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Practice Question - Chaptr 4

The document contains numerical examples and solutions related to calculating stock betas, required rates of return, expected returns, correlation coefficients, and standard deviations based on historical stock and market index data. Key calculations include determining betas using covariance and variance, required returns using the capital asset pricing model formula, and correlation coefficients by taking the covariance of stock and index returns divided by the product of their standard deviations. The examples analyze stocks' expected returns compared to their required returns to identify undervalued and overvalued stocks.

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125 views5 pages

Practice Question - Chaptr 4

The document contains numerical examples and solutions related to calculating stock betas, required rates of return, expected returns, correlation coefficients, and standard deviations based on historical stock and market index data. Key calculations include determining betas using covariance and variance, required returns using the capital asset pricing model formula, and correlation coefficients by taking the covariance of stock and index returns divided by the product of their standard deviations. The examples analyze stocks' expected returns compared to their required returns to identify undervalued and overvalued stocks.

Uploaded by

Pro Ten
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 4

Q.1. You expect an RFR of 10 percent and the market return (RM) of 14 percent.
Compute the expected(required) return for the following stocks.
Stock Beta E(Ri)
U 0.85
N 1.25
D –0.20
Solution. E(Ri) = RFR + βi(RM - RFR)
= .10 + βi (.14 - .10)
= .10 + .04βi
Stock Beta (Required Return) E(Ri) = .10 + .04βi
U 85 .10 + .04(0.85) = .10 + .034 = .134
N 1.25 .10 + .04(1.25) = .10 + .05 = .150
D -.20 .10 + .04(-.20) = .10 - .008 = .092

Q.2. You ask a stockbroker what the firm’s research department expects for these
stocks. The broker responds with the following information:
Stock Current Price Expected Price Expected Dividend
U 22 24 0.75
N 48 51 2.00
D 37 40 1.25
Indicate what actions you would take with regard to these stocks. Discuss your
decisions.

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Solution.
Stock Current Price Expected Price Expected Dividend Estimated Return
U 22 24 0.75 24 - 22 + 0.75
-----------------= .1250
22
N 48 51 2.00 51 - 48 + 2.00
--------------- = 0.1042
48
D 37 40 1.25 40 - 37 + 1.25
------------------ = 0.1149
37

Stock Beta Required Estimated Evaluation


U 0.85 0 .134 0.1250 Overvalued
N 1.25 0.150 0.1042 Overvalued
D - 0.20 0 .092 0.1149 Undervalued
If you believe the appropriateness of these estimated returns, you would buy
stocks D and sell stocks U and N.
Q.3. Based on five years of monthly data, you derive the following information for
the companies listed:
Company ai (Intercept) σi r iM
Intel 0.22 12.10% 0.72
Ford 0.10 14.60 0.33
Anheuser Busch 0.17 7.60 0.55
Merck 0.05 10.20 0.60
S&P 500 0.00 5.50 1.00
a. Compute the beta coefficient for each stock.
b. Assuming a risk-free rate of 8 percent and an expected return for the market
portfolio of 15 percent, compute the expected (required) return for all the stocks.

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Solution.
a.
Cov i,m Cov i,m
βi = -------------- and ri,m = -------------
σ 2m (σi) (σm)

then Cov i,m = (ri,m) (σi) (σm)


For Intel:
Cov i,m = (0.72)(0.1210)(0.0550) = 0.00479
Beta = 0.00479 / (0.055)2 = 0.00479/0.0030 = 1.597
For Ford:
COV i,m = (0.33)(0.1460)(0.0550) = 0.00265
Beta = 0.00265/ 0.0030 = 0.883
For Anheuser Busch:
COV i,m = (0.55)(0.0760)(0.0550) = 0.00230
Beta = 0.00230/ 0.0030 = 0.767
For Merck:
COV i,m = (0.60)(0.1020)(0.0550) = 0.00337
Beta = 0.00337/ 0.0030 = 1.123

b. E(Ri) = RFR + βi (RM - RFR)


= 0.08 + βi (0.15 - 0.08)
= 0.08 + 0.07 βi
Stock Beta E(R i) = .08 + .07 βi
Intel 1.597 0.08 + 0.1118 = 0.1918
Ford 0.883 0.08 + 0.0618 = 0.1418
Anheuser Busch 0.767 0.08 + 0.0537 = 0.1337
Merck 1.123 0.08 + 0.0786 = 0.1586

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Q.4. The following are the historic returns for the Chelle Computer Company:
Year Chelle Computer General Index
1 37 15
2 9 13
3 −11 14
4 8 −9
5 11 12
6 4 9

Based on this information, compute the following:


a. The correlation coefficient between Chelle Computer and the General Index.
b. The standard deviation for the company and the index.
c. The beta for the Chelle Computer Company.
Solution.
Chelle Computer General (R 1 - E(R1) x
Year (R1) Index (RM) R1 - E(R1) RM - E(RM) RM - E(RM)
1 37 15 27.33 6 163.98
2 9 13 -.67 4 -2.68
3 -11 14 -20.67 5 -103.35
4 8 -9 -1.67 -18 30.06
5 11 12 1.33 3 3.99
6 4 9 -5.67 0 0.00
∑ = 58 ∑= 54 ∑ = 92.00
E(R1) = 58/6 E(M) = 54/6
E(R1) = 9.67 E(M) = 9
Var1 = [R1 - E(R1)]2 /N VarM = [RM - E(RM)]2/N
Var1 = 1211.33/6 = 201.89 VarM = 410/6 = 68.33
σ1 = √201.89 = 14.21 σM = √ 68.33 = 8.27
COV 1, M = 92.00/6 = 15.33
(a). The correlation coefficient can be computed as follows:

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r1.M = COV 1, M / σ1 σM = 15.33/ (14.21) (8.27) = 15.33/117.52 = 0.13
(b). The standard deviations are: 14.21% for Chelle Computer and 8.27% for
index, respectively.
(c). Beta for Chelle Computer is computed as follows:
β1 = COV 1, M /VarM = 15.33/68.33 = 0.2244

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