Problems

3.1. Assume the annual price data below is for General Foods and the S&P 500, covering
the period 1997- 2012.
Year GF S&P
2012 40.58 1.211.92
2011 48.38 1.111.92
2010 40.96 879.82
2009 43.34 1.148.08
2008 55.38 1.320.28
2007 52.26 1.469.25
2006 59.49 1.229.23
2005 58.72 970.43
2004 45.93 740.74
2003 32.06 615.93
2002 21.93 459.27
2001 18.67 466.45
2000 17.24 435.71
1999 16.3 417.09
1998 9.29 330.22
1997 7.57 353.4

Calculate the beta for General Foods. Use the ESTLIN function or the SLOPE function in
the spreadsheet.

3.2. Given the spreadsheet below, calculate the portfolio beta and the expected return on
this two stock portfolio using the CAPM.

The Market’s Expected Return 9.00%

The Risk Free Rate 2.50%
Beta for Bateman Industries 0.98
Beta for Advanced Solar Arrays 1.34
Weight for Bateman 60.00%
Weight for Solar Arrays 40.00%
Portfolio Beta
Expected Return on the Portfolo

a) If the weights were 50/50, would this increase or decrease the portfolio return?
b) If the market’s expected return had been 8% with the 60/40 weights, would this
increase or decreased the portfolio return?

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3.3. Goodman Industries’s and Landry Incorporated’s stock prices and dividends, along
with the Market Index, are shown below. Stock prices are reported for December 31 of
each year, and dividends reflect those paid during the year. The market data are adjusted
to include dividends.

Goodman Industries Landry Incorporated Market Index

Year Stock Price Dividend Stock Price Dividend (Included Dividend)
2013 $25.88 $1.73 $73.13 $4.50 17,495.97
2012 $22.13 $1.59 $78.45 $4.35 13,178.55
2011 $24.75 $1.50 $73.13 $4.13 13,019.97
2010 $16.13 $1.43 $85.88 $3.75 9,651.05
2009 $17.06 $1.35 $90.00 $3.38 8,403.42
2008 $11.44 $1.28 $83.63 $3.00 7,058.96

a) Use the data given to calculate annual returns for Goodman, Landry, and the Market
Index, and then calculate average annual returns for the two stocks and the index. Assume
that dividends are already included in the index.
b) Calculate the standard deviations of the returns for Goodman, Landry, and the Market
Index.
c) Construct a scatter diagram graph that shows Goodman’s returns on the vertical axis and
the Market Index’s returns on the horizontal axis. Construct a similar graph showing
Landry’s stock returns on the vertical axis.
d) Estimate Goodman’s and Landry’s betas as the slopes of regression lines with stock
return on the vertical axis (y-axis) and market return on the horizontal axis (x-axis). Are
these betas consistent with your graph?
e) The risk-free rate on long-term Treasury bonds is 6.04%. Assume that the market risk
premium is 5%. What is the required return on the market? Now use the SML equation to
calculate the two companies’ required returns.
f) If you formed a portfolio that consisted of 50% Goodman stock and 50% Landry stock,
what would be its beta and its required return?
g) Suppose an investor wants to include some Goodman Industries stock in his portfolio.
Stocks A, B, and C are currently in the portfolio, and their betas are 0.769, 0.985, and
1.423, respectively. Calculate the new portfolio’s required return if it consists of 25%
Goodman, 15% Stock A, 40% Stock B, and 20% Stock C.

3.4. A stock has a beta of 1.13 and an expected return of 12.1 percent. A risk-free asset
currently earns 5 percent.

a) What is the expected return on a portfolio that is equally invested in the two assets?
b) If a portfolio of the two assets has a beta of .50, what are the portfolio weights?
c) If a portfolio of the two assets has an expected return of 10 percent, what is its beta?
d) If a portfolio of the two assets has a beta of 2.26, what are the portfolio weights?
e) How do you interpret the weights for the two assets in this case? Explain.

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3.5. The following are estimates for two stocks.

Stock Expected Return Beta Firm-Specific 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?

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

Weight
Stock A 30%
Stock B 45%
T-bills 25%

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

3.6. Consider a three-factor APT model. The factors and associated risk premiums are

Factor Risk Premium

Change in GNP 5%
Change in energy prices -1%
Change in long-term interest rates +2%

Calculate expected rates of return on the following stocks. The risk-free interest rate is
7%.

a) A stock whose return is uncorrelated with all three factors.

b) A stock with average exposure to each factor (i.e., with b = 1 for each).
c) A pure-play energy stock with high exposure to the energy factor (b = 2.4) but zero
exposure to the other two factors.
d) An aluminum company stock with average sensitivity to changes in interest rates and
GNP, but negative exposure of b = -1.3 to the energy factor. (The aluminum company is
energy-intensive and suffers when energy prices rise.)

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3.7. The following table shows the sensitivity of four stocks to the three Fama–French
factors. Estimate the expected return on each stock assuming that the interest rate is 3%,
the expected risk premium on the market is 6%, the expected risk premium on the size
factor is 3.7%, and the expected risk premium on the book-to-market factor is 4.8%.

Boeing Johnson & Dow Apple

Johnson Chemical
Market 1.22 0.72 1.14 1.17
Size 1.28 -0.60 0.37 -0.48
Book-to-market -0.85 0.23 0.22 -0.65

3.8. You want to create a portfolio equally as risky as the market, and you have $1,000,000
to invest. Given this information, fill in the rest of the following table:

Asset Investment Beta

Stock A $180.000 0.85
Stock B $290.000 1.40
Stock C 1.45
Risk-free asset

3.9. Suppose a factor model is appropriate to describe the returns on a stock. The current
expected return on the stock is 10.5 percent. Information about those factors is presented
in the following chart:

Factor Beta Expected value Actual value

Growth in GNP 1,87 2,1% 2,6%
Inflation -1,32 4,3% 4,8%

a) What is the systematic risk of the stock return?

b) The firm announced that its market share had unexpectedly increased from 23 percent
to 27 percent. Investors know from past experience that the stock return will increase by
0.45 percent for every 1 percent increase in its market share. What is the unsystematic risk
of the stock?
c) What is the total return on this stock?