Professor Paolo Vitale Capital Markets

Revision Questions and Classwork: The Capital Asset Pricing Model Academic Year 2018-2019

Revision Question 1
Define the notion of market portfolio.

Revision Question 2

(a) Illustrate the basic assumptions of the Capital Asset Pricing Model.
(b) Under these assumptions, possibly with the help of a numerical example, show that the market port-
folio and the tangent portfolio coincide.

Revision Question 3
Explain the main equilibrium relationship derived from the CAPM. In particular, discuss the meaning of
an asset’s beta and its implications.

Revision Question 4
Illustrate how an asset’s beta can be estimated using data on its returns and on that of a market index.

Revision Question 5
Describe the index model and the decomposition of the total volatility of an asset in its systematic and
non-systematic components.

Exercise 1
Assume the yearly return on the market portfolio is 0.23, the yearly return on the risk-free asset is 0.07,
while the standard deviation of the return on the market portfolio is 0.32. Assume the market portfolio is
efficient

a. Find the analytical expression for the CML.

b. Assume you possess $1,000 you want to invest in a portfolio whose expected return is 0.39. What’s
the standard deviation of the return of your portfolio? What’s its composition?
c. Suppose you invest $300 in the risk-free asset and $700 in the market portfolio. What’s the final
wealth you expect to receive at the end of the year?
Revision Questions and Classwork: The Capital Asset Pricing Model Capital Markets

Exercise 2
Indicate which of the following statements are true/false. Explain your answers.

(i) The CAPM suggests that an asset with a negative beta possesses a negative expected rate of return.
(ii) The expected rate of return of an asset with a beta equal to 3.0 is three times that of the market
portfolio.
(iii) If the expected return of an asset is below the security market line, then the asset is underpriced.

Exercise 3
Indicate which of the following statements are true/false. Explain your answers.

1. The CAPM suggests that investors require larger expected returns from assets with more volatile
returns.
2. The expected rate of return of an asset with a beta equal to 0 is zero.
3. An investor which spends €10,000 to purchase Italian BOT (short-term government debt instru-
ments), that is risk-free bonds, and €10,000 to purchase the MIB30 stock index possesses a portfolio
with a β equal to 1/2.

Exercise 4
Consider 3 stocks, AXA, British Airways and Cadbury, which possess expected rates of return respectively
equal to 25%, 18% and 15%. If the corresponding betas are 1.5, 1.0 and 0.5, do you believe that there is a
profitable opportunity? If you do, how do you exploit it?

Exercise 5
Assume you have access to n risky assets, each which is indexed by i, with i = 1, 2 . . . , n. Show that if your
portfolio p presents weights wi for i = 1, 2 . . . , n, with ∑ wi = 1, and if β i denotes asset i’s beta, then
n
βp = ∑ wi β i ,
i =1

where β p is portfolio p’s.

Exercise 6
Suppose the rate of return on the safe asset is 4%. Assume that Heinze Corp stock presents a standard de-
viation of its return equal to 26% and a correlation with the market portfolio return equal to 0.33. Assume,
moreover, that the return on the market portfolio presents an expected value equal to 10% and a standard
deviation equal to 16%.

Assume the CAPM holds.

1. What is the expected return on Heinze Corp stock?

2. What is the percentage of the volatility of Heinze Corp stock which is due to the non-systematic com-
ponent of risk of such an asset? How do you interpret your answer?

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Revision Questions and Classwork: The Capital Asset Pricing Model Capital Markets

Exercise 7
Assume that the index model applies so that for assets i and j

r̃i = r f + β i,m (r̃m − r f ) + ẽi , r̃ j = r f + β j,m (r̃m − r f ) + ẽ j ,

where ẽi ⊥ ẽ j ⊥ r̃m and r f is a constant. Then, show that,

Cov [r̃i , r̃ j ] = β i β j σm2 , Cor [r̃i , r̃ j ] = Cor [r̃i , r̃m ] × Cor [r̃ j , r̃m ] .

Exercise 8
Assume there are two risky assets, A and B, and a risk-free asset. Assume the supply of the two assets is
equal, so that the market portfolio is 50% invested in A and 50% invested in B. Assume r f = 0.1, σA2 = 0.04,
σB2 = 0.02 and σA,B = 0.01. In addition, suppose that the expected return on the market portfolio is 0.18.

