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Chapter 7 Risk and Return: Portfolio Theory and Asset Pricing Models

ANSWERS TO END-OF-CHAPTER QUESTIONS

7-1

a. A portfolio is made up of a group of individual assets held in combination. An asset that would be relatively risky if held in isolation may have little, or even no risk if held in a welldiversified portfolio. b. The feasible, or attainable, set represents all portfolios that can be constructed from a given set of stocks. This set is only efficient for part of its combinations. c. An efficient portfolio is that portfolio which provides the highest expected return for any degree of risk. Alternatively, the efficient portfolio is that which provides the lowest degree of risk for any expected return. d. The efficient frontier is the set of efficient portfolios out of the full set of potential portfolios. On a graph, the efficient frontier constitutes the boundary line of the set of potential portfolios. e. An indifference curve is the risk/return trade-off function for a particular investor and reflects that investor's attitude toward risk. The indifference curve specifies an investor's required rate of return for a given level of risk. The greater the slope of the indifference curve, the greater is the investor's risk aversion. f. The optimal portfolio for an investor is the point at which the efficient set of portfolios--the efficient frontier--is just tangent to the investor's indifference curve. This point marks the highest level of satisfaction an investor can attain given the set of potential portfolios. g. The Capital Asset Pricing Model (CAPM) is a general equilibrium market model developed to analyze the relationship between risk and required rates of return on assets when they are held in welldiversified portfolios. The SML is part of the CAPM. h. The Capital Market Line (CML) portfolios an investor can attain the risky market portfolio M. return on any efficient portfolio specifies the efficient set of by combining a risk-free asset and The CML states that the expected is equal to the riskless rate plus Answers and Solutions: 7 - 1

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a risk premium, and thus describes a linear relationship between expected return and risk. i. The characteristic line for a particular stock is obtained by regressing the historical returns on that stock against the historical returns on the general stock market. The slope of the characteristic line is the stock's beta, which measures the amount by which the stock's expected return increases for a given increase in the expected return on the market. j. The beta coefficient (b) is a measure of a stock's market risk. It measures the stock's volatility relative to an average stock, which has a beta of 1.0. k. Arbitrage Pricing Theory (APT) is an approach to measuring the equilibrium risk/return relationship for a given stock as a function of multiple factors, rather than the single factor (the market return) used by the CAPM. The APT is based on complex mathematical and statistical theory, but can account for several factors (such as GNP and the level of inflation) in determining the required return for a particular stock. l. The Fama-French 3-factor model has one factor for the excess market return (the market return minus the risk free rate), a second factor for size (defined as the return on a portfolio of small firms minus the return on a portfolio of big firms), and a third factor for the book-to-market effect (defined as the return on a portfolio of firms with a high book-to-market ratio minus the return on a portfolio of firms with a low book-to-market ratio). m. Most people dont behave rationally in all aspects of their personal lives, and behavioral finance assume that investors have the same types of psychological behaviors in their financial lives as in their personal lives. 7-2 Security A is less risky if held in a diversified portfolio because of its lower beta and negative correlation with other stocks. In a single-asset portfolio, Security A would be more risky because A > B and CVA > CVB.

Answers and Solutions: 7 - 2

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SOLUTIONS TO END-OF-CHAPTER PROBLEMS

7-1

a. A plot of the approximate regression line is shown in the following figure:


k x(%)
30

20

10

-30

-20

-10

10

20

30

k m (%)

-10

-20

The equation of the regression line is


ki = a + bi kM.

The stock's approximate beta coefficient is given by the slope of the regression line:

b = Slope =

Rise Y 23 - (-14) 37 = = = = 0.6. Run X 37.2 - (-26.5) 63.7

The intercept, a, seems to be about 3.5. Using a calculator with a least squares regression routine, we find the exact equation to be kX = 3.7 + 0.56 kM , with r = 0.96. b. The arithmetic average return for Stock X is calculated as follows:

kA v g =
The arithmetic

( 1 4.0 + 2 3.0 + . . . + 1 8.2 = 1 0.6% . 7


rate of return on the market portfolio,

average

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Answers and Solutions: 7 - 3

determined similarly, is 12.1%.

