Chapter 9

Problem sets

1. What must be the beta of a portfolio with E(rP) = 18%, if rf = 6% and E(rM) = 14%?

Answer: E(rp)= rf + β (rm- rf)

 18% = 6% + β (14% - 6%)
 β x 8% = 12%
 β = 12%/8% = 1.5%
2. 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.

Answer: If the security’s correlation coefficient with the market portfolio doubles (with all other variables
such as variances unchanged), then beta, and therefore the risk premium, will also double. The current risk
premium is: 14% – 6% = 8%
The new risk premium would be 16%, and the new discount rate for the security would be: 16%+ 6% = 22%
If the stock pays a constant perpetual dividend, then we know from the original data that the dividend (D)
must satisfy the equation for the present value of a perpetuity:
Price = Dividend/Discount rate
70 = D/0.14
 D = 70 x 0.14 = $9.80
At the new discount rate of 22%, the stock would be worth: $9.80/0.22 = $44.55

3. 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 .75 by investing .75 of the investment budget in T-bills and the
remainder in the market portfolio

Answer: a. False. β = 0 implies E(r) = rf, not zero.

b. False. Because investors require a risk premium only for bearing systematic (undiversifiable or
market) risk. But here total volatility includes both non-diversifiable and diversifiable risk.

c. False. T-bill has zero beta! Portfolio should be invested 75% in the market portfolio and 25% in T-
bills. Then: βP = (0.75 × 1) + (0.25 × 0) = 0.75

4. Here are data on two companies. The T-bill rate is 4% and the market risk premium is 6%.

What would be the fair return for each company according to the capital asset pricing model (CAPM)?
Answer:
Calculation of Fair Return of $1 Discount Store
Required Return, E(r) = rf + β x rM
= 0.04 + 1.5 x (0.06)
=0.04 + 0.09
= 0.1300 = 13%

Calculation of Fair Return of Everything $5

Required Return, E(r) = rf + β x rM
= 0.04 + 1.0 x (0.06)
=0.04 + 0.06
= 0.1000 = 10%

5. Characterize each company in the previous problem as underpriced, overpriced, or properly priced.
Answer: According to the CAPM, $1 Discount Stores requires a return of 13% based on its systematic risk level of
β = 1.5. However, the forecasted return is only 12%. Therefore, security is currently overvalued.

Similarly, Everything $5 requires a return of 10% based on its systematic risk level of β = 1.0. However, the
forecasted return is 11%. Therefore, security is currently undervalued.

6. What is the expected rate of return for a stock that has a beta of 1.0 if the expected return on the market is
15%?
a. 15%.
b. More than 15%.
c. Cannot be determined without the risk-free rate. The same as the expected return of the market.

Answer: 15%. Its expected return is exactly the same as the market return when beta is 1.0.

7. Kaskin, Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of .6. Which of the following statements
is most accurate?
a. The expected rate of return will be higher for the stock of Kaskin, Inc., than that of Quinn, Inc.
b. The stock of Kaskin, Inc., has more total risk than the stock of Quinn, Inc.
c. The stock of Quinn, Inc., has more systematic risk than that of Kaskin, Inc.

Answer: Since only systematic risk is rewarded, it is safe to conclude that the expected return will be higher for
Kaskin’s stock than for Quinn’s stock.

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:

a. What are the betas of the two stocks?

b. What is the expected rate of return on each stock if the two scenarios for the market return are equally
likely?
c. 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.
d. Plot the two securities on the SML graph. What are the alphas of each?
e. What hurdle rate should be used by the management of the aggressive firm for a project with the risk
characteristics of the defensive firm’s stock?