1. Find the analytical expressions and the values for σm2 , β A and β B .
2. If the CAPM holds what are the expected values on the returns on assets A and B, E A e EB ?

Exercise 9
Suppose the index model holds, so that for any risky asset the following linear relationship applies

r̃ j − r f = α j + β j (r̃m − r f ) + ẽ j ,

where α j s a constant, r f is the risk-free rate of return, r̃n is the return on the market portfolio and ẽ j is the
idiosyncratic (non-systematic) component of risk for asset j.

Assume that for assets A amd B, α A = 0.01, α B = −0.02, β A = 0.9, β B = 1.1, σe A = 0.3 and σeB =
0.1. Moreover, assume that the expected value of the excess return over the risk-free asset for the market
portfolio is 10%, while the corresponding volatility (or standard deviation) is 20%.

(i) What’s the expected excess return for assets A and B? What’s the corresponding volatility?
(ii) What’s the percentage of the volatility for A and B which corresponds to non-systematic risk?
(iii) What are the covariance and correlation between the returns on A and B? [hint: what hypothesis can
you make on Cov[ẽ A , ẽB ] if the index model holds?]
(iv) Define a portfolio invested 50% in A and 50% in B. What are the expected value and the volatility of
the excess return over the risk-free asset for such a portfolio p? What percentage of the volatility of
portfolio p corresponds to the non-systematic component of risk?

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Revision Questions and Classwork: The Capital Asset Pricing Model Capital Markets

SOLUTIONS

Exercise 1

1 ( Em −r f )
1. E p = 0.07 + 2 σp . Notice that the CML is E p = r f + σm σp . In this case r f = 0.07 and ( Em −
r f )/σm = (0.23 − 0.07)/0.32.
2. The expected return on portfolio p invested in the risk-free asset and the market portfolio with
weights x and 1 − x è
E p = 0.07 · x + 0.23 · (1 − x ) = 0.23 − 0.16 · x .

This portfolio possesses a standard equal to σp = (1 − x )σm .

Imposing the condition that E p = 0.39, we find that x = −1. This implies that you should short sale
the risk-free asset for $1,000 (that is you will have to borrow $1,000) and invest $2,000 in the market
portfolio. The standard deviation is then σp = 2 · 0.32 = 0.64.
3. This portfolio is characterized by weights x = 3/10 and 1 − x = 7/10. Hence the expected return is

3 7
E p = 0.07 · + 0.23 · = 0.182.
10 10
The expected final wealth is therefore

1, 000 · (1 + E p ) = $1, 182.

Exercise 2

(i) The statement is false, in that if the CAPM holds, then

E[r̃ j ] − r f = β j ( E[r̃ M ] − r f )

and hence if β j < 0 we have that E[r̃ j ] < r f . This does not necessarily imply that E[r̃ j ] < 0
(ii) The statement is false. In fact, consider the following counter-example, where E[r̃ M ] = 0.10 and
r f = 0.5. Applying the CAPM we find that

E[r̃ j ] = 0.05 + 3 × 0.05 = 0.20 < 0.30 = 3 × 0.10.

(iii) The statement is false. The asset is overpriced. Consider in fact that if the asset is below the security
market line, then its expected return is smaller than the equilibrium value. Let E[r̃ j ] be the expected
return on the asset. Assume for simplicity that the asset does not pay any dividends. The return on
the asset corresponds to a capital gain, that is

E[ P̃1 ] − P0
E[r̃ j ] = .
P0

Given the expected value of next period asset price, E[ P̃1 ], the expected return on the asset is smaller
than its equilibrium value only if the asset is overvalued, that is only if the current price, P0 , is larger
than its equilibrium value.

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Revision Questions and Classwork: The Capital Asset Pricing Model Capital Markets

Exercise 3

1. False. Only the beta, that is the measure of co-movement between the return on market portfolio and
the return on the asset conditions the equilibrium value of the expected return of such an asset.
According to portfolio choice, risk-averse investors hold diversified portfolios which allow to exploit
the benefits of diversification. This allows to eliminate the un-systematic component of risk of indi-
vidual assets. The systematic part, which is that correlated with the return on the market portfolio,
cannot be diversified away and it consequently conditions the equilibrium value of the expected re-
turns on assets. The beta captures such systematic component, as it the measures the correlation
between an asset return and the return on the market portfolio. This implies that we can have two
assets, where the former presents a larger variance of the return, but a smaller beta. The former asset
will then pay a smaller expected return in equilibrium.
2. False. From the CAPM equilibrium relation we know that the expected return on such as asset is
equal to the risk-free rate.
3. True. The overall wealth of the investor is €20,000. This implies that her wealth is equally split
between the two assets, the government bond and the MIB30. Since, the beta of a portfolio is equal
to the weighted average of the betas of the individual assets, where the weights are equal to the
percentage of wealth invested in the individual assets, we conclude that the portfolio’s beta is

