Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory

CHAPTER 07
CAPITAL ASSET PRICING AND ARBITRAGE PRICING
THEORY
1. The required rate of return on a stock is related to the required rate of return on the
stock market via beta. Assuming the beta of oogle remains constant! the increase in
the risk of the market "ill increase the required rate of return on the market! and thus
increase the required rate of return on oogle.
2. An e#ample of this scenario "ould be an investment in the $%& and '%( )P.*0+ ,
The -- three factor.. As of yet! there are no vehicles )inde# funds or /T-s. to directly
invest in $%& and '%(. 0hile they may prove superior to the single inde# model!
they are not yet practical! even for professional investors.
3. The APT may e#ist "ithout the CAP%! but not the other "ay. Thus! statement a is
possible! but not b. The reason being! that the APT accepts the principle of risk and
return! "hich is central to CAP%! "ithout making any assumptions regarding
individual investors and their portfolios. These assumptions are necessary to CAP%.
4. /)rP. 1 rf 2 3/)r%. , rf4
*05 1 65 2 )765 , 65. 1 76870 1 7.6
5. 9f the beta of the security doubles! then so "ill its risk premium. The current risk
premium for the stock is: )7;5 - 75. 1 <5! so the ne" risk premium "ould be 7*5!
and the ne" discount rate for the security "ould be: 7*5 2 75 1 7+5
9f the stock pays a constant dividend in perpetuity! then "e kno" from the original data
that the dividend )=. must satisfy the equation for a perpetuity:
Price 1 =ividend8=iscount rate
>0 1 =80.7; = 1 >0 0.7; 1 ?6.*0
At the ne" discount rate of 7+5! the stock "ould be "orth: ?6.*080.7+ 1 ?*7.;7
The increase in stock risk has lo"ered the value of the stock by ;7.6@5.
6. The cash flo"s for the proAect comprise a 70-year annuity of ?70 million per year plus an
additional payment in the tenth year of ?70 million )so that the total payment in the tenth
year is ?*0 million.. The appropriate discount rate for the proAect is:
rf 2 3/)r%. , rf 4 1 +5 2 7.7)7+5 , +5. 1 *<5
Bsing this discount rate:
CPD 1 ,*0 2
+

=
70
7 t
t
*< . 7
70
70
*< . 7
70
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
1 ,*0 2 370 Annuity factor )*<5! 70 years.4 2 370 PD factor )*<5! 70 years.4
1 76.<>
The internal rate of return on the proAect is >+.665. The highest value that beta can take
before the hurdle rate e#ceeds the 9EE is determined by:
>+.665 1 +5 2 )7+5 , +5. 1 >0.66870 1 >.066
7.
a. -alse. 1 0 implies /)r. 1 rf ! not Fero.
b. -alse. 9nvestors require a risk premium for bearing systematic )i.e.! market or
undiversifiable. risk.
c. -alse. Gou should invest 0.76 of your portfolio in the market portfolio! and the
remainder in T-bills. Then:
P 1 )0.76 7. 2 )0.*6 0. 1 0.76
8.
a. The beta is the sensitivity of the stockHs return to the market return. Call the
aggressive stock A and the defensive stock D. Then beta is the change in the
stock return per unit change in the market return. 0e compute each stockHs beta
by calculating the difference in its return across the t"o scenarios divided by the
difference in market return.
00 . *
*0 6
;* *
A
=

=
70 . 0
*0 6
7> 6 . ;
=
=

=
b. 0ith the t"o scenarios equal likely! the e#pected rate of return is an average of
the t"o possible outcomes:
/)rA. 1 0.6 )*5 2 ;*5. 1 775
/)r&. 1 0.6 );.65 2 7>5. 1 @.765
c. The SML is determined by the following: T-bill rate = 8% with a beta equal to
zero, beta for the market is 1.0, and the expected rate of return for the market is:
0.6 )*05 2 65. 1 7*.65
$ee the follo"ing graph.
