1

ECN226 Capital Markets 1 2013-2014

Problem set 6
1. Are the following true or false? Explain
a) Stocks with beta of zero oer an expected return of zero.
b) The CAPM implies that, for a given market risk premium, investors require
a higher return to hold highly volatile securities.
2. Consider the following table, which gives a security analysts expected return
on two stocks for two particular market conditions:
Market Return Aggressive Stock Defensive Stock
5% -2% 6%
25% 38% 12%
The variance of the market portfolio is 20%, the covariance between the ag-
gressive stock and the market portfolio is 40%, and the covariance between the
difensive stock and the market portfolio is 6%.
a) What are the betas of the two stocks?
b) What is the expected rate of return on each stock, if the market return is
equally likely to be 5% or 25%?
3. Company X has a beta of 0.8 and an expected return of 9.8%. Company Y has
an expected return of 15.8%, but has a beta of 1.8. Both stocks are fairly priced
according to the CAPM. Company Z oers an expected return of 13%, having
a beta of 1.2.
Is the stock of company Z underpriced or overpriced?
Capital Markets 1 2013-2014 Class #6