Answers and Solutions: 7 - 4

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For Stock X, the estimated standard deviation is 13.1 percent:

X =

2 2 2 ( 14.0 1 0.6) + (23.0 10.6) + .. . + (18.2 10.6) = 1 3.1%. 7 1

The standard deviation of returns for the market portfolio is similarly determined to be 22.6 percent. The results are summarized below: Stock X 10.6% 13.1 Market Portfolio 12.1% 22.6

Average return, kAvg Standard deviation,

Several points should be noted: (1) M over this particular period is higher than the historic average M of about 15 percent, indicating that the stock market was relatively volatile during this period; (2) Stock X, with X = 13.1%, has much less total risk than an average stock, with Avg = 22.6%; and (3) this example demonstrates that it is possible for a very low-risk single stock to have less risk than a portfolio of average stocks, since X < M. c. Since Stock X is in equilibrium and plots on the Security Market Line (SML), and given the further assumption that kX = kX and this equation must hold:

kM = kM --and

assumption

often

does

not

hold--then

this

kX = kRF + (k kRF ) X. b

This equation can be solved for the risk-free rate, kRF, which is the only unknown:

1 0.6 1 0.6 0.4 4 R F k kR F

= = = =

kR F + (1 2.1 kR F) .5 6 0 kR F + 6.8 0.5 6 R F k 1 0.6 6.8 3.8 / 0.4 4 = 8.6% .

d. The SML is plotted below. Data on the risk-free security (b RF = 0, kRF = 8.6%) and Security X (bX = 0.56, kX = 10.6%) provide the two points through which the SML can be drawn. kM provides a third point.

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Answers and Solutions: 7 - 5

k(%)

20

kX = 10.6% kM = 12.1% 10

kRF = 8.6

1.0

2.0

Beta

e. In theory, you would be indifferent between the two stocks. Since they have the same beta, their relevant risks are identical, and in equilibrium they should provide the same returns. The two stocks would be represented by a single point on the SML. Stock Y, with the higher standard deviation, has more diversifiable risk, but this risk will be eliminated in a well-diversified portfolio, so the market will compensate the investor only for bearing market or relevant risk. In practice, it is possible that Stock Y would have a slightly higher required return, but this premium for diversifiable risk would be small. 7-2
ky (%)
45

30

15

-30

-15

15

30

45

kM (%)

-15

Answers and Solutions: 7 - 6

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a. The regression graph is shown above. b will depend on students' freehand line. Using a calculator, we find b = 0.62. b. Because b = 0.62, Stock Y is about 62 percent as volatile as the market; thus, its relative risk is about 62 percent of that of an average firm.
2 c. 1. Total risk ( ) would be greater because the second term of the Y

firm's risk equation, 2 = b2 2 + 2 , would be greater. Y Y M eY 2. CAPM assumes that company-specific risk will be eliminated in a portfolio, so the risk premium under the CAPM would not be affected. d. 1. The stock's variance would not change, but the risk of the stock to an investor holding a diversified portfolio would be greatly reduced. 2. It would now have a negative correlation with kM. 3. Because of a relative scarcity of such stocks and the beneficial net effect on portfolios that include it, its "risk premium" is likely to be very low or even negative. Theoretically, it should be negative. e. The following figure shows a possible set of probability distributions. We can be reasonably sure that the 100-stock portfolio comprised of b = 0.62 stocks as described in Condition 2 will be less risky than
Probability Density

k100

kY kM

9.8
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Rate of Return

Answers and Solutions: 7 - 7

the "market." Hence, the distribution for Condition 2 will be more peaked than that of Condition 3. This statement can also be made on the basis of an analytical approach as shown by the material following the graph.

kY = k100 = kM = 9.8%.

