A 3.

1 B 14
=

E(c 6.60% =

Vf 3.00%
=
(m=4.50%

a) cis E(R) a
=
+

BE(Rm)
9 (6.60% 3.00%) -1.4x/4.50%
=
-
-

3.00%) 1.50%
=

in mutual
Yes. The
fund has a
positive a.
According to the CAPM

The mutual
fund is
underpriced. Iwould buythismutual fund and

hold until the price goes an

equilibrium.
(iii) Op WmOm, Op=Bm" Wm 1.4 =
=

In LAPM, all risk

systematic risk.
are B is the
proportion ofsystematic risk -
the portfolic
,
also the weight that p takes on the market
portfolio.
(iv) ECG) 4 B (E(F) F3 3.00% 1-4(4.5%-3,00]5-10%
-
= +
+ =

-
has and ~= Er
(Rm) E(R.)
-----

(r) EIr-ECrpFEIR-ER 1.5%

-

E(Rp) x x B
+ + =
=

SML
14

ECK) E((p) 4 =

[E(rm)-4)
+

-> E(Rp)=BE(Rm)
E(B) ......
difference between EC andECP)
M
E(tm) The the

mutual
equal of
is the
If -

to X the
I

fund.
: "2
-
 b)

InAPT, The
ii.
portfolios in the mutual fund and in the market index are

both well-diversified. So, the

expected level of idiosyncratic risk is zero,

iii) Yes, there is an

arbitrage opportunity.

iii. We need to
find the tracking portfolio which has the same with the mutual

fund. B: 1.4

E(Re) BE(Rn) 1.4x 1.5%

= =
= 2.1% ECF) E(Re) + H:5-10%
=

EIF) WmE(k) +(I-Wm) if

=

Wm=1.4 WF = 1 -W =

-0.4
t0 t1
frommutual
=
=

the mutual fund, withdraw money

Long $1.866
-

$ fund. +

Short the market index cover the short

position
$1.4
+ -

$1.463
Invest at the risk-free rate. return of the
-

0,4 Investment + $0.412

Initial Investment 0.

Profit +0.015

(iv. Profit rate 1.5% 2.

Profitrate EC Rmutual fund] ECP) x BECRm) -BE(Rm)
=

:
- +
=
=

X
=

With same , the mutual fund return is more than the

tracking portfolio.P
mutual
by 1.5%. The systematic risk in the
funds just offsets the systematic
in the
risk P. And idiosyncratic risks do not exist in both portfolio.
Problem 2.
Om 0.30=

F 3.00%
=

a) Ri (P(Ri,Rn))"=
=

Bio for stock i

On 82 10.60 0.3020.12
O?I: 5cj7 34 641%
x
=
=
= -

25T
Ri 0.27
2

ORBc (0-10x0.30)
=

0.22
0.33136
=

ORBC:57.564%

b. Oi BonSe
cit RBC.

systematic risk:(B:Om)" 0.0324 0.0729

firm-specific risk:Die=Oi"-Bm 0.0876 0.2585

c) Cor(Risi, RRBC) PcsT PRBC'Om 0.0486

=
=

Corr[Rest, RRBC) Cor(Rest, RRBC)/[5c5iOric) 0.2437

=
=

d) CovIRasi, Fm)=BcsTOm 0.054 =

Cor(RRBC, Rm) PRBcOm 0.081

=
=

e) No, in the CAPM model, the

intercept (x) ofevery stock must be zero.

The CAPM implies the risk premium

of
a stock
only comes from its compensation

for the
systematic risk.
If a stock has a
positive/negative intercept
a investors
can
long/short the stock to
get profit from a without risk,which eventually
increases/decreases the demand for the stock and increases/decreases its
price

until its becomes zero in

equilibrium.

f) For Stock i, E(Ri) 4i+BE(Rm

=

E()-4 2:
=

Bi[E(r)-r)
+

E(k) (i 4
=
+ -

:. )+iE(tm)
The
intercept of the new
regression equals xit-B), where Xi, i comes

from the
original regression.
+11-060%.0.03 0.032
The
intercept of 257 will be 0.02 =

the
intercept ofRBC will be -
0.05 +
(1-0.90).0.03: -0.047
0.72
9 11

i. PatWastest Waie ic=(0.6 0.b 0.4x0.9). x +

Ecr-:Aims-]
:
COV (RA, Rm) PAOm=0.72.0.32:0.0648
=
FCA):W.E, + We En

Ei-Vf= B, E(Rm
BB WA xt Wm m+Wf-, 0.5x0.72 a3x1+0
= =
+ =

0.660,"Eurtf-zE(Rm).
cov(RB, Rml= Bis Om 0.66 x0.32:0.0594,-/WEitWEz-H aE(Rm)
= =

