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Chapter 23 - Answer
Chapter 23 - Answer
CHAPTER 23
I. Questions
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Chapter 23 Capital Asset Pricing Model and Modern Portfolio Theory
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Capital Asset Pricing Model and Modern Portfolio Theory Chapter 23
1. A 4. B 7. C 10. D
2. C 5. A 8. B
3. A 6. D 9. C
III. Problems
Problem 1
(b) The market risk premium is the return on the market portfolio (r m) less
the risk-free rate (rf).
rm − rf = 0.12 − 0.07
= 0.05 or 5%
Problem 2
The risk-free rate consists of a real rate and an inflation premium. If the inflation
premium increased from 4 to 6 percent, the risk-free rate would increase from 7
to 9 percent. Inflation would also lead investors to expect a higher return on the
market portfolio which would increase the return on the market portfolio, r m,
from 12 to 14 percent. The required rate of return under the new inflationary
expectations would be:
ri = 0.09 + (1.2) (0.14 − 0.09)
= 0.15 or 15%
Thus, inflationary expectations would increase the required return for Dimension
Industries and other ordinary equity shares.
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Chapter 23 Capital Asset Pricing Model and Modern Portfolio Theory
Problem 3
(b) The four stocks that provide the lowest risk portfolio are those with the
lowest betas and therefore the lowest risk premiums, namely Stocks 2, 3,
5, and 6.
(c) The required rate of return on the portfolio of Stocks 2, 3, 5, and 6 is
determined in two steps:
First, assuming equal weights of 25 percent for each stock, the
portfolio’s beta is found by substituting these weights and the stock’s
beta.
bp = (0.25) (1.0) + (0.25) (0.8) + (0.25) (0.3) + (0.25) (1.2)
= 0.825
Next, using the capital asset pricing model produces the required rate of
return.
rp = 0.08 + (0.825) (0.14 − 0.08)
= 0.1295 or 12.95%
Problem 4
If we compute the reward-to-risk ratios, we get (22% − 7%) / 1.8 = 8.33% for
Earth, Inc. versus 8.4% for Fire Company. Relative to that of Earth, Fire’s
expected return is too high, so its price is too low.
If they are correctly priced, then they must offer the same reward-to-risk ratio.
The risk-free rate would have to be such that:
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Capital Asset Pricing Model and Modern Portfolio Theory Chapter 23
With a little algebra, we find that the risk-free rate must be 8 percent:
Problem 5
Because the expected return on the market is 16 percent, the market risk premium
is 16% − 8% = 8%.
The first stock has a beta of .7, so its expected return is:
8% + .7 x 8% = 13.6%
For the second stock, notice that the risk premium is:
24% − 8% = 16%
Because this is twice as large as the market risk premium, the beta must be
exactly equal to 2. We can verify this using the CAPM:
E (Ri) = Rf + [E (RM) − Rf] x βi
24% = 8% + (16% − 8%) x βi
βi = 16%/8%
= 2.0
Problem 6
The beta of a portfolio is the sum of the weight of each asset times the beta of
each asset. So, the beta of the portfolio is:
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Chapter 23 Capital Asset Pricing Model and Modern Portfolio Theory
Problem 7
The beta of a portfolio is the sum of the weight of each asset times the beta of
each asset. If the portfolio is as risky as the market it must have the same beta as
the market. Since the beta of the market is one, we know the beta of our portfolio
is one. We also need to remember that the beta of the risk-free asset is zero. It has
to be zero since the asset has no risk. Setting up the equation for the beta of our
portfolio, we get:
Problem 8
CAPM states the relationship between the risk of an asset and its expected return.
CAPM is:
E (Ri) = Rf + [E (RM) – Rf] × i
Substituting the values we are given, we find:
E (Ri) = .052 + (.11 – .052) (1.05)
= .1129 or 11.29%
Problem 9
We are given the values for the CAPM except for the of the stock. We need to
substitute these values into the CAPM, and solve for the of the stock. One
important thing we need to realize is that we are given the market risk premium.
