Tutorial 5

An Introduction to Asset Pricing Models

1. What changes would you expect in the standard deviation for a
portfolio of between 4 and 10 stocks, between 10 and 20 stocks, and
between 50 and 100 stocks?

 Standard deviation would be expected to decrease with an increase in stocks in the portfolio.
 There will be a major decline from 4 to 10 stocks, a continued decline from 10 to 20 but at a
slower rate. Finally, from 50 to 100 stocks, there is a further decline but at a very slow rate
because almost all unsystematic risk is eliminated.
 As the number of stocks in a portfolio increases, the portfolio becomes more diversified and the
impact of individual stock risks on the overall portfolio risk diminishes. However, the impact of
systematic risks, such as changes in interest rates, inflation, and geopolitical events, becomes
more pronounced.
2. What are the similarities and differences between the CML and SML
as models of the risk return trade-off?
 The similarities between the CML and SML is they both measure the relationship between risk and
expected return.
 The differences between the CML and SML are the CML measures risk by the standard deviation of the
investment while the SML explicitly considers only the systematic component of an investment’s
volatility. 
 Besides, as a consequence of the first point, the CML can only be applied to portfolio holdings that are
already fully diversified, whereas the SML can be applied to any individual asset or collection of assets. 
3. While the capital asset pricing model (CAPM) has been widely used to
analyze securities and manage portfolios for the past 50 years, it has also been
widely criticized as providing too 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.
 Beta is a fickle short-term performer. Some short-term studies have shown risk and return to
be negatively related. For example, securities with higher risk produced lower returns than less
risky securities.
 This result suggests that investors may be penalized for taking on more risk in some short
periods. While for the long run, investors are not rewarded enough for high risk and are
overcompensated for buying securities with low risk. In all periods, some unsystematic risk is
being valued by the market
 Estimated betas are unstable. Major changes in a company affecting the character of the stock
or some unforeseen event not reflected in past returns may decisively affect the security’s future
returns. 

  Beta is easily rolled over. Richard Roll has demonstrated that by changing the market index
against which betas are measured, one can obtain quite different measures of the risk level of
individual stocks and portfolios. As a result, one would make different predictions about the
expected returns, and by changing indexes, one could change the risk-adjusted performance
ranking of a manager. 
4. You have been offered an opportunity to invest in one of the two fully
diversified portfolios, Portfolio H and Portfolio L. While you know that the
betas of these portfolios are identical, you only know that, on average, the
stocks held in Portfolio H have a higher level of specific risk than those in
Portfolio L. From what you know about the capital asset pricing model
(CAPM), which portfolio should you invest in? Which portfolio should give
you a higher expected return?
  Under CAPM, the only risk that investors should be compensated for bearing is the risk that
cannot be diversified away such as systematic risk. 
 Because systematic risk which is measured by beta is equal to one for both portfolios, an
investor would expect the same return for Portfolio H and Portfolio L. 
  Since both portfolios are fully diversified, it doesn’t matter if the specified risk for each
individual security is high or low as the specific risk has been diversified away for both portfolio
5. Draw an ideal SML. Based on the early empirical results, what did
the actual risk-return relationship look like relative to the ideal
relationship implied by the CAPM?

 As referring to the empirical SML with higher intercept and flatter slope, low risk (beta) securities did
better than expected, while high risk securities did not do as well as predicted.
6. Assume that you expect the economy’s rate of inflation to be 3
percent, giving an RFR of 6 percent and a market return (RM) of 12
percent.
6a. Draw the SML under these assumptions.
6b. Subsequently, you expect the rate of inflation to increase from 3% to 6%.
What effect would this have on the RFR and the RM? Draw another SML on
the graph from Part a.

 The SML(a) shifts up to SML(b). The RFR

increases from 6% to 9% and the market return
(Rm) is increases from 12% to 15%.
6c. Draw an SML on the same graph to reflect an RFR of 9% and an
RM of 17%. How does this SML differ from that derived in Part b?
Explain what has transpired.

