TUTORIAL 4

1. What are the main differences between the CML and SML?
CML is used to measure the expected return on a portfolio but cannot be used to estimate
returns on an individual asset. The SML can be applied to any individual asset or collection
of assets.

2.
3. As an equity analyst, you have developed the following return forecasts and risk
estimates for two different stock mutual funds (Fund T and Fund U):
 a. If the risk-free rate is 3.9 percent and the expected market risk premium (i.e.,
E(RM) −RFR) is 6.1 percent, calculate the expected return for each mutual fund
according to the CAPM.
b. Using the estimated expected returns from Part a along with your own return
forecasts, demonstrate whether Fund T and Fund U are currently priced to fall
directly on the security market line (SML), above the SML, or below the SML.
c. According to your analysis, are Funds T and U overvalued, undervalued, or
properly valued?
(a) The following template shows, using the CAPM, the expected return, ER, of Fund T
and Fund U on the SML. The points are consistent with the following equations:

ER on stock = Risk-free rate + Beta x (Market return – Risk-free rate)

ER for Fund T = 3.9% + 1.2(6.1%)

= 11.22%

ER for Fund U = 3.9% + 0.8(6.1%)

= 8.78%

(b) Analyst estimate plot. Using the analyst’s estimates, Fund T plots below the SML and
Fund U, above the SML.

3.9%

0.8 1.2
(c) Over vs. Undervalue
Fund T is overvalued (a potential “sell” candidate) because it should provide a
11.22% return according to the CAPM, whereas the analyst has estimated only a
9.0% return.

Fund U is undervalued (a potential “buy” candidate) because it should provide an

8.8% return according to the CAPM, whereas the analyst has estimated a 10% return.

4. Suppose that three stocks (A, B and C) and two common risk factors (1 and 2) have
the following relationship:
E(RA) = (0.42)λ1+(1.16) λ2
 E(RB) = (0.18)λ1+(0.48) λ2
E(RC) = (0.3)λ1+(0.8) λ2
I. If λ0=5%, λ1 = 9% and λ2 = 6%, what are the prices expected next year for each of
the stocks? Assume that all three stocks currently sell for R40 and will not pay a
dividend in the next year.
II. Suppose that you know that next year the prices for Stocks A, B and C will actually
be R43.00. R41.50 and R50.00. If a riskless arbitrage opportunity was available and
you took advantage of it, what would your profit from this investment be?
III. What will the new current prices for Stocks A, B and C be once arbitrage trading has
occurred?
5. What are the assumptions of APT?

Capital markets are perfectly competitive

Investors always prefer more wealth to less wealth with certainty
The stochastic process generating asset returns can be expressed as a linear function of a
set of K factors or indexes

6. Identify the conditions required for a riskless arbitrage.