Answer:
a. Call the risky stock A and the safe stock D. Beta is the sensitivity of the stock’s return to the market return,
i.e., the change in the stock return for per unit change in the market return. Therefore, we compute each
stock’s beta by calculating the difference in its return across the two scenarios divided by the difference in
the market return:

−0.02−0.38 .06−.12
βA = = 2.00 & βD = = 0.30
.05−.25 .05−.25
b. With the two scenarios equally likely, the expected return is an average of the two possible outcomes:
E(rA ) = (0.5 x –.02) + (0.5 x .38) = .18 = 18%

E(rD ) = (0.5 x .06) + (0.5 x .12) = .09 = 9%

c. The SML is determined by the market expected return of [0.5 × (.25 + .05)] = 15%, with βM = 1, and rf = 6%
(which has βf = 0). See the following graph:

The equation for the security market line is: E(r) = .06 + β × (.15 – .06)

d. Based on its risk, the risky stock has a required expected return of: E(rA ) = .06 + 2.0 × (.15 – .06) = .24 = 24%
The analyst’s forecast of expected return is only 18%. Thus the stock’s alpha is:
αA = actually expected return – required return (given risk) = 18% – 24% = –6%
Similarly, the required return for the safe stock is: E(rD) = .06 + 0.3 × (.15 – .06) = 8.7%
The analyst’s forecast of expected return for D is 9%, and hence, the stock has a positive alpha:
αD = actually expected return – required return (given risk) = .09 – .087 = 0.003 = 0.3%
The points for each stock plot on the graph as indicated above.

e. The hurdle rate is determined by the project beta (0.3), not the firm’s beta. The correct discount rate is
8.7%, the fair rate of return for stock D.
For Problems 10 through 16: If the simple CAPM is valid, which of the following situations are possible?
Explain. Consider each situation independently.

10.

Answer: Not possible.

Expected Return =rf + β*(rm-rf). A portfolio with a higher beta will have a higher expected return. In the
situation, since portfolio A has a lower expected return as compared to B even though beta is higher. Hence
this situation is not possible.

11.

Answer: This situation is possible. Here, SD is a measure of total risk. If the CAPM is valid, the expected rate
of return only compensates for the market (systematic risk) represented by the beta β, rather than the
standard deviation which include the nonsystematic or firm specific risk. Thus A’s lower rate of return can be
paired with A’s standard deviation as long as A’s beta is lower than B’s beta.

12.

Answer: Not possible. The reward-to-variability ratio for Portfolio A is better than that of the market - a scenario
which is impossible according to the CAPM as it predicts that the market is the most efficient portfolio. Using the
numbers supplied:
.16 - .10 .18 - .10
SA = =0.5 SM = = 0.33

Portfolio A provides a better risk-reward tradeoff than the market portfolio.

13.

Answer: Not possible. Portfolio A clearly dominates the market portfolio as in the previous problem.
14.

Answer: Not possible. The SML for this scenario is: E(r) = 10 + β × (18 – 10)
Portfolios with beta equal to 1.5 have an expected return equal to:
E(r) = 10 + [1.5 × (18 – 10)] = 22%
The given expected return for Portfolio A is 16%; that is, Portfolio A plots below the SML ( A = – 6%), and
hence, is an overpriced portfolio. This is inconsistent with the CAPM.

15.

Answer: Not possible. The SML for this scenario is: E(r) = 10 + β × (18 – 10)
Portfolios with beta equal to 0.9 have an expected return equal to:
E(r) = 10 + [0.9 × (18 – 10)] = 17.2%
The given expected return for Portfolio A is 16%; that is, Portfolio A plots below the SML ( A = – 1.2%), and
hence, is an overpriced portfolio. This is inconsistent with the CAPM.

16.

Answer: Possible. The reward-to-variability ratio for Portfolio A is better than that of the market - a scenario
which is impossible according to the CAPM as it predicts that the market is the most efficient portfolio. Using the
numbers supplied:
.16 - .10 .18 - .10
SA = =0.27 SM = = 0.33
.22 .24
Portfolio A plots below the CML, as any asset is expected to. This scenario is not inconsistent with the CAPM.

For Problems 17 through 19: Assume that the risk-free rate of interest is 6% and the expected rate of return
on the market is 16%.

17. A share of stock sells for $50 today. It will pay a dividend of $6 per share at the end of the year. Its beta is
1.2. What do investors expect the stock to sell for at the end of the year?

Answer: Since the stock’s beta is equal to 1.2, its expected rate of return is: .06 + [1.2 x (.16 – .06)] = 18%
E(r) = (D1 + P1 – P0) / P0 → 0.18 = (6+ P1 -50) / 50
 P1= 53 is the sell price of the stock which investors can expect at the end of the year.
18. I am buying a firm with an expected perpetual cash flow of $1,000 but am unsure of its risk. If I think the
beta of the firm is .5, when in fact the beta is really 1, how much more will I offer for the firm than it is
truly worth?

