ReviewProblems:

with
Cov(e, )=0.Alsoassumethatstockjhasabetaof1.5,astandarddeviationofexcess
returnsof.4,andthatthemarketexcessreturnhasastandarddeviationof.1.
a. FindE[
b. FindVar[ ]
c. Whatproportionoftheassetjsvarianceissystematic?
d. Whatdeterminessystematicrisk?Toanswerthisquestionusetheformulasfor
thesystematicrisk.
e. Whatproportionofthevarianceisunsystematic?

1. Assumetheexcessreturnonstockjcanbewrittenas

f. Whatisthetotalsystematicandunsystematicvarianceinstockj?
g. WhatisRSquared?Toanswerthisquestionfirstanswerwithwordsandthenusinga
formulaandnotation.
h. Inthesimpleregressionabove(i.e.noteithasonlyoneexplanatoryvariable)whatisthe
relationbetweenthecorrelationbetweenRjandRMandtheRsquare?
i. Whatistheformulaforthebetashowninthemodelabove?
j. Whatistheformulaforthealphashownabove?
k. Whatistheformulaforthesecuritycharacteristiclineforassetj?

E[Rj]=j+jE[Rm]notethatE(e)=0.
Var[Rj]=Var[j+jRm+ej]=Var[jRm]+Var[ej]

=2(jRm)+2(ej)

=j22m+2(ej)

=systematicrisk+firmspecificrisk
Thismeansthatthesystematicvarianceinstockjsexcessreturnsisequalto
j22mandthatthefirmspecificvarianceis2(ej).
Thismeansthatthetotalriskinvolvedisj22m+2(ej)
Thisalsomeansthatratioofassetjssystematicrisktototalriskis
j22m/[j22m+2(ej)]<thisistheanswertoc
Basedontheformulasshownabovesystematicriskismeasuredasj22m
showingthatafirmsoverallsystematicriskwillbedeterminedbyboththe
marketvolatilityandfirmsssensitivitytothemarketascapturedbybeta(see
bookdiscussionfrom1681728ed,1701739ed)
Iftheproportionofoverallriskthatsystematicisasfollows:
j22m/[j22m+2(ej)]then1minusthisproportionwillbethe
proportionofoverallriskthatisunsystematic.
1


Puttingitalltogether:
Systematicriskinjsreturns=j22m=1.5*1.5*.1*.1=.0225
Totalrisk(variance)injsreturns=2j=.4*.4=.16

Proportionofvariancethatissystematic=j22m/[j22m+2(ej)]
=.0225/.16=.1406
Rsquareistheratiooftheexplainedvariancetototalvariance.Inotherwordsit
representstheproportionofthevariationinthedependentvariableexplainedby
theexplanatoryvariable.Usingnotationfromaboveitwouldbej22m/[j22m
+2(ej)]
=.0225/.16=.1406
IfpisthecorrelationbetweenRjandRMthenp2istheRsquarevalue
TheformulaforthebetaisCov(Rj,RM)/Var(RM).
TheformulafortheinterceptisIntercept=Average(Rj) average(RM).Notethatif
Igaveyoutheaveragevaluesusedinthisformulathatyoucouldsolveforthe
intercept.
ThesecuritycharacteristiclineforassetjwouldbeRj=intercept+beta(Rm)

2. Drawthe3figures(withlabeledaxis)thatshowcasethefollowingterms:CAL,CML,
efficientfrontier,SML,alpha,minimumvarianceportfolio,tangentportfolio,security
characteristicline,intercept,regressionline,beta,Rsquare,sharperatio,riskfreerate,
standarddeviation.

See3bookfiguresandrelateddiscussioninthetext(6.10+6.11+7.1),(6.12+7.4),and
(7.2)

3. Whatfeestructurewascommonathedgefundsafewyearsago?
20%ofprofits+aflatmanagementfeeof1.52%ofassets.

4. Assumetheriskfreerateis4%.Assumethehistoricalmarketriskpremiumis9%.Assume
investorsanticipatethatstockXwithabetaof0.9toofferarateofreturnof12percent.

