Practice Question - Chaptr 4

Chapter 4 (CAPM & APT)
Questions of CAPM
Q.1. You expect an RFR of 10 percent and the market return (RM) of 14 percent.
Compute the expected(required) return for the following stocks.
Stock Beta E(Ri)
U 0.85
N 1.25
D –0.20
Solution. E(Ri) = RFR + βi(RM - RFR)
= .10 + βi (.14 - .10)
= .10 + .04βi
Stock Beta (Required Return) E(Ri) = .10 + .04βi
U 85 .10 + .04(0.85) = .10 + .034 = .134
N 1.25 .10 + .04(1.25) = .10 + .05 = .150
D -.20 .10 + .04(-.20) = .10 - .008 = .092
Q.2. You ask a stockbroker what the firm’s research department expects for these
stocks. The broker responds with the following information:
Stock Current Price Expected Price Expected Dividend
U 22 24 0.75
N 48 51 2.00
D 37 40 1.25
Indicate what actions you would take with regard to these stocks. Discuss your
decisions.
1
Solution.
Stock Current Price Expected Price Expected Dividend Estimated Return
U 22 24 0.75 24 - 22 + 0.75
-----------------= .1250
22
N 48 51 2.00 51 - 48 + 2.00
--------------- = 0.1042
48
D 37 40 1.25 40 - 37 + 1.25
------------------ = 0.1149
37
Stock Beta Required Estimated Evaluation

U 0.85 0 .134 0.1250 Overvalued
N 1.25 0.150 0.1042 Overvalued
D - 0.20 0 .092 0.1149 Undervalued
If you believe the appropriateness of these estimated returns, you would buy
stocks D and sell stocks U and N.
Q.3. Based on five years of monthly data, you derive the following information for
the companies listed:
Company ai (Intercept) σi r iM
Intel 0.22 12.10% 0.72
Ford 0.10 14.60 0.33
Anheuser Busch 0.17 7.60 0.55
Merck 0.05 10.20 0.60
S&P 500 0.00 5.50 1.00
a. Compute the beta coefficient for each stock.
b. Assuming a risk-free rate of 8 percent and an expected return for the market
portfolio of 15 percent, compute the expected (required) return for all the stocks.
2
Solution.
a.
Cov i,m Cov i,m
βi = -------------- and ri,m = -------------
σ 2m (σi) (σm)
then Cov i,m = (ri,m) (σi) (σm)

For Intel:
Cov i,m = (0.72)(0.1210)(0.0550) = 0.00479
Beta = 0.00479 / (0.055)2 = 0.00479/0.0030 = 1.597
For Ford:
COV i,m = (0.33)(0.1460)(0.0550) = 0.00265
Beta = 0.00265/ 0.0030 = 0.883
For Anheuser Busch:
COV i,m = (0.55)(0.0760)(0.0550) = 0.00230
Beta = 0.00230/ 0.0030 = 0.767
For Merck:
COV i,m = (0.60)(0.1020)(0.0550) = 0.00337
Beta = 0.00337/ 0.0030 = 1.123
b. E(Ri) = RFR + βi (RM - RFR)

= 0.08 + βi (0.15 - 0.08)
= 0.08 + 0.07 βi
Stock Beta E(R i) = .08 + .07 βi
Intel 1.597 0.08 + 0.1118 = 0.1918
Ford 0.883 0.08 + 0.0618 = 0.1418
Anheuser Busch 0.767 0.08 + 0.0537 = 0.1337
Merck 1.123 0.08 + 0.0786 = 0.1586
3
Q.4. The following are the historic returns for the Chelle Computer Company:
Year Chelle Computer General Index
1 37 15
2 9 13
3 −11 14
4 8 −9
5 11 12
6 4 9
Based on this information, compute the following:

a. The correlation coefficient between Chelle Computer and the General Index.
b. The standard deviation for the company and the index.
c. The beta for the Chelle Computer Company.
Solution.
Chelle Computer General (R 1 - E(R1) x
Year (R1) Index (RM) R1 - E(R1) RM - E(RM) RM - E(RM)
1 37 15 27.33 6 163.98
2 9 13 -.67 4 -2.68
3 -11 14 -20.67 5 -103.35
4 8 -9 -1.67 -18 30.06
5 11 12 1.33 3 3.99
6 4 9 -5.67 0 0.00
∑ = 58 ∑= 54 ∑ = 92.00
E(R1) = 58/6 E(M) = 54/6
E(R1) = 9.67 E(M) = 9
Var1 = [R1 - E(R1)]2 /N VarM = [RM - E(RM)]2/N
Var1 = 1211.33/6 = 201.89 VarM = 410/6 = 68.33
σ1 = √201.89 = 14.21 σM = √ 68.33 = 8.27
COV 1, M = 92.00/6 = 15.33
(a). The correlation coefficient can be computed as follows:
4
r1.M = COV 1, M / σ1 σM = 15.33/ (14.21) (8.27) = 15.33/117.52 = 0.13
(b). The standard deviations are: 14.21% for Chelle Computer and 8.27% for
index, respectively.
(c). Beta for Chelle Computer is computed as follows:
β1 = COV 1, M /VarM = 15.33/68.33 = 0.2244
Questions of APT
Q.1. Consider the following data for two risk factors (1 and 2) and two securities (J
and L):
λ0 = 0.05 bJ1 = 0.80
λ1 = 0.02 bJ2 = 1.40
λ2 = 0.04 bL1 = 1.60
bL2 = 2.25
a. Compute the expected returns for both securities.
b. Suppose that Security J is currently priced at SAR 22.50 while the price of
Security L is SAR 15.00. Further, it is expected that both securities will pay a
dividend of SAR 0.75 during the coming year. What is the expected price of each
security one year from now?
Solution.
1(a). In general, for the APT, E(Rq) = λ0 + λ1bq1 + λ2bq2
For security J:
E(RJ) = 0.05 + 0.02x0.80 + 0.04x1.40
= 0.05 + 0.016 + 0.056
= .1220 or 12.20%
For Security L:
E(RL) = 0.05 +0.02x1.60 + 0.04x2.25
= 0.05 + 0.032 + 0.09
= .172 or 17.20%
1(b). Total return = dividend yield + capital gain yield
For security J, the dividend yield is SAR0.75/SAR22.50 = 0.033 or 3.33%
5
For security L, the dividend yield is SAR0.75/SAR15.00 = 0.05 or 5%
For security J, the expected capital gain is therefore 12.20%– 3.33% = 8.87%
For security L the expected capital gain is therefore 17.20% - 5.00% = 12.20%
Therefore:
The expected price for security J is SAR22.50x (1.0887) = SAR25.50
The expected price for security L is SAR15.00x (1.1220) = SAR16.83
Q.2. You have been assigned the task of estimating the expected returns for three
different stocks: QRS, TUV, and WXY. Your preliminary analysis has established
the historical risk premiums associated with three risk factors that could
potentially be included in your calculations: the excess return on a proxy for the
market portfolio (MKT), and two variables capturing general macroeconomic
exposures (MACRO1 and MACRO2). These values are: λ MKT = 7.5%, λMACRO1 = −0.3%,
and λMACRO2 = 0.6%. You have also estimated the following factor betas (i.e.,
loadings) for all three stocks with respect to each of these potential risk factors:
FACTOR LOADING
Stock MKT MACRO1 MACRO2
QRS 1.24 −0.42 0.00
TUV 0.91 0.54 0.23
WXY 1.03 −0.09 0.00
a. Calculate expected returns for the three stocks using just the MKT risk factor.
Assume a risk-free rate of 4.5%.
b. Calculate the expected returns for the three stocks using all three risk factors
and the same 4.5% risk-free rate.
c. Discuss the differences between the expected return estimates from the single-
factor model and those from the multifactor model. Which estimates are most
likely to be more useful in practice?
Solution.
for the APT, E(Rq) = λ0 + λ1bq1
(a). RQRS = 4.5 +7.5x1.24
= 4.5 + 9.3
= 13.8%
RTUV = 4.5 + 7.5x0.91
6
= 4.5 + 6.825
= 11.325%
RWXY = 4.5 + 7.5x1.03
= 4.5 +7.725
= 12.225%
(b). for the APT, E(Rq) = λ0 + λ1bq1 + λ2bq2
RQRS = 4.5 + 7.5x1.24 + (-0.3) x (-0.42) + 0.6x0.00
= 4.5 + 9.30 + 0.126 +0.00
= 13.926%
RTUV = 4.5 + 7.5x0.91 + (-0.3) x (0.54) + 0.6x0.23
= 4.5 + 6.825 – 0.162 + 0.138
= 11.301%
RWXY = 4.5 + 7.5x1.03 + (-0.3) x (-0.09) +0.6x0.00
= 4.5 + 7.725 + 0.027 + 0.00
= 12.252%
(c). Assuming that the factor loadings are significant the three factor model
should be more useful to the extent that the non-market factors pick up
movements in returns not captured by the market return.
Q.3. Suppose that three stocks (A, B, and C) and two common risk factors (1 and
2) have the following relationship:
E(RA) = (1.1) λ1 + (0.8) λ2
E(RB) = (0.7) λ1 + (0.6) λ2
E(RC) = (0.3) λ1 + (0.4) λ2
a. If λ1 = 4% and λ2 = 2%, what are the prices expected next year for each of the
stocks? Assume that all three stocks currently sell for SAR30 and will not pay a
dividend in the next year.
Solution.
(a). Because no stock pays a dividend, all return is due to price appreciation.
E(RA) = 1.1x0.04 + 0.8x0.02
= 0.044 + 0.016
= 0.06 or 6%
7
E (Price A) = SAR30(1.06) = SAR31.80
E(RB) = 0.7x0.04 + 0.6x0.02

= 0.28 + .012
= 0.04 or 4%
E (Price B) = SAR30(1.04) = SAR31.20
E(RC) = 0.3x0.04 + 0.4x0.02

= 0.12 + 0.008
= 0.02 or 2%
E (Price C) = SAR30(1.02) = SAR30.60

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Chapter 4 (CAPM & APT)

Stock Beta Required Estimated Evaluation

then Cov i,m = (ri,m) (σi) (σm)

b. E(Ri) = RFR + βi (RM - RFR)

Based on this information, compute the following:

E(RB) = 0.7x0.04 + 0.6x0.02

E (Price B) = SAR30(1.04) = SAR31.20

E(RC) = 0.3x0.04 + 0.4x0.02

E (Price C) = SAR30(1.02) = SAR30.60

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