Chapter 9: The Capital Asset Pricing Model: Problem Sets
Chapter 9: The Capital Asset Pricing Model: Problem Sets
PROBLEM SETS
1.
2. If the security’s correlation coefficient with the market portfolio doubles (with all
other variables such as variances unchanged), then beta, and therefore the risk
premium, will also double. The current risk premium is: 14% – 6% = 8%
The new risk premium would be 16%, and the new discount rate for the security
would be: 16% + 6% = 22%
If the stock pays a constant perpetual dividend, then we know from the original
data that the dividend (D) must satisfy the equation for the present value of a
perpetuity:
Price = Dividend/Discount rate
50 = D/0.14 D = 50 0.14 = $7.00
At the new discount rate of 22%, the stock would be worth: $7/0.22 = $31.82
The increase in stock risk has lowered its value by 36.36%.
c. False. Your portfolio should be invested 75% in the market portfolio and
25% in T-bills. Then:
4. The expected return is the return predicted by the CAPM for a given level of
systematic risk.
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CHAPTER 9: THE CAPITAL ASSET PRICING MODEL
5. According to the CAPM, $1 Discount Stores requires a return of 13% based on its
systematic risk level of β = 1.5. However, the forecasted return is only 12%.
Therefore, the security is currently overvalued.
Everything $5 requires a return of 10% based on its systematic risk level of β = 1.0.
However, the forecasted return is 11%. Therefore, the security is currently
undervalued.
6. Correct answer is choice a. The expected return of a stock with a β = 1.0 must, on
average, be the same as the expected return of the market which also has a β = 1.0.
The internal rate of return (IRR) for the project is 35.73%. Recall from your
introductory finance class that NPV is positive if IRR > discount rate (or,
equivalently, hurdle rate). The highest value that beta can take before the hurdle
rate exceeds the IRR is determined by:
.3573 = .08 + β × (.16 – .08) β = .2773/.08 = 3.47
9. a. Call the aggressive stock A and the defensive stock D. Beta is the sensitivity
of the stock’s return to the market return, i.e., the change in the stock return
per unit change in the market return. Therefore, we compute each stock’s beta
by calculating the difference in its return across the two scenarios divided by
the difference in the market return:
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CHAPTER 9: THE CAPITAL ASSET PRICING MODEL
b. With the two scenarios equally likely, the expected return is an average of
the two possible outcomes:
E(rA ) = 0.5 (–.02 + .38) = .18 = 18%
E(rD ) = 0.5 (.06 + .12) = .09 = 9%
c. The SML is determined by the market expected return of [0.5 × (.25 + .05)] =
15%, with βM = 1, and rf = 6% (which has βf = 0). See the following graph:
d. Based on its risk, the aggressive stock has a required expected return of:
E(rA ) = .06 + 2.0 × (.15 – .06) = .24 = 24%
The analyst’s forecast of expected return is only 18%. Thus the stock’s alpha is:
αA = actually expected return – required return (given risk)
= 18% – 24% = –6%
Similarly, the required return for the defensive stock is:
E(rD) = .06 + 0.3 × (.15 – .06) = 8.7%
The analyst’s forecast of expected return for D is 9%, and hence, the stock has
a positive alpha:
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CHAPTER 9: THE CAPITAL ASSET PRICING MODEL
10. Not possible. Portfolio A has a higher beta than Portfolio B, but the expected return
for Portfolio A is lower than the expected return for Portfolio B. Thus, these two
portfolios cannot exist in equilibrium.
11. Possible. If the CAPM is valid, the expected rate of return compensates only for
systematic (market) risk, represented by beta, rather than for the standard deviation,
which includes nonsystematic risk. Thus, Portfolio A’s lower rate of return can be
paired with a higher standard deviation, as long as A’s beta is less than B’s.
12. Not possible. The reward-to-variability ratio for Portfolio A is better than that of
the market. This scenario is impossible according to the CAPM because the CAPM
predicts that the market is the most efficient portfolio. Using the numbers supplied:
13. Not possible. Portfolio A clearly dominates the market portfolio. Portfolio A has
both a lower standard deviation and a higher expected return.
14. Not possible. The SML for this scenario is: E(r) = 10 + β × (18 – 10)
Portfolios with beta equal to 1.5 have an expected return equal to:
E(r) = 10 + [1.5 × (18 – 10)] = 22%
The expected return for Portfolio A is 16%; that is, Portfolio A plots below the
SML ( A = –6%) and, hence, is an overpriced portfolio. This is inconsistent with
the CAPM.
