Tutorial 7

THE UNIVERSITY OF HONG KONG

Faculty of Business and Economics
FINA2802_FINA2320_D – Investments and Portfolio Analysis
1st SEMESTER, 2017-2018

Chapter 9 The Capital Asset Pricing Model

 9.1 The Capital Asset Pricing Model

 Assumptions of CAPM
 There are many investors, each with an endowment that is small compared to the
total endowment of all investors. Investors are price-takers.
 All investors plan for one identical holding period.
 Investments are limited to a universe of publicly traded financial assets. It is
assumed also that investors may borrow or lend any amount at a fixed, risk-free
rate.
 Investors pay no taxes on returns and no transaction costs (commissions and
service charges) on trades in securities.
 All investors are rational mean-variance optimizers, meaning that they all use the
Markowitz portfolio selection model.
 All investors have homogeneous or beliefs; they analyze securities in the same
way and share the same economic view of the world.

 Implications of CAPM
 All investors will choose to hold a portfolio of risky assets in proportions that
duplicate representation of the assets in the market portfolio ( M ), which includes
all traded assets. For simplicity, we generally refer to all risky assets as stocks.
The proportion of each stock in the market portfolio equals the market value of
the stock (price per share multiplied by the number of shares outstanding) divided
by the total market value of all stocks.

 Not only will the market portfolio be on the efficient frontier, but it also will be
the tangency portfolio to the optimal capital allocation line (CAL) derived by each
and every investor. As a result, the capital market line (CML), the line from the
risk free rate through the market portfolio, M, is also the best attainable capital
allocation line. All investors hold M as their optimal risky portfolio, differing only
in the amount invested in it versus in the risk-free asset.

 The risk premium on individual assets will be proportional to the risk premium on
the market portfolio, M, and the beta coefficient of the security relative to the
market portfolio.
- Each stock contribution to the risk of the market portfolio depends on each
stock covariance with the market portfolio.
- Each stock contribution to the risk premium of the market portfolio depends
on each stock risk premium.

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Stock i contribution to risk premium of market portfolio E(ri ) − rf

=
Stock i contribution to risk of market portfolio Cov(ri , rM )
Risk premium of market portfolio E(rM ) − rf
= = Market Price of Risk
Risk of market portfolio σ2M

E(ri ) − rf E(rM ) − rf
=
Cov(ri , rM ) σ2M
Cov(ri , rM )
E(ri ) − rf = E(rM ) − rf
σ2M
E(ri ) − rf = βi [E(rM ) − rf ]
𝐄(𝐫𝐢 ) = 𝐫𝐟 + 𝛃𝐢 [𝐄(𝐫𝐌 ) − 𝐫𝐟 ]
Cov(ri , rM )
where βi =
σ2M
Note: reward-to-risk ratio is not equal to Sharpe ratio (reward-to-volatility ratio).
For portfolio, CAPM relation is still valid: E(rP) = rf + P[E(rM) – rf]

 Security Market Line (SML)

 SML plots all the fairly priced (correctly priced) stocks.
 Alpha  = Actual expected return – Fair expected return (i.e. implied)
 Under-priced stocks plot above SML
 Over-priced stocks plot below SML

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EXERCISE
If the simple CAPM is valid, which of the following situations are possible?
Explain and consider each situation independently.
a.
Expected
Beta
Portfolio Return
A 20% 1.4
B 25% 1.2

b.
Expected
Standard Deviation
Portfolio Return
Risk-free 10%
Market 18% 24%
A 16% 12%

c.
Expected
Standard Deviation
Portfolio Return
Risk-free 10%
Market 18% 24%
A 20% 22%

d.
Expected
Beta
Portfolio Return
Risk-free 10%
Market 18% 1.0
A 16% 1.5

e.
Expected
Beta
Portfolio Return
Risk-free 10%
Market 18% 1.0
A 16% 0.9
f.
Expected
Standard Deviation
Portfolio Return
Risk-free 10%
Market 18% 24%
A 16% 22%

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PROBLEM SET 1
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.