Answer: The series of $1,000 payments is a perpetuity. If beta is 0.5, the cash flow should be discounted at the
rate of return: .06 + [0.5 × (.16 – .06)] = .11 = 11%
PV = $1,000/0.11 = $9,090.91

If, however, beta is equal to 1, then the investment should yield 16%, and the price paid for the firm should be:
PV = $1,000/0.16 = $6,250
The difference, ($9,090.91 - $6,250) = $2,840.91, is the amount I will overpay if I erroneously assume that beta
is 0.5 rather than 1.

19. A stock has an expected rate of return of 4%. What is its beta?

Answer: Using the SML: .04 = .06 + β × (.16 – .06) => β = –.02/.10 = -2. This asset has a negative market beta.
Therefore, it’s return is negatively correlated with the market.

20. Two investment advisers are comparing performance. One averaged a 19% rate of return and other a 16%
rate of return. However, the beta of the first investor was 1.5, whereas that of the second investor was 1.
a. Can you tell which investor was a better selector of individual stocks (aside from the issue of general
movements in the market)?
b. If the T-bill rate was 6% and the market return during the period was 14%, which investor would be
considered the superior stock selector?
c. What if the T-bill rate was 3% and the market return was 15%?

Answer: r1 = 19%; r2 = 16%; β1 = 1.5; β2 = 1

a. To determine which investor was a better selector of individual stocks we look at abnormal return,
which is the ex-post alpha; that is, the abnormal return is the difference between the actual return and
that predicted by the SML. Without information about the parameters of this equation (risk-free rate
and market rate of return) we cannot determine which investor was more accurate.

b. If rf = 6% and rM = 14%, then (using the notation alpha for the abnormal return):
We know,
r1-rf = α1+ β (rM - rf)
α1 = .19 – .06 – [1.5 × (.14 – .06)] = .19 – .18 = 1%
α 2 = .16 – .06 – [1 × (.14 – .06)] = .16 – .14 = 2%
Here, the second investor has the larger abnormal return and thus appears to be the superior stock
selector. By making better predictions, the second investor appears to have tilted his portfolio toward
underpriced stocks.

c. If rf = 3% and rM = 15%, then:

α1 = .19 – .03 – [1.5 × (.15 – .03)] = .19 – .21 = –2%

α2 = .16 – .03 – [1 × (.15 – .03)] = .16 – .15 = 1%

Here, not only does the second investor appear to be the superior stock selector, but the first investor’s
predictions appear valueless (or worse).
21. Suppose the rate of return on short-term government securities (perceived to be risk-free) is about 5%.
Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is
12%. According to the capital asset pricing model:
a. What is the expected rate of return on the market portfolio?
b. What would be the expected rate of return on a stock with β = 0?
c. Suppose you consider buying a share of stock at $40. The stock is expected to pay $3 dividends next
year and you expect it to sell then for $41. The stock risk has been evaluated at β = −.5. Is the stock
overpriced or underpriced?

Answer:
a. 12%.
b. The risk-free rate, 5%.
c. Using the SML, the fair expected rate of return for a stock with β = –0.5 is:
E(r) = 0.05 + [(-0.5) x (0.12 - 0.05)] = 1.5%
The actually expected rate of return, using the expected price and dividend for next year is:
$3+ $41 - $40
E(r) = = 0.10 = 10%
$40
Because the actually expected return exceeds the fair return, the stock is underpriced.

23. a. A mutual fund with beta of .8 has an expected rate of return of 14%. If rf = 5%, and you expect the
rate of return on the market portfolio to be 15%, should you invest in this fund? What is the fund’s alpha?

b. What passive portfolio comprised of a market-index portfolio and a money market account would have
the same beta as the fund? Show that the difference between the expected rate of return on this passive
portfolio and that of the fund equals the alpha from part (a).

