FNCE10002 Principles of Finance

Semester 2, 2024

Portfolio Theory and Asset Pricing II

Tutorial Questions for Topic 6

Priority questions: A1, A3, B2, B6

A. Problems and Case Studies

A1. Answer each part separately and provide a brief explanation in each case.

a) The table below shows the beta and standard deviation for two stocks. According to the
capital asset pricing model, is the information shown in the table possible? Explain.

Standard Deviation of
Stock Beta Return
A 1.5 22.0%
B 0.9 35.0%

b) According to the capital asset pricing model, is the following information possible?
Explain.

Expected Standard Deviation of

Security Return Return
X 4% 0.0%
Y 2% 20.0%

c) If a security has a beta of 1.0 will its standard deviation be equal to the standard deviation
of the market portfolio? Explain.

A2. Answer each part separately and show your calculations.

a) The riskfree rate is 3% and the expected market risk premium is 6%. What is the expected
return on a security with a beta of 1.1?

b) The expected return on the market portfolio is 12% and the riskfree rate is 6%. What is
the expected return on a security with a beta of 0.7?

c) The expected return on a security is 14% and its beta is 1.5. What is the riskfree rate if the
expected return on the market portfolio is 10%?

Suggested Answers to Tutorial Questions for Topic 6 1

 d) If the riskfree rate equals 4% and a security with a beta of 0.75 has an expected return of
10%, what is the expected return on the market portfolio?

A3. The beta of OzCo Ltd is 1.1, the expected return on the market portfolio is 12% and the
riskfree rate is 5%. Based only on the current price and future expected cash flows from OzCo
Ltd an analyst estimates that the stock’s expected return is 14%.

a) Using the CAPM, calculate the required rate of return on OzCo.

b) Are OzCo shares currently under- or over-priced? What would you expect to happen to
OzCo’s expected return and price? Explain. (No calculations required.)

A4. Refer to the example discussed in class where we had valued Sonic Healthcare at the end of
November 2018 (section 6.5.0 of your notes). Assume that we’re now at the end of 2020. The
online broker’s revised outlook for Sonic is a dividend in 2021 of $0.97 and its re-estimated
beta is 0.9. The price of Sonic’s shares at the end of 2020 was $33.10. As the case mentioned,
we had used a riskfree rate of 4% and an expected market risk premium of 7% to estimate the
required return on Sonic’s shares. Reassess whether Sonic is under- or over-valued if the
expected growth rate of dividends is expected to be (a) 6.5% p.a. and (b) 7.5% p.a. forever.
For each case, calculate the new equilibrium share price as well.

B. Multiple Choice Questions

For each question pick the most reasonable response based only on the information provided.

B1. Assume that the CAPM is correct and a security’s beta has been estimated as 1.2. The riskfree
rate of return is 6% and the security’s expected rate of return is 18%. This implies that the
market risk premium is closest to:

a) 6.0%.
b) 10.0%.
c) 12.0%.
d) 16.0%.

B2. Assume that the riskfree rate is 5% and that you can invest in the market portfolio which has
an expected return of 15% and a standard deviation of return of 20%. You have $5,000
available for investment and you want to form a portfolio with an expected return of 20%. In
this case, you:

a) Need to lend $2,500 at the riskfree rate and invest $2,500 in the market portfolio.
b) Need to borrow $2,500 at the riskfree rate and invest $7,500 in the market portfolio.
c) Need to borrow $7,500 at the riskfree rate and invest $12,500 in the market portfolio.
d) Cannot achieve an expected return of 20% because the expected return of the market
portfolio is only 15%.

Questions B3 – B5 are based on the following information.

The earnings per share of ONO Ltd are expected to be $1.25 next year and the company is expected to
maintain a constant payout ratio of 40% forever. The company’s earnings are expected to grow at a
constant rate of 8% p.a. forever. The standard deviation of the stock’s returns is 40% and its
covariance with the market portfolio is 0.05. The expected market risk premium is 10%, the standard
deviation of the market portfolio is 25% and the government bill rate is 5%.