A) WhatwilltheCAPMexpectedreturnofthestockbe,assumingthebetaofthestockand
theoverallexpectedmarketreturndonotchange?
2

CAPMsuggeststhattheexpectedreturnshouldbe 0.04 0.9 * (0.09) 12.1%

12.1%
B) Giventhisinformation,whatwouldhappeninthemarket?Howwouldtheprice
change?

CAPMsuggeststhattheexpectedreturnshouldbe 0.04 0.9 * (0.09) 12.1% so

themarketsexpectationislessthanthatspecifiedbytheCAPM.Thismeansthat
investorswouldbebetteroffinvestinginotherassetsthatatleastprovidethe
appropriateexpectedreturnfortheamountofriskinvolved.
Inotherwords,E[r_X]<rf+beta*(E[r_M]rf)soinvestorswillnotbuythisstock.Theprice
willdecreaseuntilE[r_X]=rf+beta*(E[r_M]rf)

5. ThedataforthisquestionisintheexcelspreadsheetpostedonLearningSuiteentitleddatafor
thereviewproblemsformidterm2.
a. WritethetheoreticalversionoftheCAPMequation.
E[rj]=rf+betaj(E[rm]rf)
b. Toestimatethebetawetransformthisequationintoasingleindexmodel.Notethe
assumptionsandchangesthatareneededtowritethecorrespondingregression
equation.

WeassumethattheS&P500indexcanproxyfortheCAPMmarketportfolio.We
subtracttheriskfreeratefrombothsidesoftheequationsothatthedependent
variableintheregressionisrjrfandtheexplanatoryvariableisrmrf.Inwords,we
areregressingstockjsexcessreturnonthemarketexcessreturn.Notethatafterwe
subtracttheriskfreeratefrombothsidesoftheequationthattheinterceptinthe
regressionisnottheriskfreerate.

Theregressionequationlookslike:rjrf=+(rmrf)+error

c. Now,inthespreadsheet,modifytherawreturndatasothatyoucanregresseach
stocksexcessreturnonthemarketexcessreturnandfindthestocksbetas.Calculate
StockXsandStockYsbetas.Interpretthebetas.

Seeexcessreturnstabinexcelfile.Accordingtomycalculationsthebetasare1.72
and1.11.

d. Whatdothestandarderror,pvalue,andRsquaredvaluesmean?

Thestandarderroronthebetacanbethoughtofconceptuallylikeastandarddeviation
ofbetaestimates.Thepvalueanswersthequestionofhowlikelyitisthatthereal
3

relationship(i.e.therealbeta)is0whenusingoursampleweestimatedittobethe
valuereported.

e. Whatrangeofnumbersaregenerallyusedtodescribetheaveragehistoricalrisk
premium?

Thetypicalrangeofvaluesis59%.InclassIsaidthatIexpectthistobecloseto~5%
goingforward.

6. Assumeyouhaveaportfoliothatis$35,000inTBills,$50,000intheS&P500(i.e.$50,000in
themarket),and$15,000inIBM.AssumethatIBMhasabetaof.73,theriskfreerateis.04
andtheaveragehistoricalmarketriskpremiumis6%.
a. Whatistheportfoliobeta?
Theportfoliobetaisaweightedaverageofthebetasofthesecuritiesintheportfolio.
IBMhasabetaof.73,Tbillshaveabetaof0,andtheS&P500hasabetaof1.
Portfoliobeta=(35/100)(0)+(50/100)(1)+(15/100)(.73)=.705
b. Whatisthelongtermexpectedreturnontheportfolio?
E[r]=.04+.705(.06)=8.23%
c. Inpartawesawthattheportfoliobetaistheweightedaverageofthesecuritiesinthe
portfolio.Istheriskontheportfoliotheweightedaverageoftheriskintheindividual
securities?
Ifbyriskyouaretalkingaboutbeta(i.e.nondiversifiablerisk)thenthebetaof
theportfolioisjusttheweightedaverageoftheindividualbetas.Ifbyriskyou
aretalkingabouttotalriskthendiversificationmakestheriskintheportfolio
notequaltotheweightedaverageofthetotalriskinthesecurities.
7. Trueorfalse?Explainorqualifyeachasnecessary.

