Campus de Gualtar

4710-057 Braga – P School of Economics and Management

Financial Investments

Exercises – Chapter 5

1. An investors invested 10 000€ in the market portfolio that has an expected return of 15% and
5000€ in Treasury Bills, that earn 10%.
a. Compute the beta of this investment.
The beta of a portfolio is the weighted average of the betas of the individual securities
that compose the portfolio

p= wm × m + wTB × TB

10000 5000
𝛽𝑝 = ×1+ × 0 = 0.6667
15000 15000

b. Suggest the investor a way of increasing her return on the investment to 16.5%.
To achieve a return of 16.5%, the investor must make a new combination of the market
portfolio and Rf.

16.5 = 15 wm + 10 wTB 16.5 = 15 (1- wTB) + 10 wTB

wTB = - 0.3
wm = 1.3

She must invest 130% of her wealth (19500 = 130% × 15000) in the market portfolio.
For such, she must borrow 30% (4500 = 30% × 15000) at the risk-free rate.

2. “Alfa and Beta” manages a portfolio composed of 5 stocks with the following market
values and betas:
Stock Market Value Beta
A 100 000 1.1
B 50 000 1.2
C 75 000 0.75
D 125 000 0.8
E 150 000 1.4

If the return on the risk-free asset is 7% and the return on the market is 14%, what is the
expected return of this portfolio?

Proportion A: 100000/500000 = 0.2

Proportion B: 50000/500000 = 0.1
 Proportion C: 75000/500000 = 0.15
Proportion D: 125000/500000 = 0.25
Proportion E: 150000/500000 = 0.3

p = 0.2×1.1 + 0.1×1.2 + 0.15×0.75 + 0.25×0.8 + 0.3×1.4 = 1.0725

Expected return of the portfolio = 0.07 + (0.14 - 0.07) 1.0725 = 14.5%

3. If the CAPM is valid, are the following situations below possible? Explain.
a.
Portfolio E[r] Beta
A 20% 1.4
B 25% 1.2

Not possible.
b.
Portfolio E[r] Standard Deviation
A 30% 35%
B 40% 25%

Possible.
c.
Portfolio E[r] Standard deviation
Risk-free 10% 0
Market 18% 24%
A 20% 22%

Not possible.
d.
Portfolio E[r] Beta
Risk-free 10% 0
Market 18% 1
A 16% 1.5

Not possible.
e.
Portfolio E[r] Beta
Risk-free 10% 0
Market 18% 1
A 16% 0.9

Not possible.

4. Consider the following information:

Stock A Stock B Market portfolio Riskfree Asset

Expected equilibrium return ? ? 15% 10%
Correlation coefficient with
0.9 0.8 1 0
the market portfolio
Standard deviation of return 12% 15% 8% 0%
 a. Compute the betas of stocks A and B.
𝑐𝑜𝑣(𝑟𝐴, 𝑟𝑚 ) 𝜌𝐴𝑀 𝜎𝐴 𝜎𝑚 0.9 × 0.12 × 0.08
𝛽𝐴 = 2
= 2
= = 1.35
𝜎𝑚 𝜎𝑚 (0.08)2
𝑐𝑜𝑣(𝑟𝐵, 𝑟𝑚 ) 𝜌𝐵𝑀 𝜎𝐵 𝜎𝑚 0.8 × 0.15 × 0.08
𝛽𝐵 = 2
= 2
= = 1.5
𝜎𝑚 𝜎𝑚 (0.08)2

b. What are the expected returns of stocks A and B?

𝐸(𝑟𝐴 ) = 0.1 + (0.15 – 0.1) × 1.35 = 0.1675

𝐸(𝑟𝐵 ) = 0.1 + (0.15 – 0.1) × 1.5 = 0.175

5. Two investment advisers are comparing performance. One averaged 19% return and the other
a 16% return. However the beta of the first adviser was 1.5 while that of the second was 1.0.
a. Can you tell which adviser was a better selector of individual stocks (aside from the
issue of general movements in the market)?
We denote the first investment advisor 1, who has r1 = 19% and 1 = 1.5, and the
second investment advisor 2, as r2 = 16% and 2 = 1.0. In order to determine which
investor was a better selector of individual stocks, we look at the abnormal return,
which is the ex-post alpha; that is, the abnormal return is the difference between the
actual return and that predicted by the SML.