1 1 1
× 0 + ×1 = .
2 2 2

Exercise 4
Consider portfolio p, invested 50 percent into AXX stock and 50 percent into Cadbury stock. This portfolio
possesses the same beta of British Airways stock.

1 1
βp = β AXA + β Cadbury = 0.75 + 0.25 = β BA .
2 2

However, portfolio p presents a larger expected rate of return than British Airways stock, 20% as opposed
to 18%. It is profitable to short sell British Airways stock and buy portfolio p, with a margin of 2 percent on
the value of the investment.

The inconsistency depends on the fact that the three stocks are not aligned on the security market line.

Exercise 5
By definition portfolio p’s beta is

Cov(r̃ p , r̃m ) Cov(∑in=1 wi r̃i , r̃m ) ∑n Cov(wi r̃i , r̃m ) ∑n w Cov(r̃i , r̃m )
βp = = = i =1 = i =1 i .
Var(r̃m ) Var(r̃m ) Var(r̃m ) Var(r̃m )

where r̃m is the return on the market portfolio. Then,

n n
Cov(r̃i , r̃m )
βp = ∑ wi Var(r̃m )
= ∑ wi β i
i =1 i =1

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Revision Questions and Classwork: The Capital Asset Pricing Model Capital Markets

where we have exploited the linearity of the expectation operator so that Cov(y + z, x ) = Cov(y, x ) +
Cov(z, x ) and Cov( ay, x ) = a Cov(y, x ).

Exercise 6

1. Assuming the CAPM holds, we derive the beta, β, for Heinze Corp stock. By definition
cov(r̃ M , r̃ H ) σ 0.26
β = 2
= cor(r̃ M , r̃ H ) H = 0.33 = 0.54,
σM σM 0.16
where r̃ M , r̃ H denote the returns on the market portfolio and Heinze Corp stock.
From the CAPM equilibrium condition, using the beta of Heinze Corp stock, the expected return on
the market portfolio, E[r̃ M ] = 0.10, and the risk-free rate of return, r f = 4%, we find that

E[r̃ H ] = r f + β ( E[r̃ M ] − r f ) = 0.04 + 0.54 · 0.06 = 0.072.

2. According to the CAPM the following decomposition applies to the variance of the return on Heinze
Corp stock,
2
σH = β2 σM
2
+ σe2 ,
where ẽ is the idiosyncratic component of the return on Heinze Corp stock and σe2 is the corresponding
variance. Indeed, from the CAPM we find that

r̃ H = r f + β (r̃ M − r f ) + ẽ.

Hence,
(0.26)2 = (0.54)2 (0.16)2 + σe2 ⇔ σe = 0.24522.
In other words, about 94% (0.24522/0.26 ≈ 0.943) of the volatility of Heinze Corp stock is attributable
to the non-systematic component of risk, which can be eliminated via diversification.

Exercise 7
Consider that

Cov [r̃i , r̃ j ] = Cov(r f + β i,m (r̃m − r f ) + ẽi , r f + β j,m (r̃m − r f ) + ẽ j )

= Cov( β i,m r̃m + ẽi , β j,m r̃m + ẽ j ) (as r f is constant)

= Cov( β i,m r̃m , β j,m r̃m ) + Cov( β i,m r̃m , ẽ j ) + Cov(ẽi , β j,m r̃m ) + Cov(ẽi , ẽ j )

= Cov( β i,m r̃m , β j,m r̃m ) (as Cov( β i,m r̃m , ẽ j ) = Cov(ẽi , β j,m r̃m ) = Cov(ẽi , ẽ j ) = 0) ,

= β i β j Cov(r̃m , r̃m ) = β i β j σm2 .