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
E(r)

8%
12.5%
1.0
2.0
A
SML

M

.7

D
D
The equation for the security market line is: /)r. 1 @5 2 )7*.65 , @5.
d. The aggressive stock has a fair e#pected rate of return of:
/)rA. 1 @5 2 *.0)7*.65 , @5. 1 775
The security analystIs estimate of the e#pected rate of return is also 775.
Thus the alpha for the aggressive stock is Fero. $imilarly! the required return
for the defensive stock is:
/)r=. 1 @5 2 0.7)7*.65 , @5. 1 77.765
The security analystIs estimate of the e#pected return for = is only @.765! and
hence:
= 1 actual e#pected return , required return predicted by CAP%
1 @.765 , 77.765 1 ,*.>5
The points for each stock are plotted on the graph above.
e. The hurdle rate is determined by the proAect beta )i.e.! 0.7.! not by the firmIs
beta. The correct discount rate is therefore 77.765! the fair rate of return on
stock =.
9. Not possible. Portfolio A has a higher beta than Portfolio B, but the expected return
for Portfolio A is lower.
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
10. Possible. 9f the CAP% is valid! the e#pected rate of return compensates only for
systematic )market. risk as measured by beta! rather than the standard deviation!
"hich includes nonsystematic risk. Thus! Portfolio AHs lo"er e#pected rate of return
can be paired "ith a higher standard deviation! as long as Portfolio AHs beta is lo"er
than that of Portfolio &. (variance = systemmatic Var + firm-specific risk Var
11. Cot possible. The re"ard-to-variability ratio for Portfolio A is better than that of the
market! "hich is not possible according to the CAP%! since the CAP% predicts that the
market portfolio is the most efficient portfolio. Bsing the numbers supplied:
$A 1
6 . 0
7*
70 7<
=

$% 1
;; . 0
*>
70 7@
=

These figures imply that Portfolio A provides a better risk-re"ard tradeoff than the
market portfolio.
12. Cot possible. Portfolio A clearly dominates the market portfolio. 9t has a lo"er
standard deviation "ith a higher e#pected return. )$harpe ratio.
13. Cot possible. iven these data! the $%( is: /)r. 1 705 2 )7@5 , 705.
A portfolio "ith beta of 7.6 should have an e#pected return of:
/)r. 1 705 2 7.6 )7@5 , 705. 1 **5
The expected return for Portfolio A is 16% so that Portfolio A plots below the SML
(i.e., has an alpha of 6%), and hence is an overpriced portfolio. This is inconsistent
with the CAPM.
14. Cot possible. The $%( is the same as in Problem 7*. 'ere! the required e#pected
return for Portfolio A is: 705 2 )0.+ @5. 1 77.*5
This is still higher than 7<5. Portfolio A is overpriced! "ith alpha equal to: ,7.*5
15. Possible. Portfolio AHs ratio of risk premium to standard deviation is less attractive
than the marketHs. This situation is consistent "ith the CAP%. The market portfolio
should provide the highest re"ard-to-variability ratio.
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
16.
a.
b.
As a first pass "e note that large standard deviation of the beta estimates. Cone of
the subperiod estimates deviate from the overall period estimate by more than t"o
standard deviations. That is! the t-statistic of the deviation from the overall period
is not significant for any of the subperiod beta estimates. (ooking beyond the
aforementioned observation! the differences can be attributed to different alpha
values during the subperiods. The case of Toyota is most revealing: The alpha
estimate for the first t"o years is positive and for the last t"o years negative )both
large.. -ollo"ing a good performance in the JnormalJ years prior to the crisis!
Toyota surprised investors "ith a negative performance! beyond "hat could be
e#pected from the inde#. This suggests that a beta of around 0.6 is more reliable.
