Investment and Portfolio Management

TOPIC 5 – TUTORIAL 5

Index model Sercurities charecteristic line CML Capital market line CAPM sercurities market line

SCL CML SML

E(Ri) E(ri) E(ri)

E(Rm) si bi

E(Ri) = Alpha + Beta i * E(Rm) E(ri) = rf + (E(rm) – rf)/ sm * si E(ri) = rf + (E(rm) – rf) * bi
Slope: Beta bi Slope: (E(rm) – rf)/ sm Slope: (E(rm) – rf)
Sharpe Ratio Risk Premium

1. The following are estimates for two stocks.

Firm–specific
Stock Expected Return Beta
Standard Deviation

A 13% 0.8 30%

B 18% 1.2 40%

The market index has a standard deviation of 22% and the risk-free rate is 8%.
a. What are the standard deviations of stocks A and B?
 Investment and Portfolio Management

ð 𝜎! = 34.78%
ð 𝜎" = 47.93%

b. Suppose that we were to construct a portfolio with proportions:

Stock A 0.50

Stock B 0.30

T-bills 0.20

Compute the expected return, standard deviation, beta, and nonsystematic standard deviation of
the portfolio.

Expected return = 0.5 * 13% + 0.3 * 18% + 0.2 * 8% = 13.5%

Total risk:
𝜎#$ = (𝑊! 𝜎! )$ + (𝑊" 𝜎" )$ + (𝑊%& 𝜎%& )$ + 2𝑤! 𝑤" 𝜎! 𝜎" 𝜌!," + 2𝑤! 𝑤%& 𝜎! 𝜎%& 𝜌!,%&
+ 2𝑤" 𝑤%& 𝜎" 𝜎%& 𝜌",%&
ð 𝜎( = 25.47% (Use 𝜎! , 𝜎" calculated in the previous question)

Firm-specific risk:
𝜌)! ,)" * , because: Firm specific risk A = no relation with Firm-specific risk B
Because the index model assumes that firm-specific surprises are mutually uncorrelated, the only
source of covariance between any pair of securities is their common dependence on the market
return
ð 𝜎)$ = (𝑊! 𝜎)! )$ + (𝑊" 𝜎)" )$
ð 𝜎) = 19.21%

Beta: bP = bA * WA + bB * WB + bRf * WRf

ð bP = 0.76
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2. Consider the two (excess return) index model regression results for A and B.
RA = 3% + 0.9 * RM RB = −2% + 1.2 * RM
R-square = 0.576 R-square = 0.636
Residual standard deviation = 10.3% Residual standard deviation = 11.1%

a. Which stock has more firm-specific risk?

B has higher Residual standard deviation => B has more firm-specific risk

b. Which has greater market risk?

B has higher Beta => B has greater market risk

c. For which stock does market movement explain a greater fraction of return variability?
B has higher R-square => for B, market movement explains a greater fraction of return
variability

d. If rf were constant at 6% and the regression had been run using total rather than excess
returns, what would have been the regression intercept for stock A?
E(Ri) = ai + bi * E(RM)
ð E(ri) - rf = ai + bi * [E(rM) - rf]
ð E(ri) = (ai + rf - bi * rf) + bi * E(rM)
ð New intercept = (ai + rf - bi * rf) = 3%+ (1 - 0.9) *6% = 3.6%
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3. Consider the following two regression lines for stocks 2 and 4 in the following figure.

a. Which stock has higher firm-specific risk?

Stock 4 has greater deviation from the line => Stock 4 has higher firm-specific risk
b. Which stock has greater systematic (market) risk?
Stock 2 is steeper (a higher slope) => Stock 2 has greater systematic (market) risk
c. Which stock has higher R2?
In regression 2, market return better explains the stock return => Stock 2 has higher R2
d. Which stock has higher alpha?
Stock 4 has higher intercept => Stock 4 has higher alpha
e. Which stock has higher correlation with the market?

𝜌-,. = 5𝑅-$

Stock 2 has higher R2 => Stock 2 has higher correlation with the market

Use the following data for Problems 4 through 9: Suppose that the index model for stocks A
and B is estimated from excess returns with the following results:
RA = 3% + .7RM + eA
RB = −2%+1.2RM +eB
σM = 25%; R-squareA = .20; R-squareB = .12
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4. What is the standard deviation of each stock?

