

1. According to the capital asset pricing model (CAPM), fairly priced securities have positive betas. Securities with positive betas are expected to earn returns higher than the risk-free rate due to their exposure to non-diversifiable market risk. 2. The CAPM assumes that all investors have the same level of risk aversion, analyze securities in the same way, and share the same economic view of the world. It also assumes that individual trades do not affect stock prices and that all investors plan for one identical holding period. 3. A portfolio with a beta of 0.728 can be constructed by shorting $20,000 of Intel (beta of 1.3), going long $32,

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199 views2 pages

Homework #7

1. According to the capital asset pricing model (CAPM), fairly priced securities have positive betas. Securities with positive betas are expected to earn returns higher than the risk-free rate due to their exposure to non-diversifiable market risk. 2. The CAPM assumes that all investors have the same level of risk aversion, analyze securities in the same way, and share the same economic view of the world. It also assumes that individual trades do not affect stock prices and that all investors plan for one identical holding period. 3. A portfolio with a beta of 0.728 can be constructed by shorting $20,000 of Intel (beta of 1.3), going long $32,

Uploaded by

Ryan Ben Slimane
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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FNCE 5710 – Intro to Financial Models

Homework #7
1. Stocks A and B have the same market beta, but Stock A has a smaller market
capitalization (size) than Stock B. Which of the following is consistent with CAPM's
prediction?
a. 𝐸(𝑅𝐴 ) > 𝐸(𝑅𝐵 )
b. 𝐸(𝑅𝐴 ) < 𝐸(𝑅𝐵 )
c. 𝑬(𝑹𝑨 ) = 𝑬(𝑹𝑩 )
d. Need more information

2. According to the capital asset pricing model, fairly priced securities have __________.
a. negative betas
b. positive alphas
c. positive betas
d. zero alphas

3. Security A has an expected rate of return of 17% and a beta of 1.1. The market expected
rate of return is 8%, and the risk-free rate is 5%. The alpha of the stock is __________.
a. −1.7%
b. 3.7%
c. 5.5%
d. 8.7%

4. The risk-free rate is 4%. The expected market rate of return is 11%. If you expect stock X
with a beta of 0.8 to offer a rate of return of 12%, then you should __________.
a. buy stock X because it is overpriced
b. buy stock X because it is underpriced
c. sell short stock X because it is overpriced
d. sell short stock X because it is underpriced

5. Which of the following are assumptions of the simple CAPM model?


1. Individual trades of investors do not affect a stock's price.
2. All investors plan for one identical holding period.
3. All investors analyze securities in the same way and share the same economic view of
the world.
4. All investors have the same level of risk aversion.
a. 1, 2, and 4 only
b. 1, 2, and 3 only
c. 2, 3, and 4 only
d. 1, 2, 3, and 4
6. You have a $50,000 portfolio consisting of Intel, GE, and Con Edison. You short $20,000
in Intel, long $32,000 in GE, and the rest in Con Edison. Intel, GE, and Con Edison have
betas of 1.3, 1, and 0.8, respectively. What is your portfolio beta?
Weights:
W(Intel)=-20,000/50,000=-0.4
W(GE)=32,000/50,000=0.64
W(Con Edison)=1-W(Intel)-W(GE)=1+0.4-0.64=0.76
Betas:
B(Intel)=1.3
B(GE)=1
B(Con Edison)=0.8
➔B(p)=Sum(W(i)*B(i))=-0.4*1.3+0.64*1+0.76*0.8=-0.52+0.64+0.608=0.728

7. Consider the following situations and briefly explain whether they are consistent or not
with the CAPM.

Security Expected Return Beta

Risk-free 8% 0

Market 16% 1.0

Stock A 18% 1.5

E(rf)=rf+B(rf)*(E(Rm)-rf)=8%+0*(8%-8%)=8% ➔ E(rf)=rf ➔Consistent with CAPM (it’s the


risk free asset after all)
E(Rm)=rf+B(Rm)*(E(Rm)-rf)=8%+1*(16%-8%)=16% ➔ Consistent with CAPM (market
portfolio)
E(rA)=rf+B(rA)*(E(Rm)-rf)=8%+1.5*(16%-8%)=8%+12%=20%<>18% ➔ Not consistent with
CAPM.

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