The shift of the intercepts from positive to negative "hen the inde# moved to
largely negative returns! e#plains "hy the line is steeper "hen estimated for the
overall period. =ra" a line in the positive quadrant for the inde# "ith a slope of 0.6
and positive intercept. Then dra" a line "ith similar slope in the negative quadrant
of the inde# "ith a negative intercept. Gou can see that a line that reconciles the
observations for both quadrants "ill be steeper. The same logic e#plains part of the
behavior of subperiod betas for -ord and %.
17. Since the stock's beta is equal to 1.0, its expected rate of return should be equal to that
of the market, that is, 18%.
/)r. 1
0
0 7
P
P P = +
0.7@ 1
700
700 P +
7
+
P7 1 ?70+
18. 9f beta is Fero! the cash flo" should be discounted at the risk-free rate! @5:
PD 1 ?7!00080.0@ 1 ?7*!600
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
9f! ho"ever! beta is actually equal to 7! the investment should yield 7@5! and the price
paid for the firm should be:
PD 1 ?7!00080.7@ 1 ?6!666.6<
The difference )?<+>>.>>. is the amount you "ill overpay if you erroneously assume
that beta is Fero rather than 7.
1!. Bsing the $%(: <5 1 @5 2 )7@5 , @5. 1 ,*870 1 ,0.*
20. r7 1 7+5K r* 1 7<5K 7 1 7.6K * 1 7.0
a. 9n order to determine "hich investor "as a better selector of individual stocks
"e look at the abnormal return! "hich is the e#-post alphaK that is! the abnormal
return is the difference bet"een the actual return and that predicted by the $%(.
0ithout information about the parameters of this equation )i.e.! the risk-free rate
and the market rate of return. "e cannot determine "hich investment adviser is
the better selector of individual stocks.
b. 9f rf 1 <5 and r% 1 7>5! then )using alpha for the abnormal return.:
7 1 7+5 , 3<5 2 7.6)7>5 , <5.4 1 7+5 , 7@5 1 75
* 1 7<5 , 3<5 2 7.0)7>5 , <5.4 1 7<5 , 7>5 1 *5
'ere! the second investment adviser has the larger abnormal return and thus
appears to be the better selector of individual stocks. &y making better
predictions! the second adviser appears to have tilted his portfolio to"ard under-
priced stocks.
c. 9f rf 1 ;5 and r% 1 765! then:
7 17+5 , 3;5 2 7.6)765 , ;5.4 1 7+5 , *75 1 ,*5
* 1 7<5 , 3;52 7.0)765 , ;5.4 1 7<5 , 765 1 75
'ere! not only does the second investment adviser appear to be a better stock
selector! but the first adviserHs selections appear valueless )or "orse..
21.
a. $ince the market portfolio! by definition! has a beta of 7.0! its e#pected rate of
return is 7*5.
b. 1 0 means the stock has no systematic risk. 'ence! the portfolioHs e#pected
rate of return is the risk-free rate! >5.
c. Bsing the $%(! the fair rate of return for a stock "ith 1 ,0.6 is:
/)r. 1 >5 2 ),0.6.)7*5 , >5. 1 0.05
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
The expected rate of return! using the e#pected price and dividend for ne#t year:
/)r. 1 )?>>8?>0. , 7 1 0.70 1 705
&ecause the e#pected return e#ceeds the fair return! the stock must be under-
priced.
22. The data can be summariFed as follo"s:
a. Using the SML, the expected rate of return for any portfolio P is:
/)rP. 1 rf 2 3/)r%. , rf 4
Substituting for portfolios A and B:
/)rA. 1 <5 2 0.@ )7*5 , <5. 1 70.@5
/)r&. 1 <5 2 7.6 )7*5 , <5. 1 76.05
Hence, Portfolio A is desirable and Portfolio B is not.
b. The slope of the CAL supported by a portfolio P is given by:
$ 1
P
f P
L
r . /)r
Computing this slope for each of the three alternative portfolios, we have:
$ )$MP 600. 1 <8*0
$ )A. 1 6870
$ )&. 1 @8;7
'ence! portfolio A "ould be a good substitute for the $MP 600.
