RSM336 – Capital Markets Review Quiz

Chapter 11: Risk and Return: The Capital Asset Pricing Model
Solutions to Practice Questions

NOTE: This solution has been annotated to help you study. Important concepts are
highlighted in red and are testable, as is your ability to solve numerical examples.
11.1 The portfolio weight of an asset is the total investment in that asset divided by the total portfolio
value. First, we will find the portfolio value, which is:

Total value = 135 shares × $47 + 105 shares × $41 = $10,650

The portfolio weight for each stock is:

WeightA = (135 shares × $47)/$10,650 = 0.5958

WeightB = (105 shares × $41)/$10,650 = 0.4042

11.2 The expected return of a portfolio is the sum of the weight of each asset times the expected return
of each asset.

Investment in stock A = $1,900; Investment in stock B = $2,300

Return on stock A = 10%; Return on stock B = 15%
Total value of the investment = $1,900 + $2,300 = $4,200
Expected return of this portfolio = ($1,900/$4,200) × 10% + ($2,300/$4,200) × 15% = 12.74%

11.3 The expected return of a portfolio is the sum of the weight of each stock times the expected return
of each stock. So, the expected return of the portfolio is:

Expected return of this portfolio = 0.25 × 0.11 + 0.40 × 0.17 + 0.35 × 0.14 = 0.1445 or 14.45%

11.4 Here we are given the expected return of the portfolio and the expected return of each asset in the
portfolio and are asked to find the weight of each asset. We can use the equation for the expected
return of a portfolio to solve this problem. Since the total weight of a portfolio must equal 1
(100%), the weight of Stock Y must be one minus the weight of Stock X. Mathematically speaking,
this means:

Expected return of this portfolio = 0.129 = 0.14 × XX + 0.09 × (1 – XX)

We can now solve this equation for the weight of Stock X as:

0.129 = 0.14 × XX + 0.09 – 0.09 × XX

0.039 = 0.05 × XX
XX =0.78 or 78%

Ross et al, Corporate Finance 9th Canadian Edition Solutions Manual

© 2022 McGraw– Hill Education Ltd.
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 So, the dollar amount invested in Stock X is the weight of Stock X times the total portfolio value,
or:

Investment in X = 78% × $10,000 = $7,800

And the dollar amount invested in Stock Y is:

Investment in Y = (1 – 0.78) × $10,000 = $2,200

11.5 a. E(RA) = 0.3 × 20% + 0.5 × 15% + 0.2 × 1% =13.70%

σ2A = 0.3 × (20% − 13.70%)2 + 0.5 × (15% − 13.70%)2 + 0.2 × (1% −13.70%)2
= 0.45%
σA = (0.45%)0.5 = 6.71%

b. E(RP) = 0.5 × 13.70% + 0.5 × 10% =11.85%

σ2p = 0.52× 6.71%2 + 0.52 × 13.89%2 + 2 × 0.5 × 0.5 × 0.93
= 1.06%
σP = (1.06%)0.5 =10.30%

c. CORR A,B =COVA,B /(σAσB)= 0.93%/(6.71% × 13.89%) =1

d. 𝛽𝐵 = 2

e. βA = (CORR A,M σA)/σM = (0.3 × 6.71%)/5% = 0.4

f. βp = WA×0.4 + WB×2 + WRf×0 = 1

WA×0.4 + WB×2 = 1 (i)

Weights should sum up to 100%

WA+WB =1 – WRf = 0.8
WB = 0.8 – WA (ii)

(i) and (ii) imply

WA × 0.4 + (0.8 – WA) × 2 = 1
Solve for WA = 0.375
WB = 0.8 – 0.375 = 0.425

g. CAPM for Stock A: 2% + 0.4 × 4% = 3.61% < 13.70%

Stock A plots above the SML
Stock A must be underpriced

CAPM for Stock B: 2% + 2 × 4%=10%, which is equal to the expected return based
on your analysis.
Stock B plots on the SML
Stock B must be correctly priced.
Ross et al, Corporate Finance 9th Canadian Edition Solutions Manual
© 2022 McGraw– Hill Education Ltd.
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11.12The 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:

p = 1.0 = 1/3 × 0 + 1/3 × 1.65 + 1/3 × X

Solving for the beta of Stock X, we get:

X = 1.35

11.13 CAPM states the relationship between the risk of an asset and its expected return. CAPM is:

𝑅 = RF+(𝑅M – RF)

Substituting the values we are given, we find:

𝑅 = 0.05 + 1.25 × (0.12 – 0.05) = 0.1375 or 13.75%

11.14 We are given the values for the CAPM except for the beta of the stock. We need to substitute
these values into the CAPM, and solve for the beta 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:

𝑅 = 0.102 = 0.04 + 0.07 × 

 = 0.89

11.15 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:

𝑅 = 0.134 = 0.055 + 1.60 × (𝑅M – 0.055)

𝑅M = 0.1044 or 10.44%

11.16 Here we need to find the risk– free rate using the CAPM. Substituting the values given, and solving
for the risk– free rate, we find:

𝑅 = 0.131 = RF + 1.28 × (0.11 – RF)