2 = b2 2. p p M

For Condition 2, with 100 stocks in the portfolio, 2 0 , so e


2 2 = (0.62) 2 p M

p =

2 (0.62) 2 = 0.62M. M

Since p is only 62 percent of M, the probability distribution for Condition 2 is clearly more peaked than that for Condition 3; thus, we can be reasonably confident of the relevant locations of the distributions for Conditions 2 and 3. With regard to Condition 1, the single-asset portfolio, we can be sure that its probability distribution is less peaked than that for the 100-stock portfolio. Analytically, since b = 0.62 both for the single stock portfolio and for the 100-stock portfolio,
2 2 2 = (0.62 M) + 2 > (0.62 M) + 0 2. Y e p

We can also say on the basis of the available information that Y is smaller than M; Stock Y's market risk is only 62 percent of the "market," but it does have company-specific risk, while the market portfolio does not. However, we know from the given data that Y = 13.8%, while M = 19.6%. Thus, we have drawn the distribution for the single stock portfolio more peaked than that of the market. The relative rates of return are not reasonable. The return for any stock should be ki = kRF + (kM - kRF)bi. Stock Y has b = 0.62, while the average stock (M) has b = 1.0; therefore, kY = kRF + (kM - kRF)0.62 < kM = kRF + (kM - kRF)1.0. A disequilibrium exists--Stock Y should be bid up to drive its yield down. More likely, however, the data simply reflect the fact that past returns are not an exact basis for expectations of future returns.

7-3

b a. ki = kRF + (kM kRF) i = kRF + (kM kRF)

riM i . M

Answers and Solutions: 7 - 8

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b. CML:

k kRF p. kp = kRF + M M

SML:

k kRF riMi. ki = kRF + M M

With some arranging, the similarities between the CML and SML are obvious. When in this form, both have the same market price of risk, or slope,(kM - kRF)/ M. The measure of risk in the CML is p. Since the CML applies only to efficient portfolios, p not only represents the portfolio's total risk, but also its market risk. However, the SML applies to all portfolios and individual securities. Thus, the appropriate risk measure is not i, the total risk, but the market risk, which in this form of the SML is riM i, and is less than for all assets except those which are perfectly positively correlated with the market, and hence have riM = +1.0. 7-4 a. Using the CAPM:

ki = k RF +(k M k RF )b i =7% +(1.1)(6.5% )=14.15%.

b. Using the 3-factor model:

ki = kRF+(kM krf)bi +(kSMB)ci+(kHML)di =7%+(1.1)(6.5%)+(5%)(0.7)+(4%)(-0.3)=16.45%

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Answers and Solutions: 7 - 9

MINI CASE

TO

BEGIN,

BRIEFLY

REVIEW

THE

CHAPTER

MINI

CASE.

THEN,

EXTEND

YOUR

KNOWLEDGE OF RISK AND RETURN BY ANSWERING THE FOLLOWING QUESTIONS. A. WHAT IS THE CAPITAL ASSET PRICING MODEL (CAPM)? WHAT ARE THE

ASSUMPTIONS THAT UNDERLIE THE MODEL? ANSWER: THE CAPITAL ASSET PRICING MODEL (CAPM) IS AN EQUILIBRIUM MODEL WHICH SPECIFIES THE RELATIONSHIP BETWEEN RISK AND REQUIRED RATES OF RETURN ON ASSETS WHEN THEY ARE HELD IN WELL-DIVERSIFIED PORTFOLIOS. CAPM REQUIRES AN EXTENSIVE SET OF ASSUMPTIONS: ALL INVESTORS ARE SINGLE-PERIOD EXPECTED UTILITY OF TERMINAL WEALTH MAXIMIZERS, WHO CHOOSE AMONG ALTERNATIVE PORTFOLIOS ON THE BASIS OF EACH PORTFOLIO'S EXPECTED RETURN AND STANDARD DEVIATION. ALL INVESTORS CAN BORROW OR LEND AN UNLIMITED AMOUNT AT A GIVEN RISKFREE RATE OF INTEREST. INVESTORS HAVE HOMOGENEOUS EXPECTATIONS (THAT IS, INVESTORS HAVE THE

IDENTICAL ESTIMATES OF THE EXPECTED VALUES, VARIANCES, AND COVARIANCES OF RETURNS AMONG ALL ASSETS). ALL ASSETS ARE PERFECTLY DIVISIBLE AND PERFECTLY MARKETABLE AT THE

GOING PRICE, AND THERE ARE NO TRANSACTIONS COSTS. THERE ARE NO TAXES. ALL INVESTORS ARE PRICE TAKERS (THAT IS, ALL INVESTORS ASSUME THAT THEIR OWN BUYING AND SELLING ACTIVITY WILL NOT AFFECT STOCK PRICES). THE QUANTITIES OF ALL ASSETS ARE GIVEN AND FIXED.