Answer:
a. E(rP) = rf + βP × [E (rM ) – rf ] = 5% + 0.8 (15% − 5%) = 13%
= 14% - 13% = 1%
I should invest in this fund because alpha is positive.

b. The passive portfolio with the same beta as the fund should be invested 80% in the market-index
portfolio and 20% in the money market account. For this portfolio:
E(rP) = (0.8 × 15%) + (0.2 × 5%) = 13%

14% − 13% = 1% = 
CFA problems
1. a. John Wilson is a portfolio manager at Austin & Associates. For all of his clients, Wilson manages portfolios
that lie on the Markowitz efficient frontier. Wilson asks Mary Regan, CFA, a managing director at Austin, to
review the portfolios of two of his clients, the Eagle Manufacturing Company and the Rainbow Life
Insurance Co. The expected returns of the two portfolios are substantially different. Regan determines that
the Rainbow portfolio is virtually identical to the market portfolio and concludes that the Rainbow portfolio
must be superior to the Eagle portfolio. Do you agree or disagree with Regan’s conclusion that the Rainbow
portfolio is superior to the Eagle portfolio? Justify your response with reference to the capital market line.
b. Wilson remarks that the Rainbow portfolio has a higher expected return because it has greater
nonsystematic risk than Eagle’s portfolio

Answer:
a. Agree. By definition, the market portfolio lies on the capital market line (CML). Under the assumptions
of capital market theory, all portfolios on the CML dominate in terms of risk-return than the portfolios
that lie on the Markowitz efficient frontier because, the CML creates a portfolio possibility line that is
higher than all points on the efficient frontier except for the market portfolio, which is Rainbow’s
portfolio. Because Eagle’s portfolio lies on the Markowitz efficient frontier at a point other than the
market portfolio, Rainbow’s portfolio dominates Eagle’s portfolio

b. Nonsystematic risk is the unique risk of individual stocks in a portfolio that is diversified away by holding
a well-diversified portfolio.
Disagree; Wilson’s remark is incorrect. Because both portfolios lie on the Markowitz efficient frontier,
neither Eagle nor Rainbow has any nonsystematic risk. Therefore, non-systematic risk does not explain
the different expected returns. The determining factor is that Rainbow lies on the CML connecting the
risk-free asset and the market portfolio, at the point of tangency to the Markowitz efficient frontier
having the highest return per unit of risk.

2. Wilson is now evaluating the expected performance of two common stocks, Furhman Labs Inc. and
Garten Testing Inc. He has gathered the following information:
 The risk-free rate is 5%.
 The expected return on the market portfolio is 11.5%.
 The beta of Furhman stock is 1.5.
 The beta of Garten stock is .8.
Based on his own analysis, Wilson’s forecasts of the returns on the two stocks are 13.25% for Furhman
stock and 11.25% for Garten stock. Calculate the required rate of return for Furhman Labs stock and for
Garten Testing stock. Indicate whether each stock is undervalued, fairly valued, or overvalued.

Answer: E(r) = rf + β × [E(r M ) − rf ]

Furhman Labs: E(r) = .05 + 1.5 × [.115 − .05] = 14.75%
Garten Testing: E(r) = .05 + 0.8 × [.115 − .05] = 10.20%
Furhman Labs, α: Forecast return – Fair Expected or Required return = 13.25% − 14.75% = −1.50%
Garten Testing, α: Forecast return – Fair Expected or Required return = 11.25% − 10.20% = 1.05%
Therefore, Furhman Labs is overvalued and Garten Testing is undervalued.

3. The security market line depicts:

a. A security’s expected return as a function of its systematic risk.
b. The market portfolio as the optimal portfolio of risky securities.
c. The relationship between a security’s return and the return on an index.
d. The complete portfolio as a combination of the market portfolio and the risk-free asset.
Answer: a. The security market line (SML) is a visualization of the capital asset pricing model (CAPM). SML
shows the relationship between the expected return on an asset (y axis) and its systematic or market risk, also
known as its Beta (x axis). The graphical representation of the SML is useful for determining whether a
security is overvalued or undervalued.
4. Within the context of the capital asset pricing model (CAPM), assume:
∙ Expected return on the market = 15%
∙ Risk-free rate = 8%
∙ Expected rate of return on XYZ security = 17%
∙ Beta of XYZ security = 1.25
Which one of the following is correct?
a. XYZ is overpriced.
b. XYZ is fairly priced.
c. XYZ’s alpha is −.25%.
d. XYZ’s alpha is .25%.