23. $ince the beta for Portfolio - is Fero! the e#pected return for Portfolio - equals the
risk-free rate.
-or Portfolio A! the ratio of risk premium to beta is: )705 >5.87 1 <5
The ratio for Portfolio / is higher: )+5 >5.8)*8;. 1 7.65
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
This implies that an arbitrage opportunity e#ists. -or instance! you can create a
Portfolio "ith beta equal to 7.0 )the same as the beta for Portfolio A. by taking a long
position in Portfolio / and a short position in Portfolio - )that is! borro"ing at the risk-
free rate and investing the proceeds in Portfolio /.. -or the beta of to equal 7.0! the
proportion )". of funds invested in / must be: ;8* 1 7.6 )N/ 1 *8;.
The e#pected return of is then:
/)r. 1 3)0.60. >54 2 )7.6 +5. 1 77.65
1 7.6 )*8;. 1 7.0
Comparing Portfolio to Portfolio A! has the same beta and a higher e#pected
return. Co"! consider Portfolio '! "hich is a short position in Portfolio A "ith the
proceeds invested in Portfolio :
' 1 7 2 )7.A 1 )7 7. 2 3)7. 74 1 0
/)r'. 1 )7 r. 2 3)7. rA4 1 )7 77.65. 2 3) 7. 7054 1 7.65
The result is a Fero investment portfolio )all proceeds from the short sale of Portfolio A
are invested in Portfolio . "ith Fero risk )because = 0 and the portfolios are "ell
diversified.! and a positive return of 7.65. Portfolio ' is an arbitrage portfolio.
24. $ubstituting the portfolio returns and betas in the e#pected return-beta relationship! "e
obtain t"o equations in the unkno"ns! the risk-free rate )rf . and the factor return )-.:
7>.05 1 rf 2 7 )- , rf .
7>.@5 1 rf 2 7.7 )- , rf .
-rom the first equation "e find that - 1 7>5. $ubstituting this value for - into the second
equation! "e get:
7>.@5 1 rf 2 7.7 )7>5 , rf . rf 1 <5
25.
a. $horting equal amounts of the 70 negative-alpha stocks and investing the proceeds
equally in the 70 positive-alpha stocks eliminates the market e#posure and creates a
Fero-investment portfolio. Bsing equation 7.6! and denoting the market factor as E%!
the e#pected dollar return is 3noting that the e#pectation of residual risk )e. in
equation 7.@ is Fero4:
?7!000!000 30.0; 2 )7.0 E%.4 , ?7!000!000 3),0.0;. 2 )7.0 E%.4
1 ?7!000!000 0.0< 1 ?<0!000
The sensitivity of the payoff of this portfolio to the market factor is Fero because the
e#posures of the positive alpha and negative alpha stocks cancel out. )Cotice that
the terms involving E% sum to Fero.. Thus! the systematic component of total risk
also is Fero. The variance of the analystHs profit is not Fero! ho"ever! since this
portfolio is not "ell diversified.
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
-or n 1 *0 stocks )i.e.! long 70 stocks and short 70 stocks. the investor "ill have a
?700!000 position )either long or short. in each stock )?7 million for a portfolio..
Cet market e#posure is Fero! but firm-specific risk has not been fully diversified.
The variance of dollar returns from the positions in the *0 firms is: )Lp
*
1 N
*
Lm
*
2
Le)i.
*
! "hile systematic risk 1 0! variance includes only firm-specific risk. Cote:
corelation coefficient of firm-specific risk 1 0..
*0 3)700!000 0.;0.
*
4 1 7@!000!000!000 (30" =# 0.3$%100.000
The standard deviation of dollar returns is ?7;>!7<>.
b. 9f n 1 60 stocks )i.e.! *6 long and *6 short.! ?>0!000 is placed in each position!
and the variance of dollar returns is:
60 3)>0!000 0.;0.
*
4 1 7!*00!000!000
The standard deviation of dollar returns is ?@>!@6;.
