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An Introduction to Asset Pricing Models

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

E(Ri) = RFR + bi(RM - RFR)


= .10 + bi(.14 - .10)
= .10 + .04bi

Stock Beta (Required Return) E(Ri) = .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

Plot your estimated returns on the graph from Part a


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

Current Expected Expected


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

• Stock Beta Required Estimated Evaluation


• 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

Buy D stock and sell U and N stocks


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

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 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

• Solution see Excel File Ch-8 problems