IF2207: Financial Markets

Problem set 6

Attempt all of these problems before your scheduled tutorial in week 7

and bring your attempts with you to class.

1. Write a paragraph explaining each of the following;

(a) Explain the difference between beta as a measure of risk and stan-
dard deviation (or variance) as a risk measure? When is each
appropriate?
(b) What are the differences between the two main pictures associated
with the CAPM (i.e. that showing the Capital Market line and
that showing the Security Market line)? Must assets or portfolios
lie on the CML? Must they lie on the SML?
(c) The CAPM equation tells that us;

E(Rj ) = Rf + βj [E(RM ) − Rf ]

Explain each of the terms in the equation. Proceed to describe

what the equation tells us about the determination of expected
returns and why different stocks have different expected returns.
Use the definition of βj in your answer.

2. A risk-free asset exists with a return of 12% per annum. A risky asset
exists with an expected annual return of 30% and annual standard
deviation of 40%.

(a) Construct a portfolio of these two assets that has a standard devi-
ation of 30%. What is its expected return? Interpret the weights
that you obtain.
(b) Construct a portfolio of the two assets with an expected return
of 40% and interpret the weights that you obtain. Compute this
portfolio’s standard deviation and compare to that of the risky
asset.

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3. The risk-free rate is 2% and the expected return on the market portfolio
is 10 percent. Use the CAPM to answer the following questions.

(a) Plot the security market line and point out the positions of the
risk-free asset and the market portfolio.
(b) What is the required return on an investment with a beta of 1.25?
How does it compare to the expected return on the market? Give
an explanation of why it is intuitively reasonable for this asset to
earn more/less than the expected return on the market.
(c) A stock with a beta of 0.5 offers an expected return of 8%. Is it
fairly priced? If not, what is its abnormal return?
(d) If the market expects a stock to deliver a return of 18%, what is
its beta?

4. Your investment portfolio consists of an investment in only one stock

- Marks and Spencer plc. The risk-free rate is 4%, M&S stock has
an expected return of 12% and a volatility of 36%, and the market
portfolio has an expected return of 10% and a volatility of 20%. If the
CAPM holds;

(a) What alternative investment has the lowest possible volatility

while having the same expected return as M&S? [HINT: what
combination of the risk-free asset and the market has the same
expected return as M&S.]
(b) What investment has the highest possible expected return while
having the same volatility as M&S? [HINT: what combination of
the risk-free asset and the market has the same return volatility
as M&S.]
(c) What is the volatility of the portfolio in part (a)?
(d) What is the expected return of the portfolio in part (b)?
(e) Plot the capital market line implied by the data above and mark
the set of portfolios that clearly dominates investing all of your

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money in M&S stock. What is the market Sharpe Ratio? And
the Sharpe Ratio for M&S stock?