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i. Historical rates of return for the market and for Stock A are given below:
1 6.0% 8.0%
2 -8.0 3.0
3 -8.0 -2.0
4 18.0 12.0
If the required return on the market is 11 percent and the risk-free rate is 6 percent, what is
a. 6.00%
b. 6.57%
c. 7.25%
d. 7.79%
e. 8.27%
CAPM and required return Answer: a Diff: M
ii. Some returns data for the market and for Countercyclical Corp. are given below:
The required return on the market is 14 percent and the risk-free rate is 8 percent. What is
a. 3.42%
b. 4.58%
c. 8.00%
d. 11.76%
e. 14.00%
iii. Stock X, Stock Y, and the market have had the following returns over the past four years.
Year Market X Y
2000 7 4 -3
2001 17 12 21
2002 -3 -2 -5
The risk-free rate is 7 percent. The market risk premium is 5 percent. What is the required
rate of return for a portfolio that consists of $14,000 invested in Stock X and $6,000 invested
in Stock Y?
a. 9.94%
b. 10.68%
c. 11.58%
d. 12.41%
e. 13.67%
Portfolio return Answer: b Diff: M
iv. The risk-free rate, kRF, is 6 percent and the market risk premium,
(kM – kRF), is 5 percent. Assume that required returns are based on the CAPM. Your $1 million
portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested in a
stock that has a beta of 0.8. Which of the following statements is most correct?
b. If the risk-free rate remains unchanged but the market risk premium increases by 2 percentage
points, the required return on your portfolio will increase by more than 2 percentage points.
c. If the market risk premium remains unchanged but expected inflation increases by 2 percentage
points, the required return on your portfolio will increase by more than 2 percentage points.
d. If the stock market is efficient, your portfolio’s expected return should equal the expected return on
Y 20 million 1.0
Z 40 million 0.8
The manager plans to sell his holdings of Stock Y. The money from the sale will be used to
purchase another $15 million of Stock X and another $5 million of Stock Z. The risk-free rate is
5 percent and the market risk premium is 5.5 percent. How many percentage points higher will
a. 0.07%
b. 0.18%
c. 0.39%
d. 0.67%
e. 1.34%
i. CAPM and required return Answer: e Diff: M
kA = 6% + (11% - 6%)bA.
Calculate bA as follows using a financial calculator:
6 Input 8 +
-8 Input 3 +
-8 Input -2 +
18 Input 12 +
0 y ,m
swap bA = 0.4534.
kA = 6% + 5%(0.4534) = 8.2669% 8.27%
0 y ,m
swap bC = -0.76.
kC = 8% + (14% - 8%)(-0.76) = 8% - 4.58% = 3.42%.
Calculate bX and bY for the stocks using the regression function of a calculator.
bX = 0.7358; bY = 1.3349.
kX = 7% + 5%(0.7358) = 10.679%.
kY = 7% + 5%(1.3349) = 13.6745%.
kp = 14/20(10.679%) + 6/20(13.6745%) = 11.58%.
Answer: b Diff: M
Statement b is correct; all the other statements are false. If the market risk premium increases by 2 percent and k RF
remains unchanged, then the portfolio’s return will increase by 2%(1.08) = 2.16%. Statement a is false, since k p = 6% +
(5%)bp. The portfolio’s beta is calculated as 0.7(1.2) + 0.3(0.8) = 1.08. Therefore, k p = 6% + 5%(1.08) = 11.4%.
Statement c is false. If kRF increases by 2 percent, but RPM remains unchanged, the portfolio’s return will increase by 2
percent. Statement d is false. Market efficiency states that the expected return should equal the required return; therefore,
k^ p = kp = 11.4%.
Answer: c Diff: M
Find the initial portfolio’s beta and its required return. Then, find the new beta and new required return.
Then subtract the two.
Step 1: The portfolio beta is the weighted average beta of the stocks in the portfolio. The total invested is $70
million ($10 + $20 + $40).
bOld =
( $$ 1070 ) (1.4) +
( $$ 2070 ) (1.0) +
( $$ 4070 ) (0.8)
bOld = 0.9429.
Step 2: Now, change the weights. The amount of X owned is now $25 million ($10 + $15), the
amount of Y owned is now $0 million, and the amount of Z owned is $45 million ($40 +
$5).
bNew =
( $$ 2570 ) (1.4) +
( $$700 ) (1.0) +
( $$ 4570 ) (0.8)
bNew = 1.0143.