Problem Set Week 2

Purpose

Try to solve the following set of problems related with contents explored in Week 2. Revisit the learning
materials made available during Week 2.

Duration

Try to solve this set of problems in 50 minutes, maximum.

Problem set

1. Consider the following statements. Are they true or false? Explain your answer.

a) All uncertainty to which an investor is exposed can be measured through standard statistical tools

b) Equity markets have become increasingly riskier during the last five years. As a result, betas for all
companies have increased.

c) According to the CAPM model, only the Market and the expected return of the market portfolio is
relevant. The motivation of Fama and French to include a size and a book-to-market factors was to get
a better perception of the market portfolio characteristics.

2. Consider the following information (downloaded from Bloomberg) about the Beta regression between
Apple returns and the S&P500 returns.
 a) According to obtained results Beta of Apple is 0.936. Is this number reflecting the full risk of Apple?

b) Looking at the R - squared of the regression (0.119) what can you conclude about Apple’s risk that
can be potentially diversifiable away in a portfolio?

c) Specifically regarding the regression analysis above disclosed, comment on the accuracy of the
Beta estimation and its impact for investment decisions.

3. Consider the following three factor model (Fama-French, 1996) 1 for the expected return of stock i :

E ( Ri ) =Rf + β ℑ ( R Mt−R f ) + β iSMB SMBt + β iHML HML t ,(1)

Where:

SMBt : Small Minus Big, i.e, the return of a portfolio of small stocks in excess of the return on a portfolio of
large stocks;
HMLt : High Minus Low, i.e, the return of a portfolio of stocks with a high book-to-market ratio in excess of
the return on a portfolio of stocks with a low book-to-market ratio.

Consider also the Fama/French Research Factors updated by the authors for the US relatively to the 12-
month period between November 2013 and November 2014:2

Fama/French
Research Factors 

Rm-Rf 14,91

SMB -11,34

HML -5,21

1
Fama, E. and K.French, 1996, “Multifactor Explanations of Asset Pricing Anomalies”, Journal of Finance 51, 55-84
2
Source: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html#Developed
Assume that, for stocks A and B, regression (1) was run for the same period of time and the obtained betas
are:

βℑ β iSMB β iHML

Stock A 1,0 0,4 0,9

Stock B 0,9 1,1 0,7

a) Using the obtained risk factor betas what is the expected excess returns of stocks A and B?

b) Decompose the expected excess returns for stocks A and B by risk factor?

c) Qualitatively, using only this data, how do you describe the risk profile of assets A and B?

d) Point out one drawback in this exercise to compute expected returns.