INDIVIDUAL ASSIGNMENT

TITLE: Tutorial 3 Problems

Submitted by: Dahir Hussein Abdullahi

Course: Investment & Risk Management

Instructor: Ustad Omar Bubal

Date: 22/August/2024

Hormuud University, Lincoln

Discussions

1. The capital asset pricing model (CAPM) contends that there is systematic and unsystematic risks for an individual security. Which is the
relevant risk variable and why is relevant? Why is other risk variable being un-relevant?

Answer

In the Capital Asset Pricing Model (CAPM), systematic risk is the relevant risk variable for an individual security. Here’s why:

• Systematic Risk: This is the risk that affects the entire market or economy, such as economic downturns, political instability, or changes in
interest rates. It's relevant because it cannot be eliminated through diversification. CAPM quantifies this risk using Beta (β), which measures
a security’s sensitivity to overall market movements. Since investors cannot avoid systematic risk through diversification, it is the primary
risk factor considered in determining the expected return of a security.

• Unsystematic Risk: This is the risk specific to an individual security or company, such as management decisions, product recalls, or
competitive pressures. It is not relevant in the CAPM framework because it can be reduced or eliminated through diversification across a
portfolio. Investors who hold a diversified portfolio do not need to be compensated for unsystematic risk, as it can be mitigated by holding
a variety of assets.

By The Way In CAPM, only systematic risk is relevant because it affects all securities and cannot be diversified away, while unsystematic
risk is irrelevant as it can be reduced through diversification.

2. While the CAPM has been widely used to analyze securities and manage portfolios for the past 50 years. It has also been widely criticized as
providing to simple a view of risk. Describe three problems in relation to the definition and estimation of the beta measure in the CAPM that
would support this criticism.
Answer
three key problems related to the beta measure in CAPM that support criticisms of its simplicity:

Historical Beta Limitations:

Problem: Beta is typically calculated using historical data of a security's returns relative to the market's returns. However, past performance
may not accurately reflect future risk. Changes in a company’s operations or market conditions can make historical beta unreliable.
Impact: Investors might make decisions based on outdated or inaccurate beta estimates.
Beta Stability:
 Problem: Beta values can vary over time due to changes in the company’s risk profile, market conditions, or economic environment. Beta is
not constant; it can change as the business or its industry evolves.
Impact: This variability makes it challenging to rely on a single beta estimate for long-term investment decisions.
Beta Assumes Linear Relationship:

Problem: CAPM assumes a linear relationship between the security’s returns and market returns. However, this relationship may not always
hold true, especially during market crises or extreme conditions.
Impact: The assumption of linearity might not capture the true risk behavior of a security, leading to potential mispricing.
Remember The problems with beta in CAPM include its reliance on historical data, its instability over time, and the assumption of a linear
relationship between security and market returns, all of which limit its accuracy and reliability.
3. Differentiate between capital asset pricing model (CAPM) and Arbitrage pricing theory.
Answer
concise differentiation between the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT),
Capital Asset Pricing Model (CAPM):
Single Factor Model:
o Focus: CAPM uses the overall market return as the sole factor to estimate an asset's expected return.
o Beta: Measures how sensitive an asset's returns are to market returns.
Assumptions:
o Market Efficiency: Assumes markets are efficient and investors have the same information.
o Investors: Assumes all investors have homogeneous expectations and access to the same risk-free rate.
Risk Considered:
o Systematic Risk: Only systematic risk (market risk) is considered, which is captured by beta.
Use:
o Application: Primarily used to determine the expected return of an asset based on its risk relative to the market.
Arbitrage Pricing Theory (APT):
Multi-Factor Model:
o Focus: APT considers multiple factors that could affect an asset's returns, rather than just the market return.
o Factors: Includes various economic, financial, or fundamental factors.
Assumptions:
o Market Efficiency: Based on the principle of no arbitrage opportunities, meaning that profit should not be possible without taking on
risk.
o Flexibility: Does not require specific assumptions about investor behavior or market conditions.
Risk Considered:
o Systematic Risk: Takes into account multiple sources of systematic risk, which are determined empirically.
Use:
 o Application: Provides a more flexible framework for assessing how different factors affect asset returns, accommodating a broader
range of risks compared to CAPM.
By The Way
•CAPM focuses on a single market factor and is based on beta to measure risk.
•APT uses multiple factors to assess risk and return, providing a broader and more flexible approach compared to CAPM.

4. Assume that you expect the economy’s rate of inflation to be 3%, given an RFR of 6% and Market return of 12%.
a) Draw the SML under these assumptions.
b) Subsequently, you expect the rate of inflation to increase from 3% to 6%, what effect would this have on the RFR and Market return?
Draw another SML on the graph from part (a).
Answer
A. E®= RFR+B(Rm-RFR)
6%+0(0.06) = 6%
E®= When Beta is 1
6%+1(6%) = 12%
B. When Inflation Increase 3 to 6
E®= 0.09+0(6%) = 9%
When Beta is 1
E®= 0.09+1(0.06) = 15%
5. You expect an RFR of 10% and the market return of 14%. Compute the expected return for the following stocks, and plot them on an SML
graph.
a)
Stock Beta
U 0.85
N 1.25
D -0.20

b) You ask a Stockbroker what the firm research department expects for these three 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

Plot the estimated return on the graph from part (a) and indicate what action you would take with regard to these stocks. Explain your
decisions.
Answer
E(Ri) = RFR + bi(RM - RFR)
= .10 + bi(.14 - .10)
= .10 + .04bi

Stock Beta (Required Return) E(Ri) = .10 + .04bi

U 0.85 .10 + .04(.85) = .10 + .034 = .134

N 1.25 .10 + .04(1.25)= .10 + .05 = .150
D -.20 .10 + .04(-.20) = .10 - .008 = .092

RRR (CAPM) > Expected Return, then stock is over-valued. All

stocks are presented by SML by respective Betas
 Current Expected Expected
Stock Estimated Return
Price Price Dividend
24 − 22 + 0.75
U = .1250
P-3 22 24 0.75 22

51 − 48 + 2.00
= .1042
N 48 51 2.00 48

40 − 37 + 1.25
D = .1149
37 40 1.25 37
 • Stock Beta Required Estimated Evaluation
• U .85 .134 .1250 Overvalued
• N 1.25 .150 .1042 Overvalued
• D -.20 .092 .1149 Undervalued
• U, N and D represent the
returns calculated by CAPM
• U, N and D should be on
Rm=.14 Rf=.10 SML according to their
Betas
• while U*, N* and D*
represent the expected
returns

Market B=1
Buy D stock and sell U and N stocks
Analysis
Buy Stock D because it is undervalued.
Sell Stocks U and N because they are overvalued