AndyNZ

Callard Corp. stock has a beta of 1.5. If the current risk-free interest rate is 6%, and the expected return on the market is 14%, what is the expected rate of return for Callard Corp.’s stock?

A) 20%.

B) 18%.

C) 14%.

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ERcc = 0.06 + 1.5(0.14 − 0.06) = 18%

AndyNZ

Howard Michaels, CFA, is an analyst for Donaldson Associates. Michaels is considering recommending a position in the retail sector for Donaldson’s institutional clients. Michaels has gathered the following information to help his guide his decision. Based on previous research, Michaels expects the market and Treasury bills to return 10% and 4%, respectively.

Company [td] $1 Discount Store	Everything $5 [/td]
Forecasted Return	12%	11%
Standard Deviation of Returns	8%	10%
Beta	1.5	1.0

What would be the expected return for each investment, assuming the capital asset pricing model (CAPM) holds?

Discount

Everything

A) 13% 10%

B) 19% 10%

C) 19% 14%

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The expected return is the return predicted by the CAPM for a given level of systematic risk (β). To calculate the expected return for each investment, use the following formula:

E(Ri) = RF + βi (E(RM – RF))

Therefore, the required for $1 Discount = 4% + 1.5(10% – 4%) = 13%. Similarly, the expected return for Everything $5 = 4% + 1.0(10% – 4%) = 10%.

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According to the CAPM which investment is either underpriced, overpriced, or properly priced?

Discount

Everything

A) Underpriced Properly priced

B) Underpriced Overpriced

C) Overpriced Underpriced

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According to the CAPM, $1 Discount Stores requires a return of 13% based on its systematic risk level of β = 1.5. However, the forecasted return is only 12%. Therefore, the security is current overvalued.
According to the CAPM Everything $5 requires a return of 10% based on its systematic risk level of β = 1.0. However, the forecasted return is 11%. Therefore, the security is current undervalued.
To illustrate this result graphically, we plot both securities in relation to the security market line (SML). Note that β is in the independent variable on the X-axis, not σ (total risk). Since $1 Discount is overvalued, it plots below the line while Everything $5 is undervalued and plots above the SML.

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Harry Jordan, an associate of Michaels, recommends the $1 Discount Store investment because it has a higher forecasted return and lower risk. Is Jordan’s assertion correct?

A) Yes, because from the table, we can confirm Jordan's statement that Discount has a higher return and lower risk than everything.

B) No, since capital market theory states that the return on investment is based on the amount of total risk in the investment.

C) No, because according to the CAPM model it has been determined that Discount is overvalued.

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Jordan is incorrect by basing his claim on the use of standard deviation (total risk) as the measure of risk. Capital market theory asserts that the return on an investment is based on the amount of systematic risk in the investment (β). Because the unsystematic, or security specific portion of total risk can be diversified away, an investor is only compensated for assuming systematic risk.

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Which of the following is least likely an assumption that is necessary to derive the CAPM?

A) Investors expectations are homogeneous.

B) Markets are perfectly competitive.

C) Limited risk-free borrowing.

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The CAPM assumes that unlimited risk-free borrowing and lending is permitted.

AndyNZ

According to the capital asset pricing model (CAPM), if the expected return on an asset is too low given its beta, investors will:

A) sell the stock until the price falls to the point where the expected return is again equal to that predicted by the security market line.

B) sell the stock until the price rises to the point where the expected return is again equal to that predicted by the security market line.

C) buy the stock until the price rises to the point where the expected return is again equal to that predicted by the security market line.

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The CAPM is an equilibrium model: its predictions result from market forces acting to return the market to equilibrium. If the expected return on an asset is temporarily too low given its beta according to the SML (which means the market price is too high), investors will sell the stock until the price falls to the point where the expected return is again equal to that predicted by the SML

AndyNZ

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

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

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

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The CML is derived by using the risk-free rate, portfolio variance (standard deviation), market variance (standard deviation), and expected market return to calculate expected portfolio returns.

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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) Markets are perfectly competitive.

C) Represented by a multi-factor model.

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The CAPM is represented by a single factor model with the factor being market risk. The APT is a multifactor model where several factors could be used to explain the model's returns.

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

A) Management tenure and qualifications.

B) Companies’ position in the business cycle.

C) Changes in payout ratios.

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Microeconomic factors are factors measured by characteristics of the companies themselves, like price-to-earnings (P/E) ratios or growth rates. Macroeconomic factors are economic influences on security returns. A company’s position in the business cycle is dependent on the cycle itself, and cannot be accurately measured by looking at a company’s fundamentals. Payout ratios and management tenure are pieces of company-specific data suitable for use in a microeconomic factor model.

