Solution of Tutorial 1

1. Mr. Anish, who was issueless and widower, had left his substantial wealth as legacy to his nephew and niece
through a will. Detailed instructions had been left on how the estate should be shared between the two , once
both of them attained the age of majority. A week before his demise he had taken a fancy to the capital
market and had invested a sizeable amount in equity shares, specifically, Rs.6 million in Arihant Pharma,
Rs.4.8 million in Best Industries and Rs. 1.2 million in Century Limited. As the partition among the siblings
had to wait for at least one more year as the girl was still a minor, the portfolio of shares had to be
maintained as they were for the time being. The will had entrusted the job of administering the estate for the
benefit of the beneficiaries and partitioning in due course to the reputed firm of Chartered Accountants,
Jhones and Jhones, where youre employed. Meanwhile the young beneficiaries were very eager to know
certain details of the securities and had asked the senior partner of the firm to brief them in this regard. For
this purpose the senior partner has asked you to prepare a detailed note to him with calculations using
CAPM, to answer the following possible doubts.
1. What is the expected return and risk (standard deviation) of the portfolio?
2. What is the scope for appreciation in market price of the three stocks-are they overvalued or
undervalued?
You find that out the three stocks, your firm has already been tracking two viz. Arihant Pharma (A) and Best
Industries (B)-their betas being 1.2 and 0.8 respectively. Further, you have obtained the following historical
data on the returns of Century Limited(C):

On the future returns of the three stocks, you are able to obtain the following forecast from a reputed firm of
portfolio managers.

Prepare your report

Answer:

Security Expected Return Standard Deviation

A 17.2% 14.6%

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B 11.2% 10.2%
C 1.4% 9.9%
Market 14.4% 12.1%

Covariance between A and B = 149.8

Covariance between B and C = - 90.8
Covariance between A and C = - 130.9

Expected Return of Portfolio = 13.2%

Standard Deviation of Portfolio Return = 10.5%

Historical average return of C = 10%

Historical average return of Market = 7%

Beta of Century Ltd = 0.3

Security Beta
A 1.2
B 0.8
C 0.3

Expected Return on Market = 14.4%

Risk Free Rate = 6%

Security Market Line Equation: 6 + 8.4 x Beta

Security Required Rate of Return As per CAPM Expected Return Result

A 16.1% 17.2% Undervalued
B 12.7% 11.2% Overvalued
C 8.5% 1.4% Overvalued

2. The following table gives an analysts expected return on two stocks for a particular market returns:

Market Aggressive Defensive

Return Stock Stock
6% 2% 8%
20% 30% 16%
a) What are the betas of the two stocks?
b) What is the expected return on each stock if the market return is equally likely to be 6% or 20%?
c) If the risk-free rate is 7% and market return is equally likely to be 6% or 20%, what is the SML ?
d) What are the alphas of two stocks?
[Hint: Beta of a stock is the difference between max return and min return of the stock divided by the
difference between max return and min return of the market. Alpha of a stock is difference between
expected return and required return as given by CAPM]

Solution:
Marke Aggressi Defensiv
t ve Stock e Stock
Retur

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 n

6% 2% 8%
20% 30% 16%

Beta of Aggressive Stock 2.00

Beta of Defensive Stock 0.57

Probabili Weighted Weighted Weighted

ty Return of Agg Return of Return of
Stock Def Stock Market
50% 1.00% 4.00% 3.00%
50% 15.00% 8.00% 10.00%

Expected Return 16.00% 12.00% 13.00%

Risk Free Rate 7.00%

Average Market
Return 13.00%
Market Risk
Premium 6.00%

Security Market Line = 7% + (6 % x Beta)

Required
Return:
Aggressive
Stock 19.00%
Defensive
Stock 10.43%
Aplha = Expected Return - Required
Return
(Overvalue
Aggressive Stock -3.00% d)
(Undervalu
Defensive Stock 1.57% ed)

3. The rates of return on stock A and market portfolio for 15 periods are given below:
Perio Return on stock Return of market Perio Return on stock Return of market
d A(%) portfolio (%) d A(%) portfolio (%)
1 10 12 9 -9 1
2 15 14 10 14 12
3 18 13 11 15 -11
4 14 10 12 14 16
5 16 9 13 6 8
6 16 13 14 7 7
7 18 14 15 -8 10
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 8 4 7
a) What is the beta of stock A?
b) What is the characteristic line for stock A?
Solution:

4. Based on five years of monthly data, you derive the following information for the companies listed:

rim denotes the correlation coefficient between the stock and the market.

a) Compute the beta coefficient for each stock.

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 b) Assuming a risk-free rate of 8 percent and an expected return for the market portfolio of 15 percent,
compute the expected (required) return for all the stocks.
c) If the followings are the expected returns of the companies in the following year, which stocks are
undervalued or overvalued.

Intel 20 percent
Ford 15 percent
Anheuser Busch 19 percent
Merck 10 percent

(a).
Where, COVi,m = (ri,m)(i)( m)

COVi, m COVi, m
Bi and ri, m
m2 i m

For Intel:
COV i,m = (.72)(.1210)(.0550) = .00479
.00479 .00479
Beta 1.597
(.055) 2 .0030

For Ford:
COV i,m = (.33)(.1460)(.0550) = .00265

.00265
Beta .883
.0030
For Anheuser Busch:
COV i,m = (.55)(.0760)(.0550) = .00230

.00230
Beta .767
.0030
For Merck:
COV i,m = (.60)(.1020)(.0550) = .00337

.00337
Beta 1.123
.0030

(b) and (c) . E(Ri) = RFR + i(RM - RFR)

= .08 + i(.15 - .08)
= .08 + .07i
Stock Beta E(Ri) = .08 + .07i
E(R) Alpha
Remarks
Intel 1.597 0.08 + 0.1118 = 0.1918 0.20 0.82% UV
Ford 0.883 0.08 + 0.0618 = 0.1418 0.15 0.82% UV
Anheuser Busch 0.767 0.08 + 0.0537 = 0.1337 0.19 5.63% UV
Merck 1.123 0.08 + 0.0786 = 0.1586 0.10 5.86% OV

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