Reading 66: Portfolio Concepts Los e~Q13-24

Leslie, systems, capital, because, tangible

Q13. Leslie Vista has never been satisfied with the capital asset pricing model (CAPM) because of its restrictive assumptions. While the model seems to work fairly well in her own stock-valuation systems, she does not trust results that depend on assumptions that are unrealistic in the real world. Vista is a literal thinker and prefers tangible solutions. She does not hold with theory and rarely draws intuitive conclusions.

As an alternative to the CAPM, Vista decides to try out the arbitrage pricing model (APT). She likes the APT because it does not rely on the several assumptions that underlie the CAPM. Vista does some research comparing the CAPM to the APT and lists some of the assumptions of the CAPM:

Markets are perfectly competitive.
Investors use the Markowitz mean-variance framework.
Represented by a multi-factor model.
Unlimited risk-free lending and borrowing is permitted.

When Vista tells her boss, Mark Mazur, about her desire to use the APT, Mazur warns her of weaknesses in both models. Mazur also explains that the company has established the capital asset pricing model as its in-house valuation method and advises that Vista familiarize herself with how to derive the capital market line (CML) and the security market line (SML).

After reviewing studies on the CAPM and the APT, Vista decides to develop her own microeconomic multifactor model. She establishes a proxy for the market portfolio, then considers the importance of various factors in determining stock returns. She decides to use the following factors in her model:

Changes in payout ratios.
Credit rating changes.
Companies’ position in the business cycle.
Management tenure and qualifications.

In order to derive the CML, Vista needs the:

A) risk-free rate, market variance, portfolio variance, and expected market return.

B) expected market return, portfolio beta, and risk-free rate.

C) market variance, portfolio beta, risk-free rate, and expected portfolio return.

Q14.Vista’s analysis of CAPM assumptions is flawed. Which of the following assumptions that Vista noted is not part of the CAPM?

A) Investors use the Markowitz mean-variance framework.

B) Represented by a multi-factor model.

C) Markets are perfectly competitive.

Q15. Which of the following factors is least appropriate for Vista’s factor model?

A) Management tenure and qualifications.

B) Changes in payout ratios.

C) Companies’ position in the business cycle.

Q16. After further research on valuation models, Vista is most likely to use:

A) discounted cash flows, despite the need to estimate future cash flows and terminal values.

B) the zero-beta CAPM because it does not require the assumption that investors can borrow at the risk-free rate.

C) APT because it allows the use of a variety of factors.

Q17. What is the beta of Franklin stock if the current risk-free rate is 6%, the expected risk premium on the market portfolio is 9%, and the expected rate of return on Franklin is 17.7%?

A) 2.5.

B) 1.3.

C) 3.9.

Q18. Raj Shankar is a security analyst who uses the capital asset pricing model (CAPM) to determine the fair valuation for stocks. Recently, Shankar examined the prospects for Mini Software Solutions (MSS), a small software company operating in Southern California. Shankar makes the following forecasts for MSS and for the broad market:

Shankar’s forecasted return for MSS: 11%
Shankar’s forecasted beta for MSS: 1.25
Expected return on the stock market index: 12%
Risk-free rate: 4%

Using his framework of analysis, Shankar should derive the following expected return and buy/sell recommendation for MSS:

Expected Return Recommendation

A) 10% Sell

B) 14% Buy

C) 14% Sell

Q19. The market is expected to return 15% next year and the risk-free rate is 7%. What is the expected rate of return on a stock with a beta of 1.3?

A) 17.1.

B) 17.4.

C) 10.4.

Q20. What is the expected rate of return for a stock that has a beta of 0.8 if the risk-free rate is 5%, and the market risk premium is 7%?

A) 6.6%.

B) 8.0%.

C) 10.6%.

Q21. What is the expected rate of return for a stock that has a beta of 1.2 if the risk-free rate is 6% and the expected return on the market is 12%?

A) 7.2%.

B) 13.2%.

C) 12.0%.

Q22. Answer the following three questions based on the information in the table shown below for the risk-free security, market portfolio, and stocks A, B, and C. Their respective betas and forecasted returns based on fundamental analysis of the economy, industry, and specific company analysis are also provided.