Additional CAPM Exercises

Q1) Consider the following table, which gives a security analyst’s expected return on 2 stocks in
2 particular scenarios for the rate of return on the market:

Market Return Aggressive Stock Defensive Stock

5% −2% 6%
25% 38% 12%

a. What are the βs of the 2 stocks?

b. What is the expected return on each stock if the 2 scenarios for the market return are
equally likely?
c. If the T-bill rate is 6% and the market return is equally likely to be 5% or 25%, draw the
SML for this economy.
d. Plot the 2 securities on the SML graph. What are the αs of each?
e. What hurdle rate should be used by the management of the aggressive firm for a project
with the risk characteristics of the defensive firm’s stock?

Solution:

a. Call the aggressive stock A and the defensive stock D. β 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 β by calculating the difference in its return across the two
scenarios divided by the difference in the market return:

−0.02−0.38
β A= =2.00
0.05−0.25

0.06−0.12
βD= =0.30
0.05−0.25
b. With the 2 scenarios equally likely, the expected return is an average of the 2 possible
outcomes:

K A = 0.5  (–0.02 + 0.38) = 0.18 = 18%

K D = 0.5  (0.06 + 0.12) = 0.09 = 9%

c.

SML is determined by:

K m = [0.5 × (0.25 + 0.05)] = 15%  β = 1

And

R f = 6%  β = 0

SML Equation  K j = 0.06 + β × (0.15 – 0.06)

b. With the 2 scenarios equally likely, the E(r) is an average of the 2 possible outcomes:

E(rA ) = 0.5  (–0.02 + 0.38) = 0.18 = 18%

E(rD ) = 0.5  (0.06 + 0.12) = 0.09 = 9%

c. The SML is determined by the market E(r) of [0.5 × (0.25 + 0.05)] = 15%, with βM = 1, and rf
= 6% (which has βf = 0). See the following graph:

The equation for the SML is: E(r) = 0.06 + β × (0.15 – 0.06)

d. Based on its risk, the aggressive stock has a required expected return of:

rA = 0.06 + 2.0 × (0.15 – 0.06) = 0.24 = 24%

The analyst’s forecast of expected return is only 18%. Thus the stock’s α is:
αA = actually expected return – required return (given risk) = 18% – 24% = –6%
Similarly, the required return for the defensive stock is:

rD = 0.06 + 0.3 × (0.15 – 0.06) = 8.7%

The analyst’s forecast of expected return for D is 9%, and hence, the stock has a positive α:

αD = actually expected return – required return (given risk) = 0.09 – 0.087 = + 0.003 = +0.3%

The points for each stock plot on the graph as indicated above.

e. The min. acceptable rate of return is determined by the project β (0.3), not the firm’s β. The
correct disc. rate is 8.7%, the fair rate of return for stock D.

 The minimum acceptable rate of return is determined by the project β (0.3), not the firm’s β.

 The correct discount rate is 8.7%, the fair rate of return for stock D.
Note:

 α measures the performance of an investment relative to an index such as the S&P500.

 It is considered to be an investment’s active return and is used to understand how an

investment is performing as compared to the market as a whole.

 α can be < 0 or > 0 (baseline value = 0).

 Example: If an investment has an α value of 2, this means that it has outperformed the
comparison market index or benchmark by 2% (underpriced).

 By contrast, if an investment has a negative α value of 1, this means that it underperformed

the market by −1% (overpriced).

 α can be used to determine how well a portfolio manager is actually performing.

 In investing, the definition of α is the excess or abnormal rate of return of an investment.

 αj = K j – R f – β j × ( K m – R f )
2) Suppose the rate of return on short-term government securities (perceived to be risk-free) is
about 5%. Suppose also that K m = 12% and β = 1. According to the CAPM:

a. What is the expected return on the market portfolio?

b. What would be the expected return on a stock with β = 0?
c. Suppose you consider buying a share of stock at $40. The stock is expected to pay $3
dividends next year and you expect it to sell then for $41. The stock risk has been
evaluated at β = −0.5. Is the stock overpriced or underpriced?

Solution:

a. When β = 1  K j=K m =12% .

b. β = 0 means no systematic risk  K j (in market equilibrium) = R f at 5%.

c. Using the SML, the fair expected return for a stock with β = –0.5 is:

K j = 0.05 + [−0.5 × (0.12 – 0.05)] = 1.5%

The actually expected rate of return, using the expected price and dividend for next year is:

$ 41+ $ 3
K j= −1=0.10=10 %
$ 40

Because the actually expected return 10% > the fair return 1.5%  Stock is underpriced.
Q3) Suppose that borrowing is restricted so that the zero-β version of the CAPM holds.
K m =17 %, and on the zero-β portfolio it is 8%. What is the expected return on a portfolio with a
β of 0.6?

Solution:

Zero-β CAPM  K j = R f = 5%  Therefore, when β = 0.6:

K j = 8% + [0.6 × (17% – 8%)] = 13.4%

Q4) a. A mutual fund with β = 0.8 has an expected return of 14%. If  R f = 5%, and you expect
K m to be 15%, should you invest in this fund? What is the fund’s α?

b. What passive portfolio comprised of a market-index portfolio and a money market

account would have the same β as the fund? Show that the difference between the
expected rate of return on this passive portfolio and that of the fund = α from part (a).

Solution:
a.

K j = 5% + [0.8 × (15% − 5%)] = 13%  αj = 14%  13% = 1%  Decision: Invest  α is

positive.

b. The passive portfolio with the same β as the fund should be invested 80% in the market-index
portfolio and 20% in the money market account. For this portfolio:

R p = (0.8 × 15%) + (0.2 × 5%) = 13%  αp = 14% − 13% = 1%

 Passive portfolio strategy aims to mirror a market index.

 Active portfolio strategy (opposite of a passive portfolio strategy) aims to beat the market
with several investment strategies and trading decisions.