$imilarly! if n 1 700 stocks )i.e.! 60 long and 60 short.! ?*0!000 is placed in
each position! and the variance of dollar returns is:
700 3)*0!000 0.;0.
*
4 1 ;!<00!000!000
The standard deviation of dollar returns is ?<0!000.
Cotice that "hen the number of stocks increases by a factor of 6 )from *0 to 700.!
standard deviation falls by a factor of 6 1 *.*;<! from ?7;>!7<> to ?<0!000.
26. Any pattern of returns can be Je#plainedJ if "e are free to choose an indefinitely large
number of e#planatory factors. 9f a theory of asset pricing is to have value! it must
e#plain returns using a reas&na'(y (imite) number of e#planatory variables )i.e.!
systematic factors..
27. The APT factors must correlate "ith maAor sources of uncertainty! i.e.! sources of
uncertainty that are of concern to many investors. Eesearchers should investigate
factors that correlate "ith uncertainty in consumption and investment opportunities.
=P! the inflation rate and interest rates are among the factors that can be e#pected to
determine risk premiums. 9n particular! industrial production )9P. is a good indicator of
changes in the business cycle. Thus! 9P is a candidate for a factor that is highly
correlated "ith uncertainties related to investment and consumption opportunities in the
economy.
28. The revised estimate of the e#pected rate of return of the stock "ould be the old
estimate plus the sum of the une#pected changes in the factors times the sensitivity
coefficients! as follo"s:
Eevised estimate 1 7>5 2 3)7 7. 2 )0.> 7.4 1 76.>5 (c*an+e=1"
2!. /quation 7.77 applies here:
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
/)rP. 1 rf 2 P73/)r7. rf4 2 P*3/)r*. , rf4
0e need to find the risk premium for these t"o factors:
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
7 1 3/)r7. rf4 and
* 1 3/)r*. rf4
To find these values! "e solve the follo"ing t"o equations "ith t"o unkno"ns:
>05 1 75 2 7.@7 2 *.7*
705 1 75 2 *.07 2 )0.6.*
The solutions are: 7 1 >.>75 and * 1 77.@<5
Thus! the e#pected return-beta relationship is:
/)rP. 1 75 2 >.>7P7 2 77.@<P*
30. The first t"o factors )the return on a broad-based inde# and the level of interest rates.
are most promising "ith respect to the likely impact on OenniferIs firmIs cost of capital.
These are both macro factors )as opposed to firm-specific factors. that can not be
diversified a"ayK consequently! "e "ould e#pect that there is a risk premium associated
"ith these factors. Pn the other hand! the risk of changes in the price of hogs! "hile
important to some firms and industries! is likely to be diversifiable! and therefore is not
a promising factor in terms of its impact on the firmIs cost of capital.
31. $ince the risk free rate is not given! "e assume a risk free rate of 05. The APT required
)i.e.! equilibrium. rate of return on the stock based on Ef and the factor betas is:
Eequired /)r. 1 0 2 )7 # <. 2 )0.6 # *. 2 )0.76 # >. 1 705
According to the equation for the return on the stock! the actually e#pected return on
the stock is < 5 )because the e#pected surprises on all factors are Fero by definition ,
mean value of Fero , so factor values represent realiFed surprises relative to prior
e#pectation.. &ecause the actually e#pected return based on risk is less than the
equilibrium return! "e conclude that the stock is overpriced.
C-A 7
a! c and d
C-A *
a. /)rQ. 1 65 2 0.@)7>5 , 65. 1 7*.*5
Q 1 7>5 , 7*.*5 1 7.@5
/)rG. 1 65 2 7.6)7>5 , 65. 1 7@.65
G 1 775 , 7@.65 1 ,7.65
b.
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
)i. -or an investor "ho "ants to add this stock to a "ell-diversified equity
portfolio! Ray should recommend $tock Q because of its positive
alpha! "hile $tock G has a negative alpha. 9n graphical terms! $tock
QIs e#pected return8risk profile plots above the $%(! "hile $tock GIs
profile plots belo" the $%(. Also! depending on the individual risk
preferences of RayIs clients! $tock QIs lo"er beta may have a
beneficial impact on overall portfolio risk.