Mini Case: 7 - 10

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B.

CONSTRUCT A REASONABLE, BUT HYPOTHETICAL, GRAPH WHICH SHOWS RISK, AS MEASURED BY PORTFOLIO STANDARD DEVIATION, ON THE X AXIS AND EXPECTED RATE OF RETURN ON THE Y AXIS. SET IS EFFICIENT. WHAT NOW ADD AN ILLUSTRATIVE FEASIBLE (OR A PARTICULAR PORTFOLIO EFFICIENT? ATTAINABLE) SET OF PORTFOLIOS, AND SHOW WHAT PORTION OF THE FEASIBLE MAKES DON'T WORRY ABOUT SPECIFIC VALUES WHEN CONSTRUCTING THE GRAPHMERELY ILLUSTRATE HOW THINGS LOOK WITH "REASONABLE" DATA.

ANSWER:
Expected Portfolio ^ Return, k p

B
Efficient Set (A,B)

D
Feasible, or Attainable, Set

E
Risk, p

THE FIGURE ABOVE SHOWS THE FEASIBLE SET OF PORTFOLIOS. ONLY ONE SECURITY). ITS ALL THE OTHER POINTS IN THE OF

THE POINTS SHADED AREA, MORE

B, C, D, AND E REPRESENT SINGLE SECURITIES (OR PORTFOLIOS CONTAINING INCLUDING SECURITIES. SET. THE BOUNDARY AB DEFINES THE EFFICIENT SET OF PORTFOLIOS, WHICH IS ALSO CALLED THE EFFICIENT FRONTIER. EFFICIENT ATTAINABLE SET SET. ARE NOT POSSIBLE TO PORTFOLIOS THE PORTFOLIOS TO THE LEFT OF THE BECAUSE RIGHT THEY OF LIE THE OUTSIDE BOUNDARY THE LINE BOUNDARIES, REPRESENT PORTFOLIOS TWO OR

THE SHADED AREA IS CALLED THE FEASIBLE, OR ATTAINABLE,

(INTERIOR PORTFOLIOS) ARE INEFFICIENT BECAUSE SOME OTHER PORTFOLIO WOULD PROVIDE EITHER A HIGHER RETURN WITH THE SAME DEGREE OF RISK OR A LOWER LEVEL OF RISK FOR THE SAME RATE OF RETURN.

C.

NOW ADD A SET OF INDIFFERENCE CURVES TO THE GRAPH CREATED FOR PART B. WHAT DO THESE CURVES REPRESENT? FOR THIS INVESTOR? WHAT IS THE OPTIMAL PORTFOLIO WHY FINALLY, ADD A SECOND SET OF INDIFFERENCE CURVES

WHICH LEADS TO THE SELECTION OF A DIFFERENT OPTIMAL PORTFOLIO. DO THE TWO INVESTORS CHOOSE DIFFERENT PORTFOLIOS? ANSWER:
Expected Portfolio ^ Return, k p

B I I I I I
B2 B1

C Optimal Portfolio Investor B D Optimal Portfolio Investor A

A3 A2 A1

Risk, p

THE FIGURE ABOVE SHOWS THE INDIFFERENCE CURVES FOR TWO HYPOTHETICAL INVESTORS, A AND B. TO DETERMINE THE OPTIMAL PORTFOLIO FOR A PARTICULAR INVESTOR, WE MUST KNOW THE INVESTOR'S ATTITUDE TOWARDS RISK AS REFLECTED IN HIS OR HER RISK/RETURN TRADEOFF FUNCTION, OR INDIFFERENCE CURVE. CURVES IA1, IA2, AND IA3 REPRESENT THE INDIFFERENCE CURVES FOR INDIVIDUAL A, WITH THE HIGHER CURVE (IA3) DENOTING A GREATER LEVEL OF SATISFACTION (OR UTILITY). BETTER THAN IA2 FOR ANY LEVEL OF RISK. THE OPTIMAL PORTFOLIO IS FOUND AT THE TANGENCY POINT BETWEEN THE EFFICIENT SET OF PORTFOLIOS AND ONE OF THE INVESTOR'S INDIFFERENCE CURVES. THE THIS TANGENCY POINT MARKS THE HIGHEST LEVEL OF SATISFACTION CAN ATTAIN. THE ARROWS POINT TOWARD THE OPTIMAL INVESTOR THUS, IA3 IS

