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Chapter 10

The Capital Asset Pricing model

OPEN QUESTIONS 1. You can borrow and lend at the risk-free rate of 8%. The return on the optimal risky portfolio is 16%. What investment strategy will provide you with an expected return of 22%? Answer: Equation 10.2 states that the expected return of a portfolio on the opportunity line is the weighted average of the risk-free rate and the expected return on the risky asset. You want expected return to be 22%: 22% = wr (8%) + (1 wr)(16%). Solving, wr = 0.75 and (1 wr) = 1.75. Therefore, it is necessary to borrow an amount equal to 75% of your wealth and invest the borrowed funds, plus all of your wealth, in the risky asset. 2. Dorphene Rodgers optimal risky portfolio has an expected return of 18% and a standard deviation of 30%. The expected return on the risk-free asset is 6%. What is the slope of Dorphenes optimal opportunity line? Answer: The slope of the opportunity line is [E(RA) r]/ 3. = (18% 6%) / 30% = 0.4.

Stock Qs alpha is 0.1% and its beta is 1.3. The standard deviation of the market is 22% and the unique risk of Stock Q (measured as standard deviation) is 33%. What is the total risk of Stock Q? Answer: Equation 10.8 partitions a stocks total risk (measured as variance) into its systematic and unsystematic components: 2i = 2i 2m + 2ei. The variance of Stock X is (1.3)2(0.22)2 + 0.332 = 0.190696 and the standard deviation is 43.67%.

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Abigail formed a portfolio by combining the risk-free asset and Asset A. The risk-free rate is 6%, Asset As expected return is 22%, and its standard deviation is 40%. The standard deviation of Abigails portfolio is 30%. What is the expected return of Abigails portfolio? Answer: Abigails portfolio lies on the opportunity line drawn between the risk-free asset and Asset A. The standard deviation is given by Equation 10.3: p = (1 wr) A Here, 0.30 = (1 wr)0.40. Solving, (1 wr) = 0.75. The expected return of Abigails portfolio is given by Equation 10.2: E(Rp) = 0.25(6%) + 0.75(22%) = 18%.

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The risk-free rate is 5% and the market risk premium is 10%. The beta of Stock A is 1.4 and its standard deviation is 30%. What is the expected return of Stock A according to the CAPM? Answer:

Chapter 10

The Capital Asset Pricing Model

Using Equation 10.9, E(Ri)= 5% + 1.4(10%) = 19%. 6. Edgar invested $600 in Stock F and $400 in Stock G. Stock Fs beta is 1.2 and Stock Gs beta is 0.90. What is the beta of Edgars portfolio? Answer: The beta of a portfolio is the weighted average of the betas of the assets in the portfolio, so p = (600/1000)(1.2) + (400/1000)(0.90) = 1.08.