Furthermore
Cov [r̃i , r̃ j ] β i β j σm2 β σm β j σm
Cor [r̃i , r̃ j ] = = = i ×
σi σj σi σj σi σj
σi,m σj,m
σm2 σm σm2 σm σi,m σj,m
= × = × = Cor(r̃i , r̃m ) × Cor(r̃ j , r̃m ) .
σi σj σm σm σm σj

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Revision Questions and Classwork: The Capital Asset Pricing Model Capital Markets

Exercise 8

1. The return on the market portfolio is r̃m = 12 r̃ A + 12 r̃ B . This implies that

 2  2
1 1 11
σm2 = σA2 + σB2 + 2 σA,B = 0.25 · 0.04 + 0.25 · 0.02 + 0.5 · 0.01 = 0.02 .
2 2 22

Therefore, consider that

 
1 1 1 1
σA,m = Cov r̃ A , r̃ A + r̃ B = σA2 + σA,B = 0.5 · 0.04 + 0.5 · 0.01 = 0.025 ,
2 2 2 2

while
 
1 1 1 1
σB,m = Cov r̃ B , r̃ A + r̃ B = σA,B + σB2 = 0.5 · 0.01 + 0.5 · 0.02 = 0.015 ,
2 2 2 2

where we exploited the linearity of the covariance operator, so that

Cov( x̃, aỹ + bz̃) = a Cov( x̃, ỹ) + b Cov( x̃, z̃).

We conclude that
σA,m 0.025 σ 0.015
βA = 2
= = 1.25 , β B = B,m
2
= = 0.75 .
σm 0.02 σm 0.02

2. From the CAPM we have that

E A = r f + β A ( Em − r f ) = 0.1 + 1.25 · 0.08 = 0.2, while

EB = r f + β B ( Em − r f ) = 0.1 + 0.75 · 0.08 = 0.16.

Exercise 9

(i) Consider that for j = A, B

E[r̃ j ] − r f = α j + β j ( E[r̃ M ] − r f ) , where E[r̃ M ] − r f = 0.1 ,

and that
σj2 = β2j σM
2
+ σe2j , where σM = 0.2 .

This implies that

E[r̃ A ] − r f = 0.01 + 0.9 · 0.1 = 0.1 and E[r̃ B ] − r f = −0.02 + 1.1 · 0.1 = 0.09 ,

while

σA2 = 0.92 · 0.22 + 0.32 = 0.1224 (i.e. σA = 0.349857) and

σB2 = 1.12 · 0.22 + 0.12 = 0.0584 (i.e. σB = 0.241661) .

(ii) The non-systematic risk over the total risk is σej /σj . For the two assets it is respectively 0.3/0.349857 =
0.857493 ≈ 85.75% and 0.1/0.241661 = 0.413803 ≈ 41.38%.

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Revision Questions and Classwork: The Capital Asset Pricing Model Capital Markets

2 (this result is also shown in Exercise

(iii) Considering that ẽ A ⊥ ẽB ⊥ r̃ M , we have that σA,B = β A · β B · σM
7). In fact, since the constants do not condition the covariance, we find that

Cov[r̃ A , r̃ B ] = Cov[ β A r̃ M + ẽ A , β B r̃ M + ẽB ] .

Exploiting the linearity of the covariance operatori and the independence of the three random vari-
ables (ẽ A ⊥ ẽB ⊥ r̃ M ), the result is immediate. We conclude that Cov[r̃ A , r̃ B ] = 0.0396. The correlation
is equal to
σA,B 0.0396
Cor[r̃ A , r̃ B ] = = = 0.4684 .
σA · σB 0.349857 · 0.241661

(iv) We have that r̃ p = 21 (r̃ A + r̃ B ) and hence

1


Ep − r f = E[r̃ A ] − r f + E[r̃ B ] − r f = 0.095 ,
2
1 2 1
σp2 σA + σB2 + 2 σA,B = (0.1224 + 0.0584 + 2 · 0.0396)


=
4 4
1
= 0.26 = 0.065 (i.e. σp = 0.254951) .
4
1 1
In addition, r̃ p − r f = α p + β p (r̃ M − r f ) + ẽ p , with α p = 2 (α A + α B ), β p = 2 (β A + β B ) and ẽ p =
1
2 ( ẽ A + ẽB ). Therefore,

1 1
σe2p = σe2A + σe2B = 0.32 + 0.12 = 0.025 (i.e. σe p = 0.158114) ,



4 4
from which we conclude that the non-systematic component of risk over total risk for portfolio p is
σe p /σp = 0.158114/0.254951 = 0.620174 ≈ 62.02%.