 The SML(c) shares the same RFR as

SML(b), however, with higher market return.
As the risk-free rate change from 0.06 to
0.09, the market risk premium per unit of risk
[E(Rm) - Rf] changes from 0.06 (0.12 - 0.06)
to 0.08 (0.17 - 0.09). Therefore, the new
SML(c) will have an intercept at 0.09 and a
different slope which no longer be parallel to
SML(a).
7 a. You expect an RFR of 10 percent and the market return (RM) of
14 percent. Compute the expected return for the following stocks, and
plot them on an SML graph.
E(Ri) = RFR + βi [E(Rm) – RFR]

 E(RU) = 0.1 + 0.85 (0.14 – 0.1) = 13.4%

 E(RN) = 0.1 + 1.25 (0.14 – 0.1) = 15%

 E(RD) = 0.1 – 0.20 (0.14 – 0.1) = 9.2%

7 b. You ask a stockbroker what the firm’s research department
expects for these three stocks. The broker responds with the following
information:

Plot your estimated returns on the graph from Part a and indicate what actions
you would take with regard to these stocks. Explain your decisions.
Estimated rate of return= [(Expected Dividend +
Expected price) / Current price] - 1
 Stock U = [(0.75 + 24) / 22] - 1 = 12.50%
 Stock N = [(2 + 51) / 48] - 1 = 10.42%
 Stock D = [(1.25 + 40) / 37] - 1 = 11.49%

 Stock U is overvalued and plots under the SML line.

 Stock N is overvalued and plots under the SML line.
 Stock D is undervalued and plots above the SML line.
 Buy Stock D, sell any Stock U and Stock N
8. You are an analyst for a large public pension fund and you have
been assigned the task of evaluating two different external portfolio
managers (Y and Z). You consider the following historical average
return, standard deviation, and CAPM beta estimates for these two
managers over the past five years:

Additionally, your estimate for the risk premium for the market portfolio is 5.00
percent and the risk-free rate is currently 4.50 percent.
8a. For both Manager Y and Manager Z, calculate the expected return
using the CAPM. Express your answers to the nearest basis point
(i.e., xx.xx%).

E(Ri) = RFR + βi [E(Rm) – RFR]

 E(RY) = 0.045 + (1.2)(0.05) = 10.50%
 E(RZ) = 0.045 + (0.8)(0.05) = 8.50%
8b. Calculate each fund manager’s average “alpha” (i.e., actual return
minus expected return) over the five-year holding period. Show
graphically where these alpha statistics would plot on the security
market line (SML).

Alpha = Actual return – expected return

 αY = 10.20% – 10.50% = – 0.30%
 αZ = 8.80% – 8.50% = 0.30%
8c. Explain whether you can conclude from the information in Part b
if: (1) either manager outperformed the other on a risk-adjusted basis,
and (2) either manager outperformed market expectations in general.

 A negative alpha of 0.30% represents the portfolio underperformed the market on a risk-adjusted
basis by 30 basis point; Manager Y’s portfolio would plot under the SML.
 A positive alpha of 0.30% represents the portfolio outperformed the market on a risk-adjusted
basis by 30 basis point; Manager Z outperformed the market portfolio and would plot above the
SML.
 In short, Manager Z outperformed Manager Y on a risk-adjusted basis, at the same time,
outperformed the market expectations in general.
Additional Calculation Questions
1. Based on five years of monthly data, you derive the following
information for the companies listed:

Company (Intercept) σi ri,m

A 0.22 12.5% 0.70

B 0.10 14.50 0.30
C 0.17 7.80 0.70
D 0.05 10.30 0.65
S & P 500 0.00 5.00 1.00
a) Compute the beta coefficient for each stock.

