TUTORIAL 4

Portfolio Management
9.1
◦  What must be the beta of a portfolio with E(rP) = 18%, if rf = 6% and E(rM) = 14%?
9.5
◦ Determine which of the following two companies are undervalued or overvalued. Assume the T-bill rate
is 4% and the market risk premium is 6%.
Company $1 Discount Store Everything $5

Forecasted return 12% 11%

Standard deviation of returns 8% 10%

Beta 1.5 1.0

$1 Discount Store
According to CAPM: E(r$1discount) = 0.04 + 1.5 x 0.06 = 13%.
However, the forecasted return is only 12%, so the security is currently overvalued.
Everything $5
According to CAPM: E(reverything $5) = 0.04 + 1.0 x 0.06 = 10%
However, the forecasted return is 11%, so the security is currently undervalued.
9.9
◦ Consider
  the following table, which gives a security analyst’s expected return on two stocks in two particular
scenarios for the rate of return on the market:
Market Aggressive Stock Defensive Stock
Return
5% -2% 6%

25% 38% 12%

◦ What are the betas of the 2 stocks?

(change in stock return per unit change in market return)

◦ What is the expected rate of return on each stock if the two scenarios for the market return are equally likely?
E(rA) = 0.5 x (-0.02 + 0.38) = 18%
E(rP) = 0.5 x (0.06 + 0.12) = 9%
9.9
◦ If the T-bill rate is 6% and the market return is equally likely to be 5% or 25%, draw the SML for this
economy.
◦ The SML is determined by the market expected return of [0.5 × (.25 + .05)] = 15%, with β M = 1, and rf =
6% (which has βf = 0).
◦ The equation for the security market line is then: E(r) = 0.06 + β x (0.15 – 0.06) = 0.06 + 0.09β
10.1
◦ Suppose that two factors have been identified for the U.S. economy: the growth rate of industrial
production (IP) and the inflation rate (IR). IP is expected to be 3% and IR 5%. A stock with a beta of 1 on
IP and 0.5 on IR currently is expected to provide a rate of return of 12%. If industrial production actually
grows by 5%, while the inflation turns out to be 8%, what is your revised estimate of the expected return
on the stock?

◦ The revised estimate of the expected rate of return on the stock would be the old estimate plus the sum of
the products of the unexpected change in each factor times the respective sensitivity coefficient:
Revised estimate = 12% + [(1 x 2%) + (0.5 x 3%)] = 15.5%
◦ NB: IP estimate computes as 1 x (5% - 3%) and IR estimate as 0.5 x (8% - 5%).
10.8
◦ Assume
  that security returns are generated by the single-index model, Ri = αi + βi + ei , where Ri is the
excess return for security i and RM is the market’s excess return. The risk-free rate is 2%. Suppose that
there are three securities, characterized by the following data: Security βi E(Ri) σ(ei)
A 0.8 10% 25%
B 1.0 12% 10%
C 1.2 14% 20%

◦ If σM = 20%, calculate the variance of returns of securities A, B, and C

10.8
◦ Assume
  that security returns are generated by the single-index model, Ri = αi + βi + ei , where Ri is the
excess return for security i and RM is the market’s excess return. The risk-free rate is 2%. Suppose that
there are three securities, characterized by the following data: Security βi E(Ri) σ(ei)
A 0.8 10% 25%
B 1.0 12% 10%
C 1.2 14% 20%
◦ Now assume that there an infinite number of assets with return characteristics identical to those of A, B,
and C, respectively. If one forms a well-diversified portfolio of type A securities, what will be the mean
and variance of the portfolio’s excess returns? What about portfolios composed only of type B or C
stocks?
◦ If there an infinite number of assets with identical characteristics, then a well-diversified portfolio of
each type will have only systematic risk since the non-systematic risk will approach zero with large n.
◦ Each variance is simply Well diversified = 256; = 400; = 576
◦ Mean will equal that of the individual (identical) stocks
10.8
◦ Assume that security returns are generated by the single-index model, Ri = αi + βi + ei , where Ri is the
excess return for security i and RM is the market’s excess return. The risk-free rate is 2%. Suppose that
there are three securities, characterized by the following data: Security βi E(Ri) σ(ei)
A 0.8 10% 25%
B 1.0 12% 10%
C 1.2 14% 20%

◦ Is there an arbitrage opportunity in this market? What is it?

◦ There is no arbitrage opportunity because the well-diversified portfolios all plot on the security market
line (SML). Because they are fairly priced, there is no arbitrage.
 Factor Risk Premium
Industrial Production (I) 6%

10.11 Interest Rates (R)

Consumer Confidence
2%
4%
(C)

◦ Suppose
  that the market can be described by the three sources of systematic risk with associated risk
premiums above. The return on a particular stock is generated according to the following equation:

◦ Find the equilibrium rate of return on this stock using the APT. The T-bill rate is 6%. Is the stock over- or
under-priced? Explain.
◦ The APT required (equilibrium) rate of return based on rf and the factor betas is:
Required E(r) = 6% + 1*6% + 0.5*2% + 0.75*4% = 16%
◦ According to the equation for the return on the stock, the actually expected return on the stock is 15%
(because the expected surprises on all factors are zero by definition).
◦ Since the actually expected return based on risk is less than the equilibrium return, we conclude that the
stock is overpriced.