Capital Asset Pricing and Arbitrage Pricing Theory: Bodie, Kane, and Marcus 9 Edition
Capital Asset Pricing and Arbitrage Pricing Theory: Bodie, Kane, and Marcus 9 Edition
Capital Asset Pricing and Arbitrage Pricing Theory: Bodie, Kane, and Marcus 9 Edition
McGraw-Hill/Irwin
7-2
aversion
Investors plan for single-period horizon; they are
risky portfolio
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market portfolio
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return/risk premiums
When premiums fall, investors move funds into
risk-free asset
Equilibrium risk premium of market portfolio
proportional to
Risk of market
Risk aversion of average investor
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CAPM
Graphs individual asset risk premiums as
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asset
SML provides hurdle rate for internal projects
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T-Bills
S&P 500
0.184
0.239
1.125
0.055
0.941
Standard deviation*
0.177
5.11
10.40
Geometric average
0.180
0.107
0.600
11.65
6.60
43.17
9.04
27.45
70.42
2.29
-38.87
-40.99
0.10
36.83
42.36
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7-17
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0.5914
0.3497
0.3385
8.4585
60
Regression equation: Google (excess return) = 0.8751 + 1.2031 S&P 500 (excess return)
ANOVA
df
1
58
59
Regression
Residual
Total
SS
2231.50
4149.65
6381.15
MS
2231.50
71.55
F
31.19
p-level
0.0000
Intercept
S&P 500
Coefficie
nts
0.8751
1.2031
t-Statistic (2%)
Standard
Error
1.0920
0.2154
tStatisti
c
0.8013
5.5848
pvalue
0.4262
0.0000
LCL
-1.7375
0.6877
UCL
3.4877
1.7185
2.3924
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assumptions
Useful predictor of expected returns
Untestable as a theory
Principles still valid
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Total Return
Average
Standard
Deviation
Geometric
Average
Cumulative
Return
0.18
11.65
Market index **
0.26
5.44
0.30
19.51
SMB
0.34
2.46
0.31
20.70
HML
0.01
2.97
-0.03
-2.06
0.94
10.40
0.60
43.17
Security
T-bill
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Estimate
FF 3-Factor Specification
S&P 500
Correlation coefficient
0.59
0.61
0.70
Adjusted R-Square
0.34
0.36
0.47
8.46
8.33
7.61
0.88 (1.09)
0.64 (1.08)
0.62 (0.99)
Market beta
1.20 (0.21)
1.16 (0.20)
1.51 (0.21)
-0.20 (0.44)
-1.33 (0.37)
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*When alpha is negative, you would reverse the signs of each portfolio weight
to achieve a portfolio A with positive alpha and no net investment.
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Stock
Weight Stock
Weight
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0.9933
R-square
0.9866
Adjusted R-square
0.9864
Annualiz
ed
Regression SE
0.5968
2.067
60
t-stat
p-level
Intercept
-0.1909
0.0771
-2.4752
0.0163
Benchmark
0.9337
0.0143
65.3434
0.0000
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Period
Real Rate
1.46
1.46
0.61
1/1/96 - 12/31/00
0.57
0.54
0.17
1/1/86 - 12/31/90
0.86
0.83
0.37
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Selected Problems
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Problem 1
CAPM: E(ri) = rf + (E(rM)-rf)
a.
E(rX)
X
E(rY)
Y
=
=
=
=
Problem 1
X = 1.8%
Y = -1.5%
b. Which stock?
ii. Held alone:
i. Well diversified:
Relevant Risk Measure?
Relevant Risk Measure?
: CAPM Model
Best Choice?
Best Choice?
Calculate Sharpe
Stock X with the
ratios
positive alpha
b. Which stock?
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Problem 1
b.
(continued)SharpeRatios
Sharpe Ratio
E(r) rf
HeldAlone:
Sharpe Ratio X = (0.14 0.05)/0.36 = 0.25
Better Sharpe Ratio Y = (0.17 0.05)/0.25 = 0.48
Sharpe Ratio Index = (0.14 0.05)/0.15 = 0.60
ii.