Without information about the parameters of this equation (i.e., the risk-free rate and
the market rate of return), we cannot determine which investment adviser is the
better selector of individual stocks.

b. If the T-Bill rate were 6% and the market return during the period were 14% which
adviser would be the superior stock selector?
If rf = 6% and rM = 14%, then (using alpha for the abnormal return):
α1 = 19% – [6% + 1.5 × (14% – 6%)] = 19% – 18% = 1%
α2 = 16% – [6% + 1.0 × (14% – 6%)] = 16% – 14% = 2%
Here, the second investment adviser has the larger abnormal return and thus
appears to be the better selector of individual stocks. By making better predictions,
the second adviser appears to have tilted his portfolio toward underpriced stocks.

c. What if the T-bill rate were 3% and the market return 15%?
If rf = 3% and rM = 15%, then:
α1 =19% – [3% + 1.5 × (15% – 3%)] = 19% – 21% = –2%
α2 =16% – [3% + 1.0 × (15% – 3%)] = 19% – 15% = 1%
6. Karen Kay, a portfolio manager at Collins Asset Management, is using the capital asset pricing
model for making recommendations to her clients. Her research department has developed
the information show in the following exhibit.
Forecasted return Standard deviation Beta
Stock X 17% 36% 0.8
Stock Y 17% 25% 1.5
Market index 14% 15% 1.0
Risk-free rate 5%
 a. Calculate expected return and alpha for each stock.
𝐸(𝑟𝑋 ) = 5% + (14% – 5%) × 0.8 = 12.2%
X = 14% – 12.2% = 1.8%
𝐸(𝑟𝑌 ) = 5% + (14% – 5%) × 1.5 = 18.5%
Y= 17% – 18.5% = –1.5%
b. Identify and justify which stock would be more appropriate for an investor who wants to:
i. Add this stock to a well diversified equity portfolio;
For an investor who wants to add this stock to a well-diversified equity portfolio, it is
important to look at performance based on a performance measure adjusted for beta
– alpha.
So, Kay should recommend Stock X because of its positive alpha, while Stock Y has a
negative alpha. In graphical terms, Stock X’s expected return/risk profile plots above
the SML, while Stock Y’s profile plots below the SML. Also, depending on the individual
risk preferences of Kay’s clients, Stock X’s lower beta may have a beneficial impact
on overall portfolio risk.

ii. Hold this stock as a single stock portfolio.

When a stock is held in isolation, standard deviation is the relevant risk measure. For
assets held in isolation, beta as a measure of risk is irrelevant. Although holding a
single asset in isolation is not typically a recommended investment strategy, some
investors may hold what is essentially a single-asset portfolio (e.g., the stock of their
employer company). For such investors, the relevance of standard deviation versus
beta is an important issue. In this case, the Sharpe ratio should be used as the
performance measure.

For an investor who wants to hold this stock as a single-stock portfolio, Kay should
recommend Stock Y, because Stock Y’s Sharpe ratio is:
(0.17 − 0.05)
= 0.48
0.25
Stock X’s Sharpe ratio is only:
(0.14 − 0.05)
= 0.25
0.36
The market index has an even more attractive Sharpe ratio:
(0.14 − 0.05)
= 0.6
0.15
However, given the choice between Stock X and Y, Y is superior.