PORTFOLIOS FOR BOTH INVESTORS A AND B. THE INVESTORS CHOOSE DIFFERENT OPTIMAL PORTFOLIOS BECAUSE THEIR RISK AVERSION IS DIFFERENT. INVESTOR A CHOOSES THE PORTFOLIO WITH THE LOWER EXPECTED RETURN, BUT THE RISKINESS OF THAT PORTFOLIO IS ALSO LOWER THAN INVESTOR'S B OPTIMAL PORTFOLIO, BECAUSE INVESTOR A

IS MORE RISK AVERSE. D. NOW ADD THE RISK-FREE ASSET. EFFICIENT FRONTIER? ANSWER: THE RISK-FREE ASSET BY DEFINITION HAS ZERO RISK, AND HENCE SO IT IS PLOTTED ON THE VERTICAL AXIS. OF INVESTING IN THE RISK-FREE ASSET, INVESTORS CAN = 0%, NEW WHAT IMPACT DOES THIS HAVE ON THE

NOW, GIVEN THE POSSIBILITY CREATE

PORTFOLIOS THAT COMBINE THE RISK-FREE ASSET WITH A PORTFOLIO OF RISKY ASSETS. THIS ENABLES THEM TO ACHIEVE ANY COMBINATION OF RISK HOWEVER, THE AND RETURN THAT LIES ALONG ANY STRAIGHT LINE CONNECTING kRF WITH ANY PORTFOLIO IN THE FEASIBLE SET OF RISKY PORTFOLIOS. STRAIGHT LINE CONNECTING kRF WITH M, THE POINT OF TANGENCY BETWEEN THE LINE AND THE PORTFOLIO'S EFFICIENT SET CURVE, IS THE ONE THAT ALL INVESTORS WOULD CHOOSE. ARE PREFERRED TO THE OTHER SINCE ALL PORTFOLIOS ON THE LINE kRFMZ RISKY PORTFOLIO OPPORTUNITIES ON THE

EFFICIENT FRONTIER AB, THE POINTS ON THE LINE kRFMZ NOW REPRESENT THE BEST ATTAINABLE COMBINATIONS OF RISK AND RETURN. OR OFFERS MORE RISK FOR THE SAME AMOUNT OF RETURN. ANY COMBINATION THUS, EVERYBODY UNDER THE kRFMZ LINE OFFERS LESS RETURN FOR THE SAME AMOUNT OF RISK, WANTS TO HOLD PORTFOLIOS WHICH ARE LOCATED ON THE kRFMZ LINE.

Expected Portfolio ^ Return, k p

Z B

A k RF

Risk, p

E.

WRITE OUT THE EQUATION FOR THE CAPITAL MARKET LINE (CML) AND DRAW IT ON THE GRAPH. INTERPRET THE CML. NOW ADD A SET OF INDIFFERENCE WHAT IS CURVES, AND ILLUSTRATE HOW AN INVESTOR'S OPTIMAL PORTFOLIO IS SOME COMBINATION OF THE RISKY PORTFOLIO AND THE RISK-FREE ASSET. THE COMPOSITION OF THE RISKY PORTFOLIO?

ANSWER:

THE LINE kRFMZ IN THE FIGURE ABOVE IS CALLED THE CAPITAL MARKET LINE

(CML). IT HAS AN INTERCEPT OF kRF AND A SLOPE OF (k M kRF )/ M .