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Problem 2
E(rP) = rf + [E(rM) rf]
20% = 5% + (15% 5%)
= 15/10 = 1.5
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Problem 3
E(rP) = rf + [E(rM) rf]
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Problem 4
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Problems 5 & 6
5.
6.
5.
6.
Not possible. Portfolio A has a higher beta than Portfolio B, but the
expected return for Portfolio A is lower.
Possible.
Portfolio A's lower expected rate of return can be paired with a higher
standard deviation, as long as Portfolio A's beta is lower than that of
Portfolio B.
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Problem 7
7.
Sharpe Ratio
7.
E(r) rf
.18 .10
0.33
.24
Sharpe A
.16 .10
0.5
.12
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Problem 8
8.
8.
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Problem 9
9.
9.
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Problem 10
10.
E(r) = 10% + (18% 10%)
10.
The SML is the same as in the prior problem. Here, the required
expected return for Portfolio A is:
10% + (0.9 8%) = 17.2%
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Problem 11
11.
11.
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Problem 12
12
12.
Since the stock's beta is equal to 1.0, its expected rate of return
the market return, or 18%
should be equal to ______________________.
E(r) =
D1 P1 P0
P0
0.18 = 9 P1 100
100
In Equilibrium :
or P1 = $109
D1 P1 P0
rf (E(rM ) rf )
P0
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Problem 13
a.
r1=19%;r2=16%;1=1.5;2=1.0
We cant tell which adviser did the better job selecting stocks because
we cant calculate either the alpha or the return per unit of risk.
CAPM: ri = 6% + (14%-6%)
r1=19%;r2=16%;1=1.5;2=1.0,rf=6%;rM=14%
1=19% [6% + 1.5(14% 6%)] = 19% 18% = 1%
b.
2= 16% [6% + 1.0(14% 6%)] = 16% 14% = 2%
Thesecondadviserdidthebetterjobselectingstocks(bigger+alpha)
Part c?
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Problem 13
c. CAPM: ri = 3% + (15%-3%)
r1 = 19%; r2 = 16%; 1 = 1.5; 2 = 1.0, rf = 3%; rM = 15%
1 = 19% [3% + 1.5(15% 3%)] = 19% 21% = 2%
2 = 16% [3%+ 1.0(15% 3%)] = 16% 15% = 1%
Here, not only does the second investment adviser appear to be a
better stock selector, but the first adviser's selections appear valueless
(or worse).
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Problem 14
Problem 15
i. Since
the beta for Portfolio F is zero, the expected return for Portfolio
F equals the risk-free rate.
For Portfolio A, the ratio of risk premium to beta is: (10% - 4%)/1 = 6%
The ratio for Portfolio E is:
(9% - 4%)/(2/3) = 7.5%
ii.
Create Portfolio P by buying Portfolio E and shorting F in the
proportions to give p = A = 1, the same beta as A.
p =Wi i
1 = WE(E) + (1-WE)(F); WE = 1 / (2/3) or WE = 1.5 and WF = (1-WE) = -.5
E(rp) = 1.5(9) + -0.5(4) = 11.5%,
Buying Portfolio P and shorting A
p,-A = 11.5% - 10% = 1.5%
creates an arbitrage opportunity since
both have = 1
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Problem 16
E(IP) = 4% &
E(IR) = 6%;
E(rstock) = 14%
IP = 1.0
&
IR = 0.4
Actual IP = 5%, so unexpected IP = 1%
Actual IR = 7%, so unexpected IR = 1%
The revised estimate of the expected rate of return of the stock would
be the old estimate plus the sum of the unexpected changes in the
factors times the sensitivity coefficients, as follows:
E(rstock) + due to unexpected Factors
Revised estimate = 14% + [(1 1%) + (0.4 1%)] = 15.4%
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