CHAPTER 10: INDEX MODELS

3. a. The two figures depict the stocks security characteristic lines (SCL). Stock A has a higher firm-specific risk because the deviations of the observations from the SCL are larger for Stock A than for Stock B. Deviations are measured by the vertical distance of each observation from the SCL. Beta is the slope of the SCL, which is the measure of systematic risk. The SCL for Stock B is steeper; hence Stock Bs systematic risk is greater. The R2 (or squared correlation coefficient) of the SCL is the ratio of the explained variance of the stocks return to total variance, and the total variance is the sum of the explained variance plus the unexplained variance (the stocks residual variance).

b. b.

i2 2 R = 2 2 M2 i M + (e i )
2

Since the explained variance for Stock B is greater than for Stock A (the 2 explained variance is 2 B M , which is greater since its beta is higher), and its residual variance 2(eB ) is smaller, its R2 is higher than Stock As. d. Alpha is the intercept of the SCL with the expected return axis. Stock A has a small positive alpha whereas Stock B has a negative alpha; hence, Stock As alpha is larger. The correlation coefficient is simply the square root of R2, so Stock Bs correlation with the market is higher. Firm-specific risk is measured by the residual standard deviation. Thus, stock A has more firm-specific risk: 10.3% > 9.1% Market risk is measured by beta, the slope coefficient of the regression. A has a larger beta coefficient: 1.2 > 0.8 R2 measures the fraction of total variance of return explained by the market return. As R2 is larger than Bs: 0.576 > 0.436 The average rate of return in excess of that predicted by the CAPM is measured by alpha, the intercept of the SCL. A = 1% which is larger than B = 2%.

e.

4.

a. b. c. c.

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e.

Rewriting the SCL equation in terms of total return (r) rather than excess return (R): rA rf = + (rM rf ) rA = + rf (1 ) + r M The intercept is now equal to: + rf (1 ) = 1 + rf (l 1.2) Since rf = 6%, the intercept would be: 1 1.2 = 0.2%

5.

The standard deviation of each stock can be derived from the following equation for R2:

R i2 =
Therefore:

i2 2 M = i2

2 2 0.7 2 20 2 AM = = = 980 0.20 R2 A 2 A

A = 31.30% For stock B:

1.2 2 20 2 = 4,800 0.12 B = 69.28% 2 B =

6.

The systematic risk for A is:

2 2 2 2 A M = 0.70 20 = 196

The firm-specific risk of A (the residual variance) is the difference between As total risk and its systematic risk: 980 196 = 784 The systematic risk is:
2 2 2 2 B M = 1.20 20 = 576

Bs firm-specific risk (residual variance) is: 4800 576 = 4224

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13.

a.

Merrill Lynch adjusts beta by taking the sample estimate of beta and averaging it with 1.0, using the weights of 2/3 and 1/3, as follows: adjusted beta = [(2/3) 1.24] + [(1/3) 1.0] = 1.16

b. If you use your current estimate of beta to be t1 = 1.24, then t = 0.3 + (0.7 1.24) = 1.168

The effects of including one or the other of these stocks in a diversified portfolio may be quite different. If it can be assumed that both stocks betas will remain stable over time, then there is a large difference in systematic risk level. The betas obtained from the two brokerage houses may help the analyst draw inferences for the future. The three estimates of ABCs are similar, regardless of the sample period of the underlying data. The range of these estimates is 0.60 to 0.71, well below the market average of 1.0. The three estimates of XYZs vary significantly among the three sources, ranging as high as 1.45 for the weekly data over the most recent two years. One could infer that XYZs for the future might be well above 1.0, meaning it might have somewhat greater systematic risk than was implied by the monthly regression for the 1992 - 2001 period. These stocks appear to have significantly different systematic risk characteristics. If these stocks are added to a diversified portfolio, XYZ will add more to total volatility.

16.

c.

The R2 of the regression is: 0.702 = 0.49 Therefore, 51% of total variance is unexplained by the market; this is nonsystematic risk.

19.

b.

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