Answer: d. From CAPM, the fair expected return = 8 + 1.25 × (15 - 8) = 16.75% .
Actually expected return = 17%
= 17 16.75 = 0.25%

5. What is the expected return of a zero-beta security?

a. Market rate of return.
b. Zero rate of return.
c. Negative rate of return.
d. Risk-free rate of return.
Answer: d.

6. Capital asset pricing theory asserts that portfolio returns are best explained by:
a. Economic factors.
b. Specific risk.
c. Systematic risk.
d. Diversification
Answer: c.

7. According to CAPM, the expected rate of return of a portfolio with a beta of 1.0 and an alpha of 0 is:
a. Between rM and rf .
b. The risk-free rate, rf .
c. β (rM − rf).
d. The expected return on the market, rM.

Answer: d.

For CFA Problems 8 through 9: Refer to the following table, which shows risk and return measures for two
portfolios.
8. When plotting portfolio R on the preceding table relative to the SML, portfolio R lies:
a. On the SML.
b. Below the SML.
c. Above the SML.
d. Insufficient data given.
Answer: d. [We need to know the risk-free rate]

9. When plotting portfolio R relative to the capital market line, portfolio R lies:
a. On the CML.
b. Below the CML.
c. Above the CML.
d. Insufficient data given.

Answer: d. [We need to know the risk-free rate]

10. Briefly explain whether investors should expect a higher return from holding portfolio A versus portfolio
B according to the capital asset pricing model. Assume that both portfolios are well diversified.

Answer: Because systematic risk (measured by beta) is equal to 1.0 for both portfolios, an investor would
expect the same rate of return from both portfolios A and B. Moreover, since both portfolios are well
diversified, it doesn’t matter if the specific risk of the individual securities is high or low. The firm-specific risk
has been diversified away for both portfolios.

11. Joan McKay is a portfolio manager for a bank trust department. McKay meets with two clients, Kevin
Murray and Lisa York, to review their investment objectives. Each client expresses an interest in changing
his or her individual investment objectives. Both clients currently hold well-diversified portfolios of risky
assets.

a. Murray wants to increase the expected return of his portfolio. State what action McKay should take to
achieve Murray’s objective. Justify your response in the context of the CML.

b. York wants to reduce the risk exposure of her portfolio but does not want to engage in borrowing or
lending activities to do so. State what action McKay should take to achieve York’s objective. Justify your
response in the context of the SML.

Answer:
a. McKay should borrow funds and invest those funds proportionally in the existing portfolio (i.e. buy
riskier assets on margin). As per CAPM risk-free borrowing/lending is possible.

b. Mckay should substitute the high beta stocks with low beta stocks to reduce the overall beta of York’s
portfolio. This will reduce the systematic risk of the portfolio and therefore the portfolio’s volatility
relative to the market. This also meets the York’s objective of reducing risk exposure.
12. Karen Kay, a portfolio manager at Collins Asset Management, is using the capital asset pricing model for
making recommendations to her clients. Her research department has developed the information shown in the
following exhibit

a. Calculate expected return and alpha for each stock.

b. Identify and justify which stock would be more appropriate for an investor who wants to
i. Add this stock to a well-diversified equity portfolio.
ii. Hold this stock as a single-stock portfolio.

Answer:

a.

b. i. Kay should recommend Stock X because of its positive alpha. Also, depending on the individual risk
preferences of Kay’s clients, the lower beta for Stock X may have a beneficial effect on overall portfolio
risk.
ii. Kay should recommend Stock Y because it has higher forecasted return and lower standard deviation
than Stock X. The respective Sharpe ratios for Stocks X and Y and the market index are:
Stock X: (14% - 5%) /36% = 0.25
Stock Y: (17% - 5%) /25% = 0.48
Market index: (14% - 5%) /15% = 0.60
The market index has an even more attractive Sharpe ratio than either of the individual stocks, but, given
the choice between Stock X and Stock Y, Stock Y is the superior alternative.
When a stock is held as a single stock portfolio, standard deviation is the relevant risk measure. For such a
portfolio, beta as a risk measure is irrelevant. Although holding a single asset is not a typically
recommended investment strategy, some investors may hold what is essentially a single-asset portfolio
when they hold the stock of their employer company. For such investors, the relevance of standard
deviation versus beta is an important issue.