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CAPM and Alpha - Practice Problems - SOLUTIONS

1. According to the CAPM model, stocks with positive alphas (Green Leaf and HanBel) represent buying opportunities, while those with negative alphas (Rebecca Automobile and possibly NatSam) should be sold. 2. For a stock with a beta of 1.2, its expected return calculated using the CAPM (12.2%) exceeds the expected 11% return, so the stock does not compensate for the risk and should not be bought. 3. For a stock expected to rise to $45/share with a $1 dividend, paying a 15% total return, its beta would need to be 1.31 for the expected return to match that implied by the CAPM model.

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309 views2 pages

CAPM and Alpha - Practice Problems - SOLUTIONS

1. According to the CAPM model, stocks with positive alphas (Green Leaf and HanBel) represent buying opportunities, while those with negative alphas (Rebecca Automobile and possibly NatSam) should be sold. 2. For a stock with a beta of 1.2, its expected return calculated using the CAPM (12.2%) exceeds the expected 11% return, so the stock does not compensate for the risk and should not be bought. 3. For a stock expected to rise to $45/share with a $1 dividend, paying a 15% total return, its beta would need to be 1.31 for the expected return to match that implied by the CAPM model.

Uploaded by

Alexa Wilcox
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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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CAPM and Alphas

1. Assume that the CAPM is a good description of stock price returns. The market expected return is 7%
with 10% volatility and the risk-free rate is 3%. New news arrives that does not change any of these
numbers but it does change the expected return of the following stocks:

a. At current market prices, which stocks represent buying opportunities?


b. On which stocks should you put a sell order in?
According to the CAPM, we should hold the market portfolio. But once new news arrives and we update our
expectations, we may find profitable trading opportunities if we can trade before prices fully adjust to the
news. Assuming we initially hold the market portfolio, we can improve gain by investing more in stocks with
positive alphas and less in stocks with negative alphas.
Expected Volatility Beta Required Return Alpha
Return (CAPM)
Green Leaf 12% 20% 1.5 9.0% 3.0%
NatSam 10% 40% 1.8 10.2% -0.2%
HanBel 9% 30% 0.75 6.0% 3.0%
Rebecca Automobile 6% 35% 1.2 7.8% -1.8%

a. Green Leaf, HanBel


b. Rebecca Automobile and possibly NatSam (although its alpha is close enough to zero that we might
regard it as insignificant).

2. You are analyzing a stock that has a beta of 1.2. The risk free rate is 5% and you estimate that the
market risk premium is 6%. If you expect the stock to have a return of 11% over the next year, should
you buy it? Why or why not?

According to the CAPM, the expected return is:

E[r] = rf + beta*(rm – rf) = 5% + 1.2*6% = 12.2%

You should not buy the stock. Using the CAPM, you expect a return of 12.2% for an asset with a beta of 1.2
This asset’s expected return is only 11% and does not fully compensate you for the risk of the stock.

3. You are thinking of buying a stock priced at $40 per share. Assume that the risk free rate is 4.5% and
the market risk premium is 8%. If you think the stock will rise to $45 per share by the end of the year,
at which time it will pay a $1 dividend, what beta would it need to have for this expectation to be
consistent with the CAPM?
The one year return for this stock is:
𝐷𝑖𝑣1 + (𝑃1 − 𝑃0 ) 1 + (45 − 40)
𝑟1 = = = 15%
𝑃0 40
Then for the expected return to be consistent with the CAPM we can plug in and solve:

E[r] = rf + beta*(rm – rf)


15% = 4.5% + beta*8%
Beta = 1.31

4. At the beginning of 2007, Apples beta was 1.4 and the risk free rate was about 4.5%. Apple’s price of
$84.84. Apple’s price at the end of 2007 was $198.08. If the market risk premium was 6%, what was
the CAPM alpha for apple’s stock?

First we calculate the realized return for Apple:


198.08 − 84.84
𝑟1 = = 133.47%
84.84

Next we calculate the return implied by the CAPM

E[r] = rf + beta*(rm – rf) = 4.5% + 1.4*6% = 12.9%

Then the CAPM alpha is:

Alpha = realized return – expected return

= 133.47% - 12.9% = 120.57%

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