a. Investorsdemandhigherexpectedratesofreturnonstockswithmorevariableratesof
return.
b. TheCAPMpredictsthatasecuritywithabetaof0willofferazeroexpectedreturn.
c. Aninvestorwhoputs$10,000inTreasurybillsand$20,000intheaveragemarket
portfoliowillhaveabetaof2.0.
d. Investorsdemandhigherexpectedratesofreturnfromstockswithreturnsthatarevery
sensitivetofluctuationsinthestockmarket.
e. Investorsdemandhigherexpectedratesofreturnfromstocksofsmallcompaniesthan
stocksoflargecompanies.
4


Solutions
FALSE TheCAPMindicatesthattheexpectedreturnisafunctionofafirm'sbeta.Thebetaincreasesin
thecovarianceofthereturnswiththemarket,notnecessarilyinthevariabilityofthereturnsofthe
stock.

FALSE TheCAPMpredictsanexpectedreturnequaltotheriskfreeratewhenthebetaiszero.

FALSE AssumeTreasuryBillstobelikeariskfreeassetwithbeta=0.Themarketportfoliohasabeta
equalto1.Sointhisportfolioyouwouldexpect(1/3)(0)+(2/3)(1)=(2/3)tobetheportfolio
beta

TRUE Ifby"verysensitive"youmeanhighlypositivelycorrelatedwiththemarketfluctuationsthenyes
thehigherthepositivecorrelationthehigherthebetawhichmeansthehighertheexpected
return. Onecouldarguethat"verysensitive"couldalsomeanhighlynegativelycorrelatedwith
themarketmovements.IfthisisthecasethentheanswerwouldbeFALSEbecausethebeta
wouldbenegative.

FALSE Theexpectedreturnisafunctionofthebetaofthestockindependentofsize. Itmaybetrue

thatsmallfirm'sstockstendtohavehigherbetasbutthisisnot trueforallsmallfirms.

8. Compareclosedendandopenendfunds.Howaretheysimilar?Howdotheydiffer?
a. Openend
i. AlwaysredeemableatNAVsopriceandNAVdontdiverge
ii. Whenopenendfundholdersliquidatetheirholdingsthesharesaresoldbackto
thefund
iii. Donttradeonexchange
iv. Boardofdirectors
v. Hiredmanagementcompany
b. Closedend
i. Whenclosedendfundholdersliquidatetheirholderstheydontsellbackto
thefund,insteadtheyfindsomeoneelsetobuytheirholdings.
ii. Sharestradedonexchanges.
iii. PriceisoftenlowerthantheNAV.
iv. Boardofdirectors
v. Hiredmanagementcompany

9. Dohedgefundshavethesamefeestructureasmutualfunds?
Nowhereasmutualfundshavethefrontend,annual,andbackendfeesasdiscussed
inclass,thehedgefundmanagerstendtoclaimaround20%oftheprofitseachyearin
additionto12%ofassetvalueundermanagement.
5