The market risk premium is the expected return of the market minus the risk-free
rate. We must be careful not to use this value as the expected return of the
market. Using the CAPM, we find:
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Capital Asset Pricing Model and Modern Portfolio Theory Chapter 23
Problem 10
Here we need to find the expected return of the market using the CAPM.
Substituting the values given, and solving for the expected return of the market,
we find:
E (Ri) = .135 = .055 + [E (RM) – .055] (1.17)
E(RM) = .1234 or 12.34%
Problem 11
First, we need to find the of the portfolio. The of the risk-free asset is zero,
and the weight of the risk-free asset is one minus the weight of the stock, the of
the portfolio is:
ßp = wW (1.25) + (1 – wW) (0)
= 1.25wW
So, to find the of the portfolio for any weight of the stock, we simply multiply
the weight of the stock times its .
Even though we are solving for the and expected return of a portfolio of one
stock and the risk-free asset for different portfolio weights, we are really solving
for the SML. Any combination of this stock, and the risk-free asset will fall on
the SML. For that matter, a portfolio of any stock and the risk-free asset, or any
portfolio of stocks, will fall on the SML. We know the slope of the SML line is
the market risk premium, so using the CAPM and the information concerning
this stock, the market risk premium is:
E (RW) = .152 = .053 + MRP (1.25)
MRP = .099/1.25
= .0792 or 7.92%
So, now we know the CAPM equation for any stock is:
E (Rp) = .053 + .0793p
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Chapter 23 Capital Asset Pricing Model and Modern Portfolio Theory
The slope of the SML is equal to the market risk premium, which is 0.0792. Using
these equations to fill in the table, we get the following results:
wW E (Rp) ßp
0.00% 5.30% 0.000
25.00% 7.78% 0.313
50.00% 10.25% 0.625
75.00% 12.73% 0.938
100.00% 15.20% 1.250
125.00% 17.68% 1.563
150.00% 20.15% 1.875
Problem 12
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Using the same procedure for Stock II, we find the expected return to be:
E (RII) = .25 (–.40) + .50 (.10) + .25 (.56)
= .0900
Although Stock II has more total risk than I, it has much less systematic risk,
since its beta is much smaller than I’s. Thus, I has more systematic risk, and II
has more unsystematic and more total risk. Since unsystematic risk can be
diversified away, I is actually the “riskier” stock despite the lack of volatility in
its returns. Stock I will have a higher risk premium and a greater expected return.
Problem 13
Here we have the expected return and beta for two assets. We can express the
returns of the two assets using CAPM. If the CAPM is true, then the security
market line holds as well, which means all assets have the same risk premium.
Setting the risk premiums of the assets equal to each other and solving for the
risk-free rate, we find:
(.132 – Rf)/1.35 = (.101 – Rf)/.80
.80(.132 – Rf) = 1.35(.101 – Rf)
.1056 – .8Rf = .13635 – 1.35Rf
.55Rf = .03075
Rf = .0559 or 5.59%
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Chapter 23 Capital Asset Pricing Model and Modern Portfolio Theory
Now using CAPM to find the expected return on the market with both stocks, we
find:
.132 = .0559 + 1.35 (RM – .0559)
RM = .1123 or 11.23%
Problem 14
(a) The expected return of an asset is the sum of the probability of each return
occurring times the probability of that return occurring. So, the expected
return of each stock is:
(b) We can use the expected returns we calculated to find the slope of the
Security Market Line. We know that the beta of Stock X is .25 greater than
the beta of Stock Y. Therefore, as beta increases by .25, the expected return
on a security increases by .017 (= .1510 – .1340). The slope of the security
market line (SML) equals:
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Since the market’s beta is 1 and the risk-free rate has a beta of zero, the slope of
the Security Market Line equals the expected market risk premium. So, the
expected market risk premium must be 6.8 percent.
We could also solve this problem using CAPM. The equations for the expected
returns of the two stocks are:
Subtracting the CAPM equation for Stock Y from this equation yields:
.017 = .25MRP
MRP = .068 or 6.8%
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