THEREFORE THE EQUATION FOR THE CAPITAL MARKET LINE MAY BE EXPRESSED AS FOLLOWS:

CML:

k kRF p. kp = kRF + M M

THE CML TELLS US THAT THE EXPECTED RATE OF RETURN ON ANY EFFICIENT PORTFOLIO (THAT IS, ANY PORTFOLIO ON THE CML) IS EQUAL TO THE RISKFREE RATE PLUS A RISK PREMIUM, AND THE RISK PREMIUM IS EQUAL TO THUS, RETURN THE AND CML SPECIFIES WITH A LINEAR SLOPE OF RELATIONSHIP THE CML BETWEEN EQUAL EXPECTED TO THE

(kM kRF )/ M MULTIPLIED BY THE PORTFOLIO'S STANDARD DEVIATION, . p


RISK, THE BEING

EXPECTED RETURN ON THE MARKET PORTFOLIO OF RISKY STOCKS, k M , MINUS


THE RISK-FREE RATE, kRF, WHICH IS CALLED THE MARKET RISK PREMIUM, ALL DIVIDED BY THE STANDARD DEVIATION OF RETURNS ON THE MARKET PORTFOLIO, M.

Expected Rate ^ of Return, k p

2 I1

CML

k RF

Optimal Portfolio

Risk, p

THE FIGURE ABOVE SHOWS A SET OF INDIFFERENCE CURVES (I1, I2, AND I3), WITH I1 TOUCHING THE CML. OPTIMAL THE PORTFOLIO RISKY FOR THIS M, THIS POINT OF TANGENCY DEFINES THE AND HE OR SHE WILL IN BUY A INVESTOR, MUST

COMBINATION OF THE MARKET PORTFOLIO AND THE RISK-FREE ASSET. PORTFOLIO, CONTAIN EVERY ASSET EXACT PROPORTION TO THAT ASSET'S FRACTION OF THE TOTAL MARKET VALUE OF ALL ASSETS; THAT IS, IF SECURITY G IS X PERCENT OF THE TOTAL MARKET VALUE OF ALL SECURITIES, X PERCENT OF THE MARKET PORTFOLIO MUST CONSIST OF SECURITY G. F. WHAT IS A CHARACTERISTIC LINE? STOCKS BETA COEFFICIENT? HOW IS THIS LINE USED TO ESTIMATE A

WRITE OUT AND EXPLAIN THE FORMULA THAT

RELATES TOTAL RISK, MARKET RISK, AND DIVERSIFIABLE RISK. ANSWER: BETAS ARE CALCULATED AS THE SLOPE OF THE CHARACTERISTIC LINE, WHICH IS THE REGRESSION LINE FORMED BY PLOTTING RETURNS ON A GIVEN STOCK ON THE Y AXIS AGAINST RETURNS ON THE GENERAL STOCK MARKET ON THE X AXIS. WOULD IN PRACTICE, 5 YEARS OF MONTHLY DATA, WITH 60 OBSERVATIONS, BE USED, AND A COMPUTER WOULD BE USED TO OBTAIN A LEAST

SQUARES REGRESSION LINE. THE RELATIONSHIP BETWEEN STOCK J'S TOTAL RISK, MARKET RISK, AND DIVERSIFIABLE RISK CAN BE EXPRESSED AS FOLLOWS:

TOTAL RISK = VARIANCE = MARKET RISK + DIVERSIFIA BLE RISK 2 2 J = bJ 2 + 2 M eJ


HERE
2 J

IS THE VARIANCE OR TOTAL RISK OF STOCK J,

2 M

IS THE IS

2 VARIANCE OF THE MARKET, BJ IS STOCK J'S BETA COEFFICIENT, AND eJ

THE VARIANCE OF STOCK J'S REGRESSION ERROR TERM.

IF STOCK J IS HELD HOWEVER,

IN ISOLATION, THEN THE INVESTOR MUST BEAR ITS TOTAL RISK.


2 REGRESSION ERROR TERM, eJ

WHEN STOCK J IS HELD AS PART OF A WELL-DIVERSIFIED PORTFOLIO, THE IS DRIVEN TO ZERO; HENCE, ONLY THE MARKET RISK REMAINS.

G.