0.131 = RF + 0.1408 – 1.28 RF

RF = 0.0350 or 3.50%
Ross et al, Corporate Finance 9th Canadian Edition Solutions Manual
© 2022 McGraw– Hill Education Ltd.
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11.23 We are given the expected return and beta of a portfolio. We know that the beta of the risk– free
asset is zero. We also know the sum of the weights of each asset must be equal to one. So, the
weight of the risk– free asset is one minus the weight of Stock X and the weight of Stock Y. Using
this relationship, we can express the expected return of the portfolio as:

Expected return of the portfolio = 0.1122

= XX × 0.1535 + XY × 0.0940 + (1 – XX – XY) × 0.045

And the beta of the portfolio is:

p = 0.96 = XX × 1.55 + XY × 0.70 + (1 – XX – XY) × (0)

We have two equations and two unknowns. Solving these equations, we find that:

XX = –0.2838710
XY = 2.0000000
XRf = –0.7161290

The amount to invest in Stock X is:

Investment in stock X = –0.28387 × $100,000 = –$28,387.10

A negative portfolio weight means that you short sell the stock. If you are not familiar with short
selling, it means you borrow a stock today and sell it immediately. You must then purchase the
stock at a later date to repay the borrowed stock. If you short sell a stock, you make a profit if the
stock decreases in value. The negative weight on the risk– free asset means that we borrow money
to invest.

11.26 a. The expected return of the portfolio is the sum of the weight of each asset times the expected
return of each asset, so:

𝑅P = XF 𝑅F + XG 𝑅G
𝑅P = 0.30 × 0.10 + 0.70 × 0.17
𝑅P = 0.1490 or 14.90%

b. The variance of a portfolio of two assets can be expressed as:

 2P = X 2F  2F + X G2  G2 + 2 XF XG F G F,G
 2P = 0.302 × 0.262 + 0.702 × 0.582 + 2 × 0.30 × 0.70 × 0.26 × 0.58 × 0.25
 2P = 0.18675

So, the standard deviation is:

P = √0.18675 = 0.4322 or 43.22%

Ross et al, Corporate Finance 9th Canadian Edition Solutions Manual

© 2022 McGraw– Hill Education Ltd.
11– 4
11.28 a. (i) Using the equation to calculate beta, we find:

A = (A,M A)/M
0.85 = (A,M × 0.31)/0.20
A,M = 0.55

(ii) Using the equation to calculate beta, we find:

B = (B,M B)/M
1.40 = (0.50 × B)/0.20
B = 0.56

(iii) Using the equation to calculate beta, we find:

C = (C,M C)/M
C = (0.35 × 0.65)/0.20
C = 1.14

(iv) The market has a correlation of 1 with itself.

(v) The beta of the market is 1.

(vi) The risk– free asset has zero standard deviation.

(vii) The risk– free asset has zero correlation with the market portfolio.

(viii) The beta of the risk– free asset is 0.

b. Using the CAPM to find the expected return of the stock, we find:

Firm A:
𝑅A = RF + A(𝑅M – RF)
𝑅A = 0.05 + 0.85 × (0.12 – 0.05)
𝑅A = 0.1095 or 10.95%

According to the CAPM, the expected return on Firm A’s stock should be 10.95 percent.
However, the expected return on Firm A’s stock given in the table is only 10 percent.
Therefore, Firm A’s stock is overpriced, and you should sell it.

Firm B:
𝑅B = RF + B(𝑅M – RF)
𝑅B = 0.05 + 1.4 × (0.12 – 0.05)
𝑅B = 0.1480 or 14.80%

Ross et al, Corporate Finance 9th Canadian Edition Solutions Manual

© 2022 McGraw– Hill Education Ltd.
11– 5
 According to the CAPM, the expected return on Firm B’s stock should be 14.80 percent.
However, the expected return on Firm B’s stock given in the table is 14 percent. Therefore,
Firm B’s stock is overpriced, and you should sell it.

Firm C:
𝑅C = RF + C(𝑅M – RF)
𝑅C = 0.05 + 1.14 × (0.12 – 0.05)
𝑅C = 0.1298 or 12.98%

According to the CAPM, the expected return on Firm C’s stock should be 12.98 percent.
However, the expected return on Firm C’s stock given in the table is 16 percent. Therefore,
Firm C’s stock is underpriced, and you should buy it.

11.31 First, we need to find the standard deviation of the market and the portfolio, which are:

M = √0.0429
M = 0.2071 or 20.71%

Z = √0.1783
Z = 0.4223 or 42.23%

Now we can use the equation for beta to find the beta of the portfolio, which is:

Z = (Z,M Z)/M
Z = (0.39 × 0.4223)/0.2071
Z = 0.795

Now, we can use the CAPM to find the expected return of the portfolio, which is:

𝑅Z = RF + Z(𝑅M – Rf)
𝑅Z = 0.048 + 0.795 × (0.114 – 0.048)
𝑅Z = 0.1005 or 10.05%

Ross et al, Corporate Finance 9th Canadian Edition Solutions Manual

© 2022 McGraw– Hill Education Ltd.
11– 6