15. Not possible. The SML is the same as in Problem 14. Here, Portfolio A’s required
return is: .10 + (.9 × .08) = 17.2%
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CHAPTER 9: THE CAPITAL ASSET PRICING MODEL
16. Possible. The CML is the same as in Problem 12. Portfolio A plots below the CML,
as any asset is expected to. This scenario is not inconsistent with the CAPM.
17. Since the stock’s beta is equal to 1.2, its expected rate of return is:
.06 + [1.2 (.16 – .06)] = 18%
18. The series of $1,000 payments is a perpetuity. If beta is 0.5, the cash flow should
be discounted at the rate:
.06 + [0.5 × (.16 – .06)] = .11 = 11%
PV = $1,000/0.11 = $9,090.91
If, however, beta is equal to 1, then the investment should yield 16%, and the price
paid for the firm should be:
PV = $1,000/0.16 = $6,250
The difference, $2,840.91, is the amount you will overpay if you erroneously
assume that beta is 0.5 rather than 1.
19. Using the SML: .04 = .06 + β × (.16 – .06) β = –.02/.10 = –0.2
b. If rf = 6% and rM = 14%, then (using the notation alpha for the abnormal
return):
α1 = .19 – [.06 + 1.5 × (.14 – .06)] = .19 – .18 = 1%
α 2 = .16 – [.06 + 1 × (.14 – .06)] = .16 – .14 = 2%
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CHAPTER 9: THE CAPITAL ASSET PRICING MODEL
Here, the second investor has the larger abnormal return and thus appears to
be the superior stock selector. By making better predictions, the second
investor appears to have tilted his portfolio toward underpriced stocks.
21. a. Since the market portfolio, by definition, has a beta of 1, its expected rate of
return is 12%.
c. Using the SML, the fair expected rate of return for a stock with β = –0.5 is:
The actually expected rate of return, using the expected price and dividend for
next year is:
Because the actually expected return exceeds the fair return, the stock is
underpriced.
22. In the zero-beta CAPM the zero-beta portfolio replaces the risk-free rate, and thus:
E(r) = .08 + 0.6(.17 – .08) = .134, or 13.4%
b. The passive portfolio with the same beta as the fund should be invested 80%
in the market-index portfolio and 20% in the money market account. For this
portfolio:
E(rP) = (0.8 × 15%) + (0.2 × 5%) = 13%
14% − 13% = 1% =
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CHAPTER 9: THE CAPITAL ASSET PRICING MODEL
24. a. We would incorporate liquidity into the CCAPM in a manner analogous to the
way in which liquidity is incorporated into the conventional CAPM. In the
latter case, in addition to the market risk premium, expected return is also
dependent on the expected cost of illiquidity and three liquidity-related betas
which measure the sensitivity of: (1) the security’s illiquidity to market
illiquidity; (2) the security’s return to market illiquidity; and, (3) the
security’s illiquidity to the market return. A similar approach can be used for
the CCAPM, except that the liquidity betas would be measured relative to
consumption growth rather than the usual market index.
CFA PROBLEMS
2. E(r) = rf + β × [E(r M ) − rf ]
Furhman Labs: E(r) = .05 + 1.5 × [.115 − .05] = 14.75%
Garten Testing: E(r) = .05 + 0.8 × [.115 − .05] = 10.20%
If the forecast rate of return is less than (greater than) the required rate of return,
then the security is overvalued (undervalued).
Furhman Labs: Forecast return – Required return = 13.25% − 14.75% = −1.50%
Garten Testing: Forecast return – Required return = 11.25% − 10.20% = 1.05%
Therefore, Furhman Labs is overvalued and Garten Testing is undervalued.
3. a.
5. d.
6. c.
7. d.
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CHAPTER 9: THE CAPITAL ASSET PRICING MODEL
10. Under the CAPM, the only risk that investors are compensated for bearing is the
risk that cannot be diversified away (systematic risk). Because systematic risk
(measured by beta) is equal to 1.0 for both portfolios, an investor would expect the
same rate of return from both portfolios A and B. Moreover, since both portfolios
are well diversified, it doesn’t matter if the specific risk of the individual securities
is high or low. The firm-specific risk has been diversified away for both portfolios.
11. a. McKay should borrow funds and invest those funds proportionately in
Murray’s existing portfolio (i.e., buy more risky assets on margin). In
addition to increased expected return, the alternative portfolio on the capital
market line will also have increased risk, which is caused by the higher
proportion of risky assets in the total portfolio.
12. a.
Expected Return Alpha
Stock X 5% + 0.8 × (14% 5%) = 12.2% 14.0% 12.2% = 1.8%
Stock Y 5% + 1.5 × (14% 5%) = 18.5% 17.0% 18.5% = 1.5%
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CHAPTER 9: THE CAPITAL ASSET PRICING MODEL
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