10. Whatroledoescompetitionplayintheefficientmarketshypothesis?
a. Itisthroughcompetitionforprofitthatinformationheldbyindividualsgetsimpounded
intheprices.
11. DescribewhatalphaisontheSMLplot,intheDardencase,andinaregression.
a. TheverticaldistancefromtheSMListhealphaontheplot.
b. IntheDardencasewetalkedaboutriskadjustedreturnsasbeingconceptuallylike
alpha.
c. Inaregressionofstockjsexcessreturnonthemarketexcessreturns,theestimated
interceptisthealpha.Ifitissignificantitindicatesthatthereissomethingsystematic
thatexplainsthereturnsthatisnotcapturedbythebeta.
12. Whymightsomeonesaythattheyareseekingpositivealphas?
a. Ifalphacapturestheportionofthereturnnotexplainedbybetaanditispositiveit
representspositivereturnsaboveandbeyondwhattheriskwouldjustify.
13. CAPM:
a. Whatassumptionsareusedtoderivethemodel?
i. Seelistinslides,homework,orassignedreading.
b. Dotheassumptionsholdintherealworld?Ifnot,whatdoesthisimplyaboutCAPMs
applicabilitytoourworld?
i. Nowehavedifferenttaxrates,differenttransactioncosts,different
informationsets,andaccesstodifferentassets.Theseviolationsofthetheorys
assumptionsimplythatweeachwouldcalculateaslightlydifferentefficient
frontierandtangencyportfolio.Despitetheassumptionviolations,themain
intuitionoftheCAPMstillholds:thereisariskreturnrelation,onlynon
diversifiableriskiscompensatedinexpectation,thereisaprice
ofrisk.
c. Dobetasexplainthevariationweobserveintheactualdata?DoesCAPMdoagoodjob
inexplainingreturns?
i. Betasexplainedvariationinreturnspriorto1980butarenotgoodatpredicting
returnstoday.SotheCAPMdoesapoorjobofexplainingreturns.
d. Whatotherfactorshavebeenshowntoexplainreturns?Aretheseconsistentwith
CAPM?Aretheyconsistentwithmarketefficiency?
i. Seediscussionofeffectsandanomalies(i.e.B/M,size,momentum,etc.)
e. DescribethenatureofsomeofthetestspeoplehaveusedtotesttheCAPM?
i. Arehistoricalreturnslinearlyrelatedtobetas?
ii. Doportfoliosortsformedbysortingonnonbetacharacteristics(i.e.,size,b/m,
etc)explainvariationinreturns?I.e.,isitvariationinthesortingcharacteristic
orinbetathatappearstobeexplainingvariationinreturns?
f. IfCAPMisflawed,whyisitsowidelyused?
i. Itiseasytouse
ii. Theintuitionbehindthemodeliscompelling
iii. Itprovidesabenchmark.Evenifweallunderstandthatitisfarfromperfect,it
providesastandardizedwaytocalculateandtalkaboutexpectedreturns.
6

g. HowisCAPMusedinpractice?
i. Costofequity/hurdlerate
ii. Expectedreturncalculations
iii. Benchmark
14. Whatistheintuitionbehindusingthedifferenceinreturnsbetweensmallandbig,andhigh
M/BandlowM/Bfirmsasfactorsinamultifactormodel?
a. Therearetwogeneralwaystoidentifyadditionalriskfactorsforfactormodels:
(1) identifymajorsystematicrisksfacinginvestors.Eachsourceofrisk
wouldcarryitsownriskpremium.
(2) Searchforcharacteristicsthatseemonempiricalgroundstoproxyfor
exposuretosystematicrisk.
b. FortheFamaFrenchmodeltheytookthesecondapproach.Differentsizedfirmsand
firmswithdifferentM/Bratiosappearedtohavesystematicallydifferentreturn
movements.Sobytakingthedifferenceinreturnsbetweenfirmswithopposite
characteristicsalongthesedimensionscreatesaproxymeasureoftheunderlyingrisk
factor.
15. Doyouexpectwellmanagedfirmstoprovidehighratesofreturn?Whyorwhynot?
Weexpectthemtohaverelativelyhighreturnoninvestmentsonthefinancialstatementsbut
wedonotexpectthemtonecessarilyhavehighreturnsontheirstockvalue.Thisisbecause
investorsexpectationforfuturecashflowsaffectstodaysprice.Henceinvestorswillexpect
relativelyhighcashflowsinthefuturefromawellruncompanywhichwillmakethecurrent
pricemoveup.Investorsthatbuyintothestockafterthepricehasalreadyriseninexpectation
willnotgainabnormalreturnsgoingforwardunlessthefirmproducesevenhigherfuturecash
flowsthanalreadyexpected.
16. YouwanttocalculatetheexpectedreturnatCocaColausingthe3factormodel.Youusedata
overthepast5yearstoestimatethefactorbetasofCocaColausingtheFamaFrench3factor
model.Specificallyyouregressthemonthlyexcessreturn(therealizedreturnineachmonth
minustheriskfreerate)ofCocaColasstockontheexcessreturnforeachofthe3factor
portfolios(rmrf,SmB,HmL).ByyourestimatestheFamaFrenchmodelbetasare:
Marketbeta=.15
SmBbeta=.30
HmLbeta=.49
Thecurrentriskfreemonthlyrateis.42%(i.e.,5%/12).Determinethecostofequitycapital
usingthese3factors.Todothisyouwillneedtheriskpremiumsforeachofthesefactors.
Assumetheaveragemonthlyhistoricalriskpremiumonthemarketis.64%,theaverage
monthlyhistoricalpremiumontheSmBis.17%,andtheaveragemonthlyhistoricalpremiumon
theHmLis.53%.