)ii. -or an investor "ho "ants to hold this stock as a single-stock
portfolio! Ray should recommend $tock G! because it has higher
forecasted return and lo"er standard deviation than $tock Q. $tock
GIs $harpe ratio is:
)0.77 , 0.06.80.*6 1 0.>@
$tock QIs $harpe ratio is only:
)0.7> , 0.06.80.;< 1 0.*6
The market inde# has an even more attractive $harpe ratio:
)0.7> , 0.06.80.76 1 0.<0
'o"ever! given the choice bet"een $tock Q and G! G is superior.
0hen a stock is held in isolation! standard deviation is the relevant
risk measure. -or assets held in isolation! beta as a measure of risk is
irrelevant. Although holding a single asset in isolation is not typically
a recommended investment strategy! some investors may hold "hat is
essentially a single-asset portfolio )e.g.! the stock of their employer
company.. -or such investors! the relevance of standard deviation
versus beta is an important issue.
C-A ;
a. %cRay should borro" funds and invest those funds proportionally in %urrayIs
e#isting portfolio )i.e.! buy more risky assets on margin.. 9n addition to
increased e#pected return! the alternative portfolio on the capital market line
)C%(. "ill also have increased variability )risk.! "hich is caused by the higher
proportion of risky assets in the total portfolio.
b. %cRay should substitute lo" beta stocks for high beta stocks in order to reduce
the overall beta of GorkIs portfolio. &y reducing the overall portfolio beta!
%cRay "ill reduce the systematic risk of the portfolio and therefore the
portfolioIs volatility relative to the market. The security market line )$%(.
suggests such action )moving do"n the $%(.! even though re),cin+ 'eta may
res,(t in a s(i+*t (&ss &f p&rtf&(i& efficiency ,n(ess f,(( )iversificati&n is
maintaine). GorkIs primary obAective! ho"ever! is not to maintain efficiency
but to reduce risk e#posureK reducing portfolio beta meets that obAective.
&ecause Gork does not permit borro"ing or lending! %cRay cannot reduce risk
by selling equities and using the proceeds to buy risk free assets )i.e.! by lending
part of the portfolio..
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
C-A >
a. S&oth the CAP% and APT require a mean-variance efficient market portfolio.T
This statement is incorrect. The CAP% requires the mean-variance efficient
portfolio! but APT does not.
b. SThe CAP% assumes that one specific factor e#plains sec,rity ret,rns but APT
does not.T This statement is correct.
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a
C-A <
d
C-A 7
d Gou need to kno" the risk-free rate.
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d Gou need to kno" the risk-free rate.
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Bnder the CAP%! the only risk that investors are compensated for bearing is the risk
that cannot be diversified a"ay )i.e.! systematic risk.. &ecause systematic risk
)measured by beta. is equal to 7.0 for each of the t"o portfolios! an investor "ould
e#pect the same rate of return from each portfolio. %oreover! since both portfolios are
"ell diversified! it does not matter "hether the specific risk of the individual securities
is high or lo". The firm-specific risk has been diversified a"ay from both portfolios.
C-A 70
b rf 1 @5 and /)r%. 1 7<5
/)rQ. 1 rf 2 Q3/)r%. , rf4 1 @5 2 7.0)7<5 @5. 1 7<5
/)rG. 1 rf 2 G3/)r%. , rf4 1 @5 2 0.*6)7<5 @5. 1 705
Therefore! there is an arbitrage opportunity.
C-A 77
c
C-A 7*
d
C-A 7;
c
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Chapter 07 - Capital Asset Pricing and Arbitrage Pricing Theory
9nvestors "ill take on as large a position as possible only if the mis-pricing
opportunity is an arbitrage. Pther"ise! considerations of risk and
diversification "ill limit the position they attempt to take in the mis-priced
security.
C-A 7>
d
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