𝛽!" 𝜎#
"
𝛽!" 𝜎#
"
𝑅!" = = " "
𝜎!" 𝛽! 𝜎# + 𝜎 " (𝑒! )
5. Break down the variance of each stock into its systematic and firm-specific components.

6. What are the covariance and the correlation coefficient between the two stocks?

Cov ( ri , rj ) = bi b js M2
𝐶𝑜𝑣 (𝑟- , 𝑟/ )
𝜌-,/ =
𝜎- ∗ 𝜎/
7. What is the covariance between each stock and the market index?
"
𝐶𝑜𝑣 -𝑟! , 𝑟$ 0 = 𝛽! 𝛽$ 𝜎#
8. For portfolio P with investment proportions of .60 in A and .40 in B, rework Problems 5, 6,
and 7.
9. Rework Problem 8 for portfolio Q with investment proportions of .50 in P, .30 in the market
index, and .20 in T-bills.

10. You are a consultant to a large manufacturing corporation that is considering a project with
the following net after-tax cash flows (in millions of dollars):

Years from now After-tax Cashflow

0 -100

1-10 25

The project’s beta is 1.5

a. Assuming that rf = 8% and E(rM) = 16%, what is the net present value of the project?
b. What is the highest possible beta estimate for the project before its NPV becomes negative?

a. Cost of equity based on CAPM = 8% + 1.5 * (16% - 8%) = 20%

$0 2
ð NPV = −100 + $,% >1 − (24$,%)#$? = 4.812
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b. If NPV < 0 => IRR < Discount rate

ð IRR = 21.41% (calculated based on CFs)
ð Before NPV is negative, the discount rate < 21.41%
ð 8% + b * (16% - 8%) < 21.41%
ð b < 1.68

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

a. What are the betas of the two stocks?

b. What is the expected rate of return on each stock if the two 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 two securities on the SML graph. What are the alphas 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?

EXEL file

For Problems 12 through 13: Assume that the risk-free rate of interest is 8% and the expected
rate of return on the market is 18%.

12. A share of stock sells for $50 today. It will pay a dividend of $6 per share at the end of the
year. Its beta is 1.2. What do investors expect the stock to sell for at the end of the year?
BOY Price = $50
Dividend = $6
Required rate of return = 8% + 1.2 * (18% - 8%) = 20%
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20% = ( EOY Price – BOY Price + Dividend) / BOY Price

ð 20% = ( EOY Price – $50 + $6) / $50
ð EOY Price = $54

13. A stock has an expected rate of return of 4%. What is its beta?
Required ROR = 14% = 8% + Beta * (18% - 8%)
ð Beta = 0.6

Extra exercises:
1. The concept of beta is most closely associated with:
a. Correlation coefficients.
b. Mean-variance analysis.
c. Nonsystematic risk.
d. Systematic risk.

2. Beta and standard deviation differ as risk measures in that beta measures:
a. Only unsystematic risk, while standard deviation measures total risk.
b. Only systematic risk, while standard deviation measures total risk.
c. Both systematic and unsystematic risk, while standard deviation measures only
unsystematic risk.
d. Both systematic and unsystematic risk, while standard deviation measures only systematic
risk.

3. Kaskin, Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of .6. Which of the
following statements is most accurate?
a. The expected rate of return will be higher for the stock of Kaskin than that of Quinn
b. The stock of Kaskin has more total risk than the stock of Quinn
c. The stock of Quinn has more systematic risk than that of Kaskin

4. Assume that the risk-free rate of interest is 6% and the expected rate of return on the market is
16%. I am buying a firm with an expected perpetual cash flow of $1,000 but am unsure of its
 Investment and Portfolio Management

risk. If I think the beta of the firm is .5, when in fact the beta is really 1, how much more will
I offer for the firm than it is truly worth?

• If Beta = 0.5
ð Required ROR = 6% + 0.5 * (16% - 6%) = 11%
ð Required ROR = 11% = Perpetual CFs / Offering Price = $1,000 / Offering Price
ð Offering Price = $9,091

• If Beta = 1
ð Required ROR = 6% + 1 * (16% - 6%) = 16%
ð Required ROR = 16% = Perpetual CFs / Offering Price = $1,000 / Offering Price
ð Offering Price = $6,250

ð I offer $9,091 - $6,250 = $3,066 more