E[r]=.0042+.15*.0064+.30*.0017+.49*.0053
7

17. Twoinvestmentadvisersarecomparingperformance.Oneaverageda19%returnandthe
othera16%return.However,thebetaofthefirstadviserwas1.5whilethatofthesecondwas
1.Assumethemarketpremiumis8%.
a. Whichadviserwaslikelyabetterselectorofindividualstocks?
Inordertodeterminewhichinvestorwasabetterselectorofindividualstockswelook
attheabnormalreturn,whichistheexpostalpha;thatis,theabnormalreturnisthe
differencebetweentheactualreturnandthatpredictedbytheSML.Withoutadditional
information(i.e.,theriskfreerate)wecannotdeterminewhichinvestmentadviseris
thebetterselectorofindividualstocks.

Inpartsbandcwewillinvestigatewhatthesolutionwillbefordifferentriskfreerates
andhistoricalmarketpremiums.

b. Iftheriskreeratewere6%,whichadviserwouldbethesuperiorstockselector?
Ifrf=6%andusingalphafortheabnormalreturn:

1=19%[6%+1.5(8%)]=19%18%=1%

2=16%[6%+1.0(8%)]=16%14%=2%
Here,thesecondinvestmentadviserhasthelargerabnormalreturnandthusappearsto
bethebetterselectorofindividualstocks.Bymakingbetterpredictions,thesecond
adviserappearstohavetiltedhisportfoliotowardunderpricedstocks.

c. WhatiftheTbillratewere3%andthemarketriskpremiumwere12%(12%wouldbe
anexcessivelyhighassumption)?
Ifrf=3%andrM=15%,then:

1=19%[3%+1.5(12%)]=19%21%=2%

2=16%[3%+1.0(12%)]=16%15%=1%
Here,notonlydoesthesecondinvestmentadviserappeartobeabetterstockselector,
butthefirstadviser'sselectionsappearvalueless(orworse).

18. Doestheefficientmarketshypothesisimplythatyoucantmakeaprofit?
Notheefficientmarketshypothesissuggeststhatpricesreflectcurrentinformation.
Hencetheexpectedfuturecashflows(basedonexistinginformation)arealready
anticipatedanddiscountedattheriskappropriateratetoobtaincurrentprices.
(Rememberthatcurrentpricescanbethoughtoftheasthepresentvalueofallfuture
expectedcashflows.)Ifthefuturecashflowsoccuracrosstimeascurrentlyexpected

thenyouwillearntheratethatwasappliedthefuturecashflowstodiscountthem.I.e.,
youwillearnafairrateofreturngiventherisk.
19. Whatempiricalevidenceexiststhatsupporttheideaofmarketefficiency?Whatempirical
evidenceexiststhatisinconsistentwiththeideaofmarketefficiency?
Seechapter8andtheassociatedlectureslides.

