Tutorial 8: Chapter 9 The capital Asset Pricing Model

1. What must be the beta of a portfolio with E(rp)=18%, if rf=6% and E(rm)=14%?
E(rp)= rf+β(rm-rf)
0.18= 0.06+ β(0.14-0.06)
β(0.08)= 0.12
β= 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.
Expected retrun higher, stock price lower)
Current market risk premium =8.5
New market risk premium= 8.5%*2=17%
New rate of return on portfolio
E(rp)= rf+β(rm-rf)
= 6%+1(17%)
= 23%
Price= Dividend/rate of return
$50= Dividend/0.14
Dividend= $7
New market price= Dividend/ new rate of return
New market price= $7/0.23
= $30.43
For problem 17 through 19: Assume that the risk-free rate of interest is 6% and the
expected return rate of return on the market is 16%.(rm)
17. A share of stock sells for $50 (p0) today. It will pay a dividend of $6 per share at the end
of the year. It beta is 1.2. What do investors expect the stock to sell for at the end of the
year?
E(rp)= rf+β(rm-rf)
= 6%+1.2(16%-6%)
= 18%
Expected rate of return for a stock = [D1 + (p1-p0)]/p0
18% = [6+(p1-50)]/50
9 = 6+ p1-50/50
9 =-44+p1
P1=53
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 0.5, when in fact the beta is really 1, how much more
will I offer for the firm than it is truly worth
When β=0.5, rate of return:
E(rp)= rf+β(rm-rf)
= 6%+0.5(16%-6%)
= 11%
PV of perpetuity= cash flow/ interest rate
=$1,000/0.11
= $9,090.91
When β=1
E(rp)= rf+β(rm-rf)
= 6%+1(16%-6%)
= 16%
PV of perpetuity= cash flow/ interest rate
=$1,000/0.16
= $6,250
$9,090.91-$6,250 = $2,840.91

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)?
Compare the advisor’s realized return to what the return should have been according
the
CAPM. The difference is the advisor’s α. A positive α indicates a positive risk
-adjusted abnormal return, after correcting for market risk, the advisor “beat the
market.” A negative α indicates a negative risk -adjusted abnormal return, after
correcting for market risk, the advisor did not “beat the market.” The single factor
CAPM is not sufficient for correctly assessing risk- adjusted abnormal returns (α).

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?
E(rp)= rf+β(rm-rf)
= 6%+1.5(14%-6%)
= 18%
Abnormal profit (α) = 19%-18%=1%
E(rp)= rf+β(rm-rf)
= 6%+1(14%-6%)
= 14%
Abnormal profit (α) = 16%-14%=2%
 Although both advisors earned positive CAPM risk-adjusted excess returns, the
second advisor is the superior stock picker. The first advisor achieved a greater return
than the second advisor only by incurring more risk (higher beta), not through skill. In
other words, according to the CAPM, the first advisor should have earned 18% but
earned19%, for a risk-adjusted excess return of 1%. The second advisor should have
earned 14% but earned 16%, for a risk-adjusted excess return of 2%.

c. What if the T-bill rate was 3% and the market return was 15%?
E(rp)= rf+β(rm-rf)
= 3%+1.5(15%-3%)
= 21%
α= 19%-21%=-3%
E(rp)= rf+β(rm-rf)
= 3%+1(15%-3%)
= 15%
α= 16%-15%=1%
Now only the second advisor earned a positive CAPM risk-adjusted excess return. So
the second advisor is the superior stock picker. Again, the first advisor achieved a
greater realized return than the second advisor only by incurring more risk (higher
beta), not through skill.

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 assets pricing model:
a. What is the expected rate of return on the market portfolio?
E(rp)= rf+β(rm-rf)
= 5%+1(12%-5%)
= 12%

b. What would be the expected rate of return on a stock with beta=0? (rate of
return=risk-free rate)
E(rp)= rf+β(rm-rf)
= 5%+0(12%-5%)
= 5%

c. Suppose you consider buying a share of stock at $40. The stock is expected to pay $3
dividend next year and you expect it to sell then for $40. The stock risk has been
evaluated at beta=-0.5. Is the stock overpriced or underpriced?
E(rp)= rf+β(rm-rf)
= 5%-0.5(12%-5%)
= 1.5%
Price = dividend/ rate of return
= $3/0.015
 = $200
The stock is underpriced. (The stock has a value of 200, but sold only at 40)
FV of stock = PV(1+r)
$41+$3= PV (1+0.015)
PV of stock = $43.35
Underpriced= $43.35- $40
= $3.35
Since the market price is $40, the stock is underpriced. Therefore market participants
will buy the stock and drive up the price until it reaches $43.35 so that holders of the
stock are compensated only for the market risk they incur.

22. Suppose that borrowing is restricted so that the zero-beta version of the CAPM holds.
The expected return on the market portfolio is 17% and the zero-beta portfolio it is 8%.
What is the expected return on a portfolio with a beta of 0.6?
E(rp)= rf+β(rm-rf)
= 8%+0.6(17%-8%)
= 13.4%