7. Based on current dividend yields and expected capital gains, the expected rates of return on
portfolios A and B are 11% and 14%, respectively. The beta of A is 0.8 while that of B is 1.5.
The T-bill rate is currently 6%, while the expected rate of return of the S&P 500 Index is 12%.
The standard deviation of portfolio A is 10% annually, while that of B is 31%, and that of the
index is 20%.
The data can be summarized as follows:

Expected return Beta Standard deviation

Portfolio A 11% 0.8 10%
Portfolio B 14% 1.5 31%
S&P 500 12% 1.0 20%
T-Bills 6% 0 0%
 a. If you currently hold a market index portfolio, would you choose to add either of these
portfolios to your holdings? Explain.
Using the SML, the expected rate of return for any portfolio P is:

𝐸(𝑟𝑃 ) = 𝑟𝑓 + [𝐸(𝑟𝑃 ) – 𝑟𝑓 ] × 𝛽𝑃
So:
𝐸(𝑟𝐴 ) = 6% + (12% – 6%) × 0.8 = 10.8% < 11%
𝐸(𝑟𝐵 ) = 6% + (12% – 6%) × 1.5 = 15.0% > 14%
Hence, Portfolio A is desirable and Portfolio B is not.
b. If instead you could invest only in bills and one of these portfolios, which would
you choose?
The slope of the CAL supported by a portfolio P is given by the Sharpe ratio:
E(rP) － rf
S=
P
Computing this slope for each of the three alternative portfolios, we have:

(12% − 6%)
𝑆𝑆&𝑃500 = = 0.3
20%
(11% − 6%)
𝑆𝐴 = = 0.5 > 𝑆𝑆&𝑃500
10%
(14% − 6%)
𝑆𝐵 = = 0.258 < 𝑆𝑆&𝑃500
31%
So, choose portfolio A.

8. Go to the Excel spreadsheet presented in“Chap4_part2_exercise7” on Blackboard, where you

will find the monthly rates of returns for Apple – AAPL, Alphabet (the parent company of Google)
– GOOGL, the market – S&P500 and T- bills over the last five years (2016 to 2020).

a. What can you conclude on the alphas (performance) and betas of these stocks.

b. Compare the betas of these regressions with those estimated provided by Yahoo Finance.
What might explain these differences?

9. Consider the following data for a one-factor economy. All portfolios are well diversified.

Portfolio E[r] Beta

A 10% 1
F 4 0

Suppose another portfolio E is well diversified with a beta of 2/3 and an expected return
of 9%. Would an arbitrage opportunity exist? If so, what would the arbitrage strategy be?
A must be the market portfolio (M) and F is the riskless investment.
According to the CAPM:

𝐸(𝑟𝐸 ) = 4% + (10% – 4%) × 0.6667 = 0.08

αE =0.09 – 0.08 = 0.01
This implies that an arbitrage opportunity exists. For instance, by taking a long position in
Portfolio E (wE=1) and a short position in portfolios A(M) and F, we can create a
costless(zero-investment) strategy with zero beta and with a return equal to alpha. For the
beta of this strategy to be 0, the proportion (w) of funds invested in E must be:

𝑊𝐸 × 𝛽𝐸 + 𝑊𝑀 × 𝛽𝑀 = 0

1 × 𝛽𝐸 + 𝑊𝑀 × 1 = 0

𝑊𝑀 = −𝛽𝐸

In this case:

1 × 0.66667 + 𝑊𝑀 × 1 = 0

𝑊𝑀 = −0.66667

The rest of the funds for investing in E come from borrowing at the risk-free rate:

𝑊𝐹 = 𝛽𝐸 − 1 = −0.333333

Arbitrage strategy:
Weights Beta Return
Long E 1 1×0.6667 = 0.6667 1×0.09 = 0.0900
Short A (M) -0.6667 -0.66671×1 = -0.6667 -0.66671×0.1= -0.0667
Borrow F -0.3333 0 -0.3333×0.04=-0.0133
0 0 0.0100

This return is equal to alfa.

Taking a long position in portfolio E and a short position in portfolios A (that is, all proceeds
from the short sale of Portfolio A are invested in the new portfolio) and F (that is, borrowing
at the risk-free rate), we produce an arbitrage portfolio with zero investment, zero risk
(because  = 0 and the portfolios are well diversified), and a positive return of 1%.