WHAT ARE TWO POTENTIAL TESTS THAT CAN BE CONDUCTED TO VERIFY THE CAPM? WHAT ARE THE RESULTS OF SUCH TESTS? OF CAPM TESTS? WHAT IS ROLLS CRITIQUE

ANSWER:

SINCE THE CAPM WAS DEVELOPED ON THE BASIS OF A SET OF UNREALISTIC ASSUMPTIONS, EMPIRICAL TESTS SHOULD BE USED TO VERIFY THE CAPM. FIRST TEST LOOKS FOR STABILITY IN HISTORICAL BETAS. THE IF BETAS HAVE

BEEN STABLE IN THE PAST FOR A PARTICULAR STOCK, THEN ITS HISTORICAL BETA WOULD PROBABLY BE A GOOD PROXY FOR ITS EX-ANTE, OR EXPECTED BETA. EMPIRICAL WORK CONCLUDES THAT THE BETAS OF INDIVIDUAL SECURITIES ARE NOT GOOD ESTIMATORS OF THEIR FUTURE RISK, BUT THAT BETAS OF PORTFOLIOS OF TEN OR MORE RANDOMLY SELECTED STOCKS ARE REASONABLY STABLE, HENCE THAT PAST PORTFOLIO BETAS ARE GOOD AS WE ESTIMATORS OF FUTURE PORTFOLIO VOLATILITY. THE SECOND TYPE OF TEST IS BASED ON THE SLOPE OF THE SML. A SECURITY'S REQUIRED RATE OF RETURN AND ITS BETA. HAVE SEEN, THE CAPM STATES THAT A LINEAR RELATIONSHIP EXISTS BETWEEN FURTHER, WHEN THE SML IS GRAPHED, THE VERTICAL AXIS INTERCEPT SHOULD BE kRF, AND THE REQUIRED RATE OF RETURN FOR A STOCK (OR PORTFOLIO) WITH BETA = 1.0 SHOULD BE kM, THE REQUIRED RATE OF RETURN ON THE MARKET. CALCULATING VALUES IN BETAS GRAPHS, AND AND REALIZED THEN RATES OF RETURN, OR VARIOUS THESE THE RESEARCHERS HAVE ATTEMPTED TO TEST THE VALIDITY OF THE CAPM MODEL BY PLOTTING NOT (1) OBSERVING WHETHER

INTERCEPT IS EQUAL TO kRF, (2) THE REGRESSION LINE IS LINEAR, AND (3) THE SML PASSES THROUGH THE POINT B = 1.0, kM. OR-LESS LINEAR RELATIONSHIP BETWEEN EVIDENCE SHOWS A MORERETURNS AND MARKET REALIZED

RISK, BUT THE SLOPE IS LESS THAN PREDICTED. TESTS THAT ATTEMPT TO ASSESS THE RELATIVE IMPORTANCE OF MARKET AND COMPANY-SPECIFIC RISK DO NOT YIELD DEFINITIVE RESULTS, SO THE IRRELEVANCE OF DIVERSIFIABLE RISK SPECIFIED IN THE CAPM MODEL CAN BE QUESTIONED. ROLL QUESTIONED WHETHER IT IS EVEN CONCEPTUALLY POSSIBLE TO TEST THE CAPM. PROPERTIES ROLL SHOWED THAT THE LINEAR RELATIONSHIP WHICH PRIOR OF THE MODELS BEING TESTED, HENCE THAT A FINDING OF RESEARCHERS HAD OBSERVED IN GRAPHS RESULTED FROM THE MATHEMATICAL LINEARITY PROVED NOTHING ABOUT THE VALIDITY OF THE CAPM. ROLL'S

WORK DID NOT DISPROVE THE CAPM THEORY, BUT HE DID SHOW THAT IT IS VIRTUALLY IMPOSSIBLE TO PROVE THAT INVESTORS BEHAVE IN ACCORDANCE WITH THE THEORY. IN GENERAL, EVIDENCE SEEMS TO SUPPORT THE CAPM MODEL WHEN IT IS APPLIED TO PORTFOLIOS, BUT THE EVIDENCE IS LESS CONVINCING WHEN THE CAPM IS APPLIED TO INDIVIDUAL STOCKS. NEVERTHELESS, THE CAPM

PROVIDES A RATIONAL WAY TO THINK ABOUT RISK AND RETURN AS LONG AS ONE RECOGNIZES THE LIMITATIONS OF THE CAPM WHEN USING IT IN PRACTICE.

H.

BRIEFLY EXPLAIN THE DIFFERENCE BETWEEN THE CAPM AND THE ARBITRAGE PRICING THEORY (APT).

