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You are on page 1of 12

Problems Chapter 8

Presented by

Muhammad Khalid Sohail

Problems

P.1 Assume that you expect the

economy’s rate of inflation to be 3

percent, giving an RFR of 6 percent and

a market return (R) of 12 percent.

a. Draw the SML under these

assumptions.

b. Subsequently, you expect the rate of

inflation to increase from 3 percent to 6

percent. What effect would this have on

the RFR and the Rm? Draw another

SML on the graph from Part a.

c. Draw an SML on the same graph to

reflect an RFR of 9 percent and an Rm

of 17 percent. How does this SML differ

from that derived in Part b? Explain

what has transpired.

B=1

Problem 2

= .10 + bi(.14 - .10)

= .10 + .04bi

U 0.85 .10 + .04(.85) = .10 + .034 = .134

N 1.25 .10 + .04(1.25) = .10 + .05 = .150

D -.20 .10 + .04(-.20) = .10 - .008 = .092

P-3

and indicate what actions you

would take with regard to these stocks. Explain your

decisions.

If RRR (CAPM) > Expected Return, then stock is over-valued.

All stocks are presented by SML by respective Betas

Stock

Price Price Dividend Estimated Return

24 22 0.75

U .1250

P-3 22 24 0.75 22

51 48 2.00

N 48 51 2.00 .1042

48

40 37 1.25

D .1149

37 40 1.25 37

• U .85 .134 .1250 Overvalued

• N 1.25 .150 .1042 Overvalued

• D -.20 .092 .1149 Undervalued

• Stock Beta Required Estimated Evaluation

• U .85 .134 .1250 Overvalued

• N 1.25 .150 .1042 Overvalued

• D -.20 .092 .1149 Undervalued

• U, N and D represent the

returns calculated by CAPM

• U, N and D should be on

Rm=.14 Rf=.10 SML according to their

Betas

• while U*, N* and D*

represent the expected

returns

Market B=1

Problems 4-5-6

• Select a stock from the NYSE and collect its

month-end prices for the latest 13 months to

compute12 monthly percentage of price changes

ignoring dividends.

• Do the same for the S&P 500 series.

• Prepare a scatter plot of these series on a graph

and draw a visual characteristic line of best fit

(the line that minimizes the deviations from the

line).

• Compute the slope of this line from the graph.

• Solution see Excel File Ch-8 problems

P-11

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 and plot them on the SML.

c. Plot the following estimated returns for the next year on the SML and

indicate which stocks are undervalued or overvalued.

• Intel—20 percent

• Ford—15 percent

• Anheuser Busch—19 percent

• Merck—10 percent

Solution Part-a

COVi,m COVi,m

Bi and ri,m

2

m i m

COVi,m = (ri,m)(i)(m)

For Intel:

COV i,m = (.72)(.1210)(.0550) = .00479

c

• L Expected Ret by

Stock Ret CAPM Beta Result

Intel 0.2 0.1918 1.597under

Ford 0.15 0.1418 0.883under

Anheuser Busch 0.19 0.1337 0.767under

Merk 0.1 0.1586 1.123over

Problem 13

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