1. Stock XYZ has an expected return of 12% and beta of 1.

Stock ABC has expected return of 13% and

beta of 1.5. The market’s expected return is 11%, and RF=5%.

a. According to the CAPM, which stock is a better buy?

b. What is the alpha of each stock? Plot the SML and each stock’s risk–return point on one graph.
Show the alphas graphically.
2. What must be the beta of a portfolio with E (RP)=18%, if RF =6% and E(RM) =14%?

3. The market price of a security is $50. Its expected rate of return is 14%. The risk-free rate is 6% and
the market risk premium is 8.5%. What will be the market price of the security if its correlation
coefficient with the market portfolio doubles (and all other variables remain unchanged)? Assume
that the stock is expected to pay a constant dividend in perpetuity.

4. Are the following true or false? Explain.

a. Stocks with a beta of zero offer an expected rate of return of zero.

b. The CAPM implies that investors require a higher return to hold highly volatile securities.
c. You can construct a portfolio with beta of 0.75 by investing 0.75 of the investment budget in T-
bills and the remainder in the market portfolio.

5. Consider the following multifactor (APT) model of security returns for a particular stock.

Factor Factor Beta Factor Risk Premium

Inflation 1.2 6%
Industrial production 0.5 8%
Oil prices 0.3 3%
a. If T-bills currently offer a 6% yield, find the expected rate of return on this stock if the market
views the stock as fairly priced.
b. Suppose that the market expected the values for the three macro factors given in column 1 below,
but that the actual values turn out as given in column 2. Calculate the revised expectations for the rate
of return on the stock once the “surprises” become known.
Factor Expected Rate Actual Rate
of Change of Change
Inflation 5% 4%
Industrial production 3% 6%
Oil prices 2% 0%

6. Suppose that the market can be described by the following three sources of systematic risk with
associated risk premiums.
 Factor Factor Risk Premium
Industrial production (I) 6%
Interest rates (R) 2%
Consumer confidence (C) 4%

The return on a particular stock is generated according to the following equation:

R = 15% + 1.0 I + 0.5R + 0.75C + e
a. Find the equilibrium rate of return on this stock using the APT.
b. The T-bill rate is 6%. Is the stock over- or underpriced? Explain.

7. You expect an RF of 10% and the market return (RM) of 14%. Compute the expected (required)
return for the following stocks, and plot them on an SML graph.
Stock Beta E(R)
U 0.85
N 1.25
D -0.20
You ask a stockbroker what the firm’s research department expects for the three stocks. The
broker responds with the following information:

Stock Current Price Expected Price Expected dividend

U 22 24 0.75
N 48 51 2
D 37 40 1.25
Plot your estimated returns on the graph and indicate what actions you would take with regard
to these stocks. Discuss your decisions.

8. The following are the historic returns for the Company A:

Expected Return (%) σ (%) β
Stock X 12 20 1.3
Stock Y 9 15 0.7
Market Index 10 12 1.0
RF 5
Using only the data shown in the preceding table:
a. Draw and label a graph showing the security market line and position stocks X and Y relative
to it.
b. Compute the alphas both for Stock X and for Stock Y.
c. Assume that the risk-free rate increases to 7% with the other data in the preceding matrix
remaining unchanged. Select the stock providing the higher expected risk-adjusted return
and justify your selection.