FW, E(RuSt M Wm(Rmi +WXr=aE2Rm)

-

* +

- BA Wi, + Waz
=
ii) OR (Wcst 0cs++(WRBC.ORBC)*
=

2. WeT WRBC COV(Ri5T, Ric

=0.60.12 +0.42.0.33136 +

2x06x0.4.0.0486

=0.1195

Op 0.346 =

BB:( WA.0p) Y (Wm.Om)"+(Wf G) " 2 WAWmcor(RA, Rm)+2 WAWycorIRA. Ry)

+ 2
WmWfcor(Rm, Rf)
0.54 0.1195 1.34
=
x
0.01 +
0
+

2x
+

0.5x0.3.00648 + 0 + 0

0.0574
=

Oz 0.240
=

(iii). O:Bon Se
A B.
systematic risk:(B:Om)" 0.047 0.039

firm-specific risk:Die=Oi"-Bm 0.073 0.018

Problem 3
Ri=Xi+: Rm+ E:

1b) B:
is the coefficient that measures how the stock's excess return

responses
to the market's excess return. With higheri, the stock has more

expected excess return and also has a

higher level systematic risk.
Byknowing Pi, investors can estimate the risk and the
expected return

ofeach stock and choose stocks that suit their risk

preferences to

(build optimal portfolio).

maximize their
utility score the

a) R"measures how well the model fits the data.

07:) OYRi)-OYE:) Om
R2i 1 =
-

- =

O(Ri) &YRi) O(Ri)

model, R2 indicates how ofthe

In the case
ofsingle-index much variation in stock's

explained
excess return can be or
by the variation in the market's excess return.
predicted
a
With a
high R2, investors can
e
make better
generally
prediction or
explanation of
index
the
change in expected return based on the
change.
d) when more
factors are added in the model, R"will increase or not
 change. A higher R does not
always indicate a more accurate
regression.
R2 can be inflated byadding more factors in the model, even ifthey
are irrelevant or redundant. (Also, there is a bias-variance trade offissue
RP,
in
every regression model. With a
higher the variance
ofthe prediction &
but bias)
2) All 5% level, which 95%
betas are
significant at means we can be

confident thatthe relationshipbetween stock'sexcess return and market's excess

return. We can know this by the t-testand the p-value ofthe beta.

less than 5%,

when p-value is the factor loading will be
significant at 5%.

if systematic risk e n
sum of squared regression
N-1

residual
idiosyncraticrisk:squared

19) Is.

i) No. The result in 1 and is are not the same. The results
from index model

are calculated by PisOm which is based on the

assumption of
the relationship between
stock's excess return and the market's excess return. The results in (h) are based

on historical data of excess returns.

The result in (h) may provide more accurate

explanation and estimation
for
each stocks the
the variance covariance
among in
past years.
-

The result based the index model better prediction

on can
give a

of future performance and

expected correlation
among stocks.
 8Ri):
i, Om+o"ei) =
Total sumofsquares:1-1) OYRi) =
2 1X:-F:l"
Explained sum of
squares

R-squared. R" =1 -
8"(ei)
84Ri)
-B: Om
OYRi)
R2 1=
-
RSS
Tss
Es
=

RSS
YE:1:2(4i -4i)" ISS:RSSESS
Residual sum of
squares
=

11
x) y ↑P
sp
squaredResidual
↑estimated value. Pion
sum of true value
Geis
firm specific systematic
sum of squared of
estimate errors

**** (i)=2 (Y:-5:)"

Regression sum ofsquares
sum of squared Regression. mean value of sample.
a

⑧Ri) 2
=40.94093
=

oi):I/Ri-Fi) RSS 3 (Ri-:)

=

N-1
T

40.5849
=

⑮
 TBEY 1000 4,365
=
-

stop?Ien
365
UBEY for:TBDY

Peptide
-
:

EAR= I
riyasytos)
-

to
=
rapy
FMR=
poreys
rBEY (3655,xY7/365 n.p
=

65(10V1Y+156
-

-1365 GS10

GS,= 100-P x

360

Go

RBEY (65 586)/(360 4365x10)

=

x -

GS0:TBDy 1*-BEY 100

=

TBDy =

x i-For: 365

1: VBRY rEY 1365 Wixxy)/165-nrd

=

%ViDY 1. BEY. LI-NBDY):TBDY

BEY