20. AnopenendfundhasaNAvof$10.70pershare.Itissoldwithafrontendloadof6%.Whatis
theofferingprice?
Theofferingpriceincludesa6%frontendload,orsalescommission,meaningthateverydollar
paidresultsinonly$0.94goingtowardpurchaseofshares.Therefore:
Offeringprice=

NAV
$10.70
==$11.38

1 load 1 0.06

21. Aclosedendfundhasaportfoliocurrentlyworth$200million.Ithasliabilitiesof$3millionand
5millionsharesoutstanding.
a. WhatistheNAV?
b. Ifthefundsellsfor$36pershare,whatisthepremiumordiscountasapercentofNAV?

a. NAV=

$200 million $3million

=$39.40
5million

b. Premium(ordiscount)=

Pr ice NAV $36 $39.40

=
=0.086=8.6%
$39.40
NAV

Thefundsellsatan8.6%discountfromNAV
22. AfundstartedtheyearwithaNAVof$12.50.ByyearenditsNAVequaled$12.10.Thefund
paidyearenddistributionsofincomeandcapitalgainsof$1.50.Whatwastherateofreturnto
aninvestorinthefund?

Rateofreturn=

( NAV ) Distributions $0.40 $1.50

=
=0.0880=8.80%
Start of year NAV
$12.50

23. LoadedUpFundchargesa12b1feeof1%andmaintainsanexpenseratioof.75%.Economy
fundchargesafrontendloadof2%buthasno12b1feeandanexpenseratioof.25%.Assume
9

therateofreturnonbothfundsunderlyingportfolios(beforefees)is6%peryear.Howmuch
willaninvestmentineachfundgrowtoafter(a)1year,(b)3years,and(c)10years?Assumean
initialinvestmentof$100.
Assumeahypotheticalinvestmentof$100.

Loadedup

a.Year1=100x(1+.06.0175)=104.25

b.Year3=100x(1+.06.0175)^3=116.30

c.Year10=100x(1+.06.0175)^10=151.62

Economyfund

a.Year1=100x.98x(1+.06.0025)=103.64

b.Year3=100x.98x(1+.06.0025)^3=115.90

c.Year10=100x.98x(1+.06.0025)^10=171.41

24. Supposeyouobservetheinvestmentperformanceof350portfoliomanagersfor5yearsand
rankthembyinvestmentreturnsduringeachyear.After5years,youfindthat11ofthefunds
haveinvestmentreturnsthatplacethefundinthetophalfofthesampleeachandeveryyearof
yoursample.Suchconsistencyofperformanceindicatestoyouthatthesefundsmustbethe
fundswhosemanagersareinfactskilled,andyouinvestyourmoneyinthesefunds.Isyour
conclusionwarranted?

Supposethatfinishinginthetophalfofallportfoliomanagersispurelyluck,andthatthe
probabilityofdoingsoinanyyearisexactly.Thentheprobabilitythatanyparticularmanager
wouldfinishinthetophalfofthesamplefiveyearsinarowis()5=1/32.Wewouldthen
expecttofindthat[350(1/32)]=11managersfinishinthetophalfforeachofthefive
consecutiveyears.Thisispreciselywhatwefound.Thus,weshouldnotconcludethatthe
consistentperformanceafterfiveyearsisproofofskill.Wewouldexpecttofindeleven
managersexhibitingpreciselythislevelof"consistency"evenifperformanceisduesolelyto
luck.

25. Supposethateverytimeafundmanagertradesstock,transactioncostssuchascommissions
andbidaskspreadsamountto.4%ofthevalueofthetrade.Iftheportfolioturnoverrateof
50%,byhowmuchisthetotalreturnoftheportfolioreducedbytradingcosts?

10

Theturnoverrateis50%.Thismeansthat,onaverage,50%oftheportfolioissoldandreplaced
withothersecuritieseachyear.Tradingcostsonthesellordersare0.4%;andthebuyordersto
replacethosesecuritiesentailanother0.4%intradingcosts.Totaltradingcostswillreduce
portfolioreturnsby:20.4%0.50=0.4%

11