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

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

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

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

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APT, the zero-beta CAPM, and the security market line (part of the CAPM) are all theoretical models in that they require the use of assumptions that are impossible to justify rationally. Discounted cash flows (DCF) require some estimation, but the calculations are based on real, tangible data. In addition, DCF models are not difficult to test, and studies have shown that valuation strategies based on discounted cash flows can be successful at picking winning stocks. Since Vista is a literal thinker and prefers tangible solutions, she is most likely to use the discounted cash flow approach to valuation rather than a theoretical model.

AndyNZ

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) 1.3.

B) 2.5.

C) 3.9.

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Using the Capital Asset Pricing Model:

6% + beta (9%) = 17.7%
beta = 1.3

AndyNZ

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) 17.4.

B) 17.1.

C) 10.4.

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ERstock = Rf + ( ERM − Rf ) Betastock

AndyNZ

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) 10.6%.

B) 6.6%.

C) 8.0%.

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ERstock = 0.05 + 0.8(0.07) = 10.6%

AndyNZ

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%.

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ERstock = 0.06 + 1.2(0.12 − 0.06) = 13.2%

AndyNZ

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.

Stock	Beta	F(R)
A	0.5	0.065
B	1.0	0.095
C	1.5	0.115
Risk-free	0.0	0.030
Market	1.0	0.090

Based on the information in the above table, the expected returns for stocks A, B, and C for a risk-averse investor are:

A

B

C

A) 4.5% 9.0% 13.5%

B) 6.0% 9.0% 12.0%

C) 6.5% 9.5% 11.5%

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>
The expected rate of return for any individual security or portfolio can be calculated using the capital asset pricing model (CAPM):

E(R) = rf + Bi(RM – rf)

Expected rate of return for A = 0.03 + 0.5(0.09 – 0.03) = 0.03 + 0.03 = 0.06 or 6.0%.
Expected rate of return for B = 0.03 + 1.0(0.09 – 0.03) = 0.03 + 0.06 = 0.09 or 9.0%.
Expected rate of return for C = 0.03 + 1.5(0.09 – 0.03) = 0.03 + 0.09 = 0.12 or 12.0%.

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Based on the information in the above table, which of the stocks should be held long in a well-diversified portfolio?

A) A, B, and C.

B) Both A and B.

C) A only.

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The first step is to calculate the expected rate of return for each security using the capital asset pricing model (CAPM):

E(R) = rf + Bi(RM – rf).

Expected rate of return for A = 0.03 + 0.5(0.09 – 0.03) = 0.03 + 0.03 = 0.06 or 6.0%.
Expected rate of return for B = 0.03 + 1.0(0.09 – 0.03) = 0.03 + 0.06 = 0.09 or 9.0%.
Expected rate of return for C = 0.03 + 1.5(0.09 – 0.03) = 0.03 + 0.09 = 0.12 or 12.0%.The next step is to compare the forecasted return (FR) for each security with the expected return.

• If the forecasted return is greater than the expected return, then the stock is under-priced and should be included in the portfolio.
• If the FR is less than the expected return, then the security is over-priced and should not be included in the portfolio.

The forecasted returns for stocks A and B are greater than their expected returns. Therefore, both A and B should be included in the portfolio and not stock C.

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Based on the information in the above table, which stocks are currently in equilibrium?

A) Stocks A and B are in equilibrium.

B) None of the stocks are in equilibrium.

C) All of the stocks are in equilibrium.

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Stocks in equilibrium are properly priced and will lie on the security market line. The forecasted return for the individual security will equal the expected return based on the CAPM. The first step is to calculate the expected rate of return for each security using the CAPM:

E(R) = rf + Bi(RM − rf).

Expected rate of return for A = 0.03 + 0.5(0.09 − 0.03) = 0.03 + 0.03 = 0.06 or 6.0%.
Expected rate of return for B = 0.03 + 1.0(0.09 − 0.03) = 0.03 + 0.06 = 0.09 or 9.0%.
Expected rate of return for C = 0.03 + 1.5(0.09 − 0.03) = 0.03 + 0.09 = 0.12 or 12.0%.
Based on the expected returns given in Table 1 and the calculated required returns for stocks A, B, and C, none of the stocks are in equilibrium.

AndyNZ

The covariance between stock A and the market portfolio is 0.05634. The variance of the market is 0.04632. The beta of stock A is:

A) 1.2163.

B) 0.8222.

C) 0.0026.

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Beta = Cov(RA,RM) / Var(RM) = 0.05634/0.04632 = 1.2163.