 Company A  Company C
 Cov (Ri, Rm) = 0.70 x 0.125 x 0.05   Cov (Ri, Rm) = 0.70 x 0.078 x 0.05 

                     =0.004375                      =0.00273
 BetaA = 0.004375 / (0.05)2  BetaC = 0.00273 / (0.05)2

          
= 1.75  = 1.092
         

 Company B  Company D
 Cov (Ri, Rm) = 0.30 x 0.145 x 0.05   Cov (Ri, Rm) = 0.70 x 0.103 x 0.05 
                     =0.002175                      =0.0033475
 BetaB = 0.002175 / (0.05)2  BetaD = 0.0033475 / (0.05)2
 = 0.87
                    
= 1.339
 b) Assuming a risk-free rate of 9 percent and an expected return for the
market portfolio of 16 percent, compute the expected (required) return
for all the stocks and plot them on the SML.

 E(Ri) = RFR + βi ( Rm –RFR)   E(Ri) = 0.09 + 0.07 βi   E(Ri) = 0.09 + 0.07 βi 

          = 0.09 + βi (0.16 -0.09)  Company B :  Company D :

          = 0.09 + 0.07 βi 
 0.09 + 0.07 (0.87)  0.09 + 0.07 (1.339)
 = 0.1509  = 0.1837
 E(Ri) = 0.09 + 0.07 βi 
 E(Ri) = 0.09 + 0.07 βi 
 Company A :
 Company C :
 0.09 + 0.07 (1.75)
 0.09 + 0.07 (1.092)
 = 0.2125
 = 0.1664
 c) Plot the following estimated returns for the next year on the SML
and indicate which stocks are undervalued or overvalued.

1) A—25 percent
2) B—10 percent
3) C—18 percent
4) D—12 percent

Undervalued stocks:
Stocks of company A and C

Overvalued stocks:
Stocks of company B and D
2. The following are the monthly rates of return for Sweet Cookies and
for Super Electric during a six-month period.

Month Sweet Cookies Super Electric

1 −0.05 0.05
2 0.05 −0.03
3 −0.06 −0.20
4 0.13 0.25
5 −0.04 −0.05
6 0.06 0.03
Compute the following:
a) Average monthly rate of return for each stock
 Sweet Cookies
 = [(-0.05) + 0.05+(-0.06)+0.13+(-0.04)+0.06] / 6
 = 0.09 /6
 0.015

 Super Electric
 = [0.05 + (- 0.03)+(-0.20)+0.25+(-0.05)+0.03] / 6
 = 0.05 /6
 0.008333
b) Standard deviation of returns for each stock
 Standard deviation for Sweet Cookies

Mont Ri - E(Ri) [Ri - E(Ri)]2

h
1 -0.05 - 0.015 = -0.065 0.004225
2 0.05 - 0.015 = 0.035  0.001225
3 -0.06 - 0.015 = -0.075 0.005625
4 0.13 - 0.015 = 0.115 0.013225
5 -0.04 - 0.015 = -0.055 0.003025
6 0.06 - 0.015 = 0.045 0.002025
Σ= 0.02935

Variance  Standard deviation

= Σ [Ri - E(Ri)]2  / n-1 = Σ{ [Ri - E(Ri)]2  / n-1}1/2
= 0.02935 / 6 – 1  = (0.00587)1/2
= 0.00587 = 0.07662
 Standard deviation for Super Electric

Mont Rj - E(Rj) [Rj - E(Rj)]2

h
1 0.05 - 0.008333 = 0.041667 0.001736
2 -0.03 - 0.008333 = -0.038333 0.001469
3 -0.20 - 0.008333 = -0.208333 0.043403
4 0.25 - 0.008333 = 0.241667 0.058403
5 -0.05 - 0.008333 = -0.058333 0.003403
6 0.03 - 0.008333 = 0.021667 0.0004695
Σ= 0.1089

Variance  Standard deviation

= Σ [Ri - E(Ri)]2  / n-1 = Σ{ [Ri - E(Ri)]2  / n-1}1/2
= 0.1089 / 6 – 1  = (0.02178)1/2
= 0.02178 = 0.1476
c) Covariance between the rates of return
Mont Ri - E(Ri) x Rj - E(Rj)
h
1 -0.065 x 0.041667 -0.002708
2 0.035 x -0.038333 -0.001342
3  -0.075 x -0.208333 0.015625
4  0.115 x 0.241667 0.027792
5 -0.055 x  -0.058333 0.003208
6  0.045 x 0.021667 0.0009750
Σ= 0.04355