B3. ONO Ltd’s beta is closest to:

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 a) 0.6.
b) 0.8.
c) 1.0.
d) 1.2.

B4. In equilibrium, ONO Ltd’s stock price should be closest to:

a) $10.00.
b) $15.00.
c) $25.00.
d) $50.00.

B5. Assume that there is an unexpected rise in the market risk premium to 12%. All else being the
same, ONO Ltd’s stock price would:

a) Fall by around 24%.

b) Fall by around 14%.
c) Rise by around 32%.
d) Remain unchanged.

B6. Portfolio leveraging refers to which one of the following strategies?

a) Borrowing funds at a riskfree rate of return and investing these funds in a risky security.
b) Borrowing funds at a riskfree rate of return and investing these funds in a riskfree
security.
c) Borrowing funds at a risky rate of return and investing these funds in a risky security.
d) Borrowing funds at a risky rate of return and investing these funds in a riskfree security.

C. Closing the loop with the STOCKHISTORY function in Excel

We are going to use the spreadsheet that you used in part C of last week’s tutorial. You can find a
copy of it (with some additional title cells added) on the Canvas page for this week’s topic.

Reminder of how we amended the spreadsheet from last week:

i. Remember to include a ticker (with the prefix) in cell G5;
ii. Repeat it in cell G6, but then reselect the cell and select “Data” from the top menu and then
“Stocks” from data types.
iii. In cell F9 type the following: “=STOCKHISTORY(G5,B2,B3,0,2,0,1,5)”. This will then
populate the worksheet where the last column gives you daily returns on your chosen stock.
iv. Set a start and end date for the data examined. Let’s say 31/12/2022 as the start date in cell B2
and 31/12/2023 as the end date in cell B3.
v. Calculate a standard deviation of stock returns for each of the stocks by using the
“STDEVA()” function in cells I2 and I3 [e.g. “=STDEVA(D12:D262)”]
vi. Convert these into standard deviation of returns on an annual basis by multiplying them by
the square root of the number of observations in a year (which is 251). Insert these values in
cells J2 and J3.
vii. Calculate the correlation between the returns of these two return series by using the
“CORREL()” function where you highlight the two return series [e.g.
“=CORREL(D12:D262,I12:I262)”]. Insert this into cell M4.

Now we have introduced the market return as well in columns E (from E12) and J (from J12). We are
now going to estimate betas for these two stocks

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 (a) To estimate the standard deviation of the returns on the market proxy (the All Ordinaries
Price Index in this case), use the function “STDEVA()” and highlight the return series. [E.g.
“=STDEVA(E12:E262)”]. Insert this function in cell I4.
(b) Now convert that daily standard deviation measure into an annual measure by selecting cell
J4 typing “=I4*(251^0.5)”. This gives you a measure of annual standard deviation of the
returns on the All Ordinaries Price Index.
(c) We now have to calculate the correlation coefficient between the returns from the stocks and
the returns on the market proxy. We do this the same that we calculated the correlation
coefficient for the individual stocks last week, except this time we highlight the returns from
the market proxy. [e.g. “=CORREL(D12:D262,J12:J262)”]. Insert these values into the
correlation matrix.
(d) We now have sufficient information to calculate the betas for the two stocks. The beta for a
σ i σ M ρ i ,M
stock is β i= 2 . This is automatically coded into the spreadsheet at cells R2 and R3.
σM

To check the accuracy of your worksheet, if you had have specified XASX:BHP as your own stock
and XASX:CBA as the first stock, and the start (end) dates as 31/12/2022 (31/12/2023) then you
would end up with the following metrics:
 Annual standard deviation of returns for CBA = 15.68% p.a.
 Annual standard deviation of returns for BHP = 21.84% p.a.
 Annual standard deviation of returns for the market proxy = 10.81% p.a.
 Correlation coefficient of returns between the two stocks = 0.272
 Correlation coefficient of returns between CBA and the market = 0.701
 Correlation coefficient of returns between BHP and the market = 0.651
 Beta for CBA = 1.02
 Beta for BHP = 1.32

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