FM 300: Corporate Finance, Investments, and Financial Markets

Section A - Michaelmas Term - Michela Verardo

Classwork 1
Answer key

1.
RA = .01 + .80 RM + A
M = 0.20, A = .10 (A is the residual standard deviation).
The volatility of the return for stock A is
2A = .802 (2M )+ 2 = 0.0356, and A = .0356 = .1887

2.
The alphas of A and B are given by:
A = (E[rA] rf ) A (E[rM] rf) = 0.04 0.5 0.05 = 0.015
B = (E[rB] rf ) B (E[rM] rf) = 0.06 1.5 0.05 = 0.015
To find the variance of P, first find A and B.
Recall that the R2 is defined as the explained variance divided by the total variance:
Var[P + P(rM rf)] / Var[(rP rf)].
R2 = 2i 2M /2i
A = ( 2A 2M / R2 )= (0.52 0.22 /0.95) = .1026 = 10.26%
B = ( 2B 2M / R2 )= (1.52 0.22 /0.95) = .3078 = 30.78%
Cov(rA,rB) = A B 2M = 0.5 1.5 0.22 = 0.03
Var(rP) = wA2 A2 + wB2 B2 + 2 wA wB Cov(rA,rB)
= 0.72 0.0105 + 0.32 0.0947 + 2(0.7)(0.3) (0.03) = 0.0263

3.
RA = 3% + .7RM + A;
RB = -2% + 1.2RM + B;
M = 20%;
Rsq(A)=.20; Rsq(B)=.12;
a) The standard deviation of each stock can be derived from the following equation
for R2:
i2 2M Explained variance
R =
= Total variance
i2
2
i

Therefore:

=
2
A

A2 M2
R A2

0.7 2 .20 2
=
= 0.098
0.20

A = 31.30%

1.2 2 .20 2
= 0.48
0.12
B = 69.28%

B2 =

b) The systematic risk for A is: A2 M2 = 0.70 2 .20 2 = 0.0196

The firm-specific risk of A (the residual variance) is the difference between As total
risk and its systematic risk: 0.098 0.0196 = 0.0784
The systematic risk for B is: B2 M2 = 1.20 2 .20 2 = 0.0576
Bs firm-specific risk (residual variance) is: 0.48 0.0576 = 0.4224
c) The covariance between the returns of A and B is (since the residuals are assumed
to be uncorrelated):
Cov(rA , rB ) = A B M2 = 0.70 1.20 0.04 = 0.0336
The correlation coefficient between the returns of A and B is:

AB =

Cov (rA , rB )

A B

0.0336
= 0.155
31.30% 69.28%

d) The non-zero alphas from the regressions are inconsistent with the CAPM. The
question is whether the alpha estimates reflect sampling errors or real mispricing. To
test the hypothesis of whether the intercepts (3% for A, and 2% for B) are
significantly different from zero, we would need to compute t-values for each
intercept.

4.

avg ret
std dev
beta
alpha
R2

General
Electric
0.154
0.236

IBM
0.147
0.294

Pepsi
0.153
0.168

Apple
0.307
0.625

Johnson
0.163
0.180

3M
0.128
0.134

Kellogg
0.112
0.216

Bank of
America
0.180
0.219

Fedex
0.160
0.216

DELL
0.471
0.703

Portfolio
0.198
0.156

1.328
0.042
0.864

0.678
0.069
0.146

0.381
0.092
0.150

0.673
0.230
0.031

0.492
0.096
0.222

0.199
0.077
0.059

0.237
0.058
0.033

0.500
0.112
0.141

0.629
0.085
0.212

1.285
0.362
0.091

0.640
0.122
0.471

The portfolio earns a positive risk-adjusted return of 12.2%.

Using regression analysis (instead of the slope and intercept functions) we can calculate the standard errors (and t-statistics) and see that alpha is
significantly different from zero.

Intercept
RM-rf

Coefficients
0.122
0.640

Standard
Error
0.028
0.170

t Stat
4.30
3.77

The R2 of a well-diversified portfolio should be higher than the R2 of an individual stock (the market can explain more of its total variance). This
should be true on average. However, in this case, there is a stock with a higher R2.
An R2 of 80% is unusually high for a regression of the SML type, when the data in question describe a single stock. It is much more usual for the
R2 of a single stock to be around 20-30%.