ANSWER:

THE

CAPM

IS

SINGLE-FACTOR

MODEL,

WHILE

THE

ARBITRAGE

PRICING

THEORY (APT) CAN INCLUDE ANY NUMBER OF RISK FACTORS.

IT IS LIKELY

THAT THE REQUIRED RETURN IS DEPENDENT ON MANY FUNDAMENTAL FACTORS SUCH AS THE GNP GROWTH, EXPECTED INFLATION, AND CHANGES IN TAX LAWS, AND THAT DIFFERENT GROUPS OF STOCKS ARE AFFECTED DIFFERENTLY BY THESE FACTORS. THUS, THE APT SEEMS TO HAVE A STRONGER THEORETICAL FOOTING THAN DOES THE CAPM. HOWEVER, THE APT FACES SEVERAL MAJOR HURDLES IN IMPLEMENTATION, THE MOST SEVERE BEING THAT THE APT DOES NOT IDENTIFY THE RELEVANT FACTORS--A COMPLEX MATHEMATICAL PROCEDURE CALLED FACTOR ANALYSIS MUST BE USED TO IDENTIFY THE FACTORS. TO DATE, IT APPEARS THAT ONLY THREE OR FOUR FACTORS ARE REQUIRED IN THE APT, BUT MUCH MORE RESEARCH IS REQUIRED BEFORE THE APT IS FULLY UNDERSTOOD AND PRESENTS A TRUE CHALLENGE TO THE CAPM.

I. ANSWER:

WHAT IS THE CURRENT STATUS OF THE APT? THE APT IS IN AN EARLY STAGE OF DEVELOPMENT, AND THERE ARE STILL MANY UNANSWERED QUESTIONS. APT--THAT RETURNS CAN BE NEVERTHELESS, THE BASIC PREMISE OF THE A FUNCTION OF SEVERAL FACTORS--HAS IF THE FACTORS CAN BE IDENTIFIED,

CONSIDERABLE INTUITIVE APPEAL.

AND THE THEORY SATISFACTORILY EXPLAINED TO PRACTITIONERS, THEN THE APT MIGHT REPLACE THE CAPM AS THE PRIMARY MODEL THAT DESCRIBES THE RELATIONSHIP BETWEEN RISK AND RETURN. CURRENTLY, THOUGH, CAPM RULES.

J.

SUPPOSE COMPANY,

YOU BI,

ARE IS

GIVEN 0.9,

THE

FOLLOWING FREE

INFORMATION. RATE, KRF, IS

THE 6.8%,

BETA AND

OF THE

THE

RISK

EXPECTED MARKET PREMIUM, KM-KRF, IS 6.3%. LOWER BOOK-TO-MARKET RATIO), FROM YOU THE THINK

BECAUSE YOUR COMPANY IS THE FAMA-FRENCH 3-FACTOR 3-FACTOR THE

LARGER THAN AVERAGE AND MORE SUCCESSFUL THAN AVERAGE (I.E., IT HAS A MODEL MIGHT BE MORE APPROPRIATE THAN THE CAPM. ADDITIONAL COEFFICIENTS FAMA-FRENCH YOU ESTIMATE THE MODEL:

COEFFICIENT FOR THE SIZE EFFECT, CI, IS -0.5, AND THE COEFFICIENT FOR THE BOOK-TO-MARKET EFFECT, DI, IS 0.3. SIZE FACTOR IS 4% AND THE EXPECTED IF THE EXPECTED VALUE OF THE VALUE OF THE BOOK-TO-MARKET

FACTOR IS 5%, WHAT IS THE REQUIRED RETURN USING THE FAMA-FRENCH 3FACTOR MODEL? USING CAPM? ANSWER: THE ki = ki = = THE ki = ki = = FAMA-FRENCH MODEL: kRF + (kM - kRF)bi + (kSMB)ci + (kHMB)dj 6.8% + (6.3%)(0.9) + (4%)(-0.5) + (5%)(-0.3) 8.97% CAPM: kRF + (kM - kRF)bi 6.8% + (6.3%)(0.9) 12.47% (ASSUME THAT AI = 0.0.) WHAT IS THE REQUIRED RETURN

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