Assignment 5 Answers

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Assignment 5 Answers

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Fall 2007

Assignment 5 --- Due 9/20

Answer only 5 of the questions --- Selected Answers

1. Explain the significant advance made by Louis Bachelier. What are the implications

of this advance for investment strategies?

No answer provided

2. Compare and contrast the work of Charles Dow and Alfred Cowles.

No answer provided

3. Compare and contrast the essential points in the work of Harry Markowitz and

William Sharpe.

No answer provided

4. Write an essay that clearly and fully discusses the intuition behind the equilibrium

concept in CAPM and how the adjustment process to equilibrium is supposed to take

place.

No answer provided

5. Assume the expected return on the market to be 15%, risk-free rate of 8%, expected

rate of return on XYZ security of 17%, and beta of XYZ security of 1.25. Within the

context of CAPM, is XYZ overpriced, underpriced, or fairly priced? Explain your

answer.

The expected rate of return based on CAPM would be

CAPM

rXYZ

8% 1.25(15% 8%) 16.75%

Since the return (17%) exceeds the CAPM, then we say that it is underpriced.

People sometimes have trouble thinking about the over- or under- priced asset in the

CAPM context. If you do, try changing the story a bit. Suppose you looked at the

results of XYZ for the past year and found that it did in fact have a 17% rate of

return. You also go back and calculate what the CAPM rate of return should have

been for the past year you calculate the 16.75%. Now, looking back, you might

think I wish that I would have bought some of XYZ! in that case you are really

saying that XYZ was underpriced during the past year. Remember, other things

equal, if you begin purchasing the stock, youll drive the price upward and as you

do the actual rate of return will fall --- following CAPM you would do this until the

return fell to the CAPM level.

6. If CAPM is valid, then discuss which of the following situations are possible.

a.

A

B

Expected Return

20%

25%

Beta

1.4

1.2

This surely could not be correct according to CAPM. According to CAPM, the

greater the beta hence, the risk the higher the expected rate of return. Since A

has a higher systematic risk beta it should have a higher expected return.

b.

A

B

Expected Return

30%

15%

Beta

1.5

.75

Suppose the risk-free rate is 12% and the market return is 24%, then for A,

E (rA ) r f A [ E (rM ) r f ] 12% 1.5(24 12) 30%

What about B?

So, in fact, the returns are not correct by CAPM standards. On the other hand, if

the 30% and 15% had been Expected Excess Returns (i.e., expected return minus

the risk-free rate), then things would be fine according to CAPM in fact, this is the

way I intended to have this particular option often times it is easier to always think

in terms of excess returns which I tend to do. Its easier because you see that you

can directly translate relative betas into relative excess returns. For example, solve

the CAPM for beta.

A

E (rA ) r f

E (rM ) r f

E (rB ) r f

E (rM ) r f

E (rA ) r f

E (rA ) r f 30%

A E (rM ) r f

2

E (rB ) r f

B

E (rB ) r f 15%

E (rM ) r f

Thus, the relative excess returns must be equal to the relative betas. It is not true

that the relative rates of return will be equal to relative betas. These are the points I

wanted to bring out in this question.

c.

Portfolio (or, asset) Expected Return

Beta

risk-free

market

A

10%

18%

22%

1

1.5

7. An entrepreneur is considering purchasing a business. The entrepreneur expects the

business to have yearly profits forever of $1 million. The risk-free rate is currently

8% and the expected rate of return on the market is 18%. The entrepreneur believes that

the beta for this business is 1.15. How much should the entrepreneur pay for this

business?

First, we calculate the CAPM expected rate of return.

E ( r ) r f [ E ( rM ) r f ] 8% 1.15(18% 8%) 19.5%

forever. I attempted to simplify the problem by assuming the income would be the

same forever. This makes the investment appear much like a consol. In capital

budgeting problems, such as this one, one can use the CAPM expected rate of return

as the appropriate discount factor.

P

$1,000,000

$5,128,205 This is the approximate price, rounding to the

.195

nearest dollar.

Notice, when one first learns to use present value formulas, some sort of interest rate

is typically used as the discount factor. This interest rate could be the interest rate

on the loan or the risk-free rate (as the opportunity cost of the money). In any case,

this sort of procedure ignores the relevant risk of the investment. If we had used the

risk-free rate as the discount factor, then the price we would be willing to pay for a

$1 million annual income stream would be the following.

P

$1,000,000

$12,500,000

.08

Hence, we would have been willing to pay much, much more. The intuitive

explanation for us be willing to pay more is that we ignored the risk of the

investment in coming up with this price.

8. Suppose equity holders investment in the publicly regulate utility company is $100

million and beta is .60. If the risk-free rate is 3% and the expected rate of return on the

market is 5%, then calculate the fair according to CAPM - rate of return for investors

and their profits.

First, we calculate the CAPM expected rate of return.

E (r ) r f [ E ( rM ) r f ] 3% .6(5% 3%) 4.2%

Notice, the CAPM rate of return for the utility company is less than the market

return. Why? Because the beta of .60 is less than 1 tells us that the utilitys return

fluctuates less than the market it is less risky than the market. On the other hand,

it is greater than the risk-free rate because it is still risky.

Second, the investment is $100 million, so we can easily calculate the fair profits.

$100 million x .042 = $4,200,000

The regulatory agency will now allow the company to set a per unit price to target

the profit figure.

9. For this question, assume that the risk-free rate is 4% and the market rate of return is

14%.

a. An investor using CAPM is considering purchasing a particular stock with a beta of .5.

According to CAPM, what would be the expected rate of return on this stock?

E (r ) 4% .5(14% 4%) 9%

b. A judge uses CAPM to determine the damages in a copyright infringement case. The

judge has been advised that the a beta of 2.0 is typical for the publishing industry. What

would be the fair according to CAPM - rate of return to be used to determine

damages?

E (r ) 4% 2(14% 4%) 24%

c. The owner of an investment firm is deciding on whether or not to pay a bonus to his

two portfolio managers. One manager (Mr. Marko) was able to obtain a 22% rate of

return on his portfolio the portfolio had a beta of 1.5. The other manager (Mr. Witz)

was able to earn a 12% rate of return on his portfolio the portfolio had a beta of 1.0.

Assuming the owner uses a CAPM criteria to determine bonuses, which manager - if any

deserves the bonus?

First, calculate the expected rates of return based on CAPM.

E (rWitz ) 4% 1.0(14% 4%) 14%

Now, note that based on the risk of Markos portfolio he should have earned only

19%. In fact, Marko has been able to beat the market or beat CAPM by earning

a 22% rate of return. Graphically, you can picture Markos returns as lying above

the security market line (SML). Witz on the other hand should have been able to

earn a 14% rate of return on is portfolio according to CAPM. He actually only

earned a 12% rate of return his portfolio lies below the SML (in saying this, please

do not confuse the reference to the SML here with our use of it when determining

when a particular asset is under or over priced). Mr. Marko deserves the bonus

not because he achieved a higher return than Witz, but rather because he obtained a

higher return than expected by CAPM! Given Markos riskier portfolio we would

expect him (on average, over time) to earn a higher return than Witz however, we

would not expect him to consistently beat CAPM. By doing so, especially if this was

on a long-term basis, we would say that Marko is superior at picking stocks

something well begin to check out.

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