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
50 = D/0.14  D = 50  0.14 = $7.00
At the new discount rate of 22%, the stock would be worth: $7/0.22 = $31.82
The increase in stock risk has lowered its value by 36.36%.

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PROBLEM SET 2
Are the following true or false?
a. Stocks with a beta of zero offer an expected rate of return of zero.
False. β = 0 implies E(r) = rf , not zero.

b. The CAPM implies that investors require a higher return to hold highly volatile securities.
False. Investors require a risk premium only for bearing systematic (undiversifiable or market)
risk. Total volatility includes diversifiable risk.

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.
False. Your portfolio should be invested 75% in the market portfolio and 25% in T-bills. Then:
 P  (0.75  1)  (0.25  0)  0.75

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PROBLEM SET 3
Here are the data on two companies. The T-bill rate is 4% and the market risk premium is 6%.

Company $1 Discount Store Everything $5

Forecasted return 12% 11%
Standard deviation of returns 8% 10%
Beta 1.5 1.0
a. What would be the fair return for each company, according to the capital asset pricing model
(CAPM)?

E (ri )  rf  i  [ E (rM )  rf ]
E (r$1 Discount )  .04  1.5  (.10  .04)  .13  13%
E (rEverything $5 )  .04  1.0  (.10  .04)  .10  10%

b. Characterize each company as underpriced, overpriced, or properly priced.

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

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PROBLEM SET 4
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 expected return of a stock with a β = 1.0 must, on average, be the same as the expected
return of the market which also has a β = 1.0.

PROBLEM SET 5
Kaskin Inc., stock has a beta of 1.2 and Quinn, Inc., stock has a beta of 0.6. Which of the
following statements is most accurate?
a. The expected rate of return will be higher for Kaskin Inc than that of Quinn Inc.
b. The stock of Kaskin Inc., has more total risk than Quinn Inc.
c. Quinn Inc., has more systematic risk than that of Kaskin Inc.
Beta is a measure of systematic risk. 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.

PROBLEM SET 6
Assume that the risk-free rate of interest is 6% and the expected rate of return on the market is
16%. 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?
Since the stock’s beta is equal to 1.2, its expected rate of return is:
6% + [1.2  (16% – 6%)] = 18%
D1  P1  P0 P  $50  $6
E (r )   0.18  1  P1  $53
P0 $50

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PROBLEM SET 7
Assume that the risk-free rate of interest is 6% and the expected rate of return on the market is
16%. You are buying a firm with an expected perpetual cash flow of $1,000 with next cash flow
to be received a year later. You think the beta of the firm is 0.5, when in fact the beta is really 1,
how much more will you offer for the firm than it is truly worth?
The series of $1,000 payments is a perpetuity. If beta is 0.5, the cash flow should be discounted
at the rate:
.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, $2,840.91 is the amount you will overpay if you erroneously assume that beta is
0.5 rather than 1.

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PROBLEM SET 8
Two investment advisers are comparing performance. One averaged a 19% rate of return and
the other a 16% rate of return. However, the beta of the first investor was 1.5, whereas that of the
second was 1.
a. If the T-bill rate were 6% and the market return during the period were 14%, which investor
would be the superior stock selector?
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.

b. What if the T-bill rate was 3% and the market return were 15%?
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).

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PROBLEM SET 9
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?
Since the market portfolio, by definition, has a beta of 1, its expected rate of return is 12%.

b. What would be the expected rate of return on a stock with β=0?

β = 0 means no systematic risk. Hence, the stock’s expected rate of return in market
equilibrium is the risk-free rate, 5%.

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= -0.5. Is the stock overpriced or underpriced?
Using the SML, the fair expected rate of return for a stock with β = –0.5 is:
E(r )  0.05  [(0.5)  (0.12  0.05)]  1.5%
The actually expected rate of return, using the expected price and dividend for next year is:
$41  $3
E (r )   1  0.10  10%
$40
Because the actually expected return exceeds the fair return, the stock is underpriced.

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