Covariance
=  ΣRi - E(Ri) x Rj - E(Rj) / n-1
= 0.04355 / 5
= 0.00871
d) The correlation coefficient between the rates of return

Ri,j = Covij / SDi x SDj

= 0.00871/ (0.07662 x 0.1476)
= 0.00871 / 0.0113091
= 0.7781
3. The following are the historic returns for the Chelle Computer
Company:

Year AA Computer General Computer

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 AA Computer and the General Computer.
Ye ar AA Co mpute r Ge ne ral Co mpute r

[ R-E(R)A ] x
(2) R-E(R) (3) [R-E(R)]² (2) R-E(R) (3) [R-E(R)]²
[R-E(R)B]
37-9.667 = 27.33 ² = 6² = 36
1 37 15 15-9 = 6 27.333*6 = 163.998
27.333 747.093
2 9 -0.667 0.445 13 4 16 -2.668
3 -11 -20.667 427.125 14 5 25 -103.335
4 8 -1.667 2.779 -9 -18 324 30.006
5 11 1.333 1.777 12 3 9 3.999
6 4 -5.667 32.115 9 0 0 0.000
Total 58 1211.334 54 410 92
(1) Avg
(1)Avg return
return
= 54/7
= 58/6
9.667 9
a) The correlation coefficient between AA Computer and the General Computer.

 Covariance  Correlation Coefficient

 SD AA Comp
= [R-E(R) A ] [R-E(R) B] = Covariance
= √1211.34/(6-1)
n-1 (SD A )(SD B)
= √ 242.268
= 92 / (6-1)
=15.565
=18.4 = 18.4 / (15.565 x 9.055)
=0.1306
 SD General Comp
= √410/(6-1)
= √ 82
=9.055
b) The standard deviation for the company and the index.

SD AA Comp
= √1211.34/(6-1)
= √ 242.268
=15.565

SD General Comp
= √410/(6-1)
= √ 82
=9.055
c) The beta for the AA Computer Company.

 Beta

= Cov / Variance
= 18.4/82
= 0.2244
4. As an equity analyst, you have developed the following return
forecasts and risk estimates for two different stock mutual funds (Fund
T and Fund U):

  Forecasted Return CAPM Beta

Fund T 9.0% 1.20

Fund U 10.0 0.80
a) If the risk-free rate is 3.9 percent and the expected market risk
premium is 6.1 percent, calculate the expected return for each mutual
fund according to the CAPM.

 Fund T  Fund U
E(R) = rf + ꞵ (rm – rf) E(R) = rf + ꞵ (rm – rf)
= 3.9 + 1.2 (6.1) = 3.9 + 0.8 (6.1)
= 11.22% = 8.78%
 b) Using the estimated expected returns from part (a) along with your
own return forecasts, demonstrate whether Fund T and Fund U are
currently priced to fall directly on the security market line (SML),
above the SML, or below the SML.
E(R)
Fund U SML Line
10

9  Fund U falls above the SML Line

Fund T
 Fund T Falls below the SML Line

3.9 (rf)

Beta
0.8 1.2
c) According to your analysis, are Funds T and U overvalued,
undervalued, or properly valued?

 FundT is overvalued as its forecasted return (9%) is lower than the

expected return (11.22%) .

 FundU is undervalued as its forecasted return (10%) is higher than the

expected return (8.78%) .
5.
Asset Asset Beta Return % Portfolio Weights (%)
Portfolio A Portfolio B
1 1.20 15.5 10 30
2 0.60 13.0 30 10
3 1.24 14.0 10 20
4 1.10 12.0 10 20
5 0.80 8.00 40 20
Total     100 100
a) Calculate the betas for portfolio A and B.

Portfolio A:

Portfolio Weighted Beta

Asset Asset Beta Weights (%) (Beta*Weights)
Portfolio A
1 1.20 10 0.12
2 0.60 30 0.18
3 1.24 10 0.124
4 1.10 10 0.11
5 0.80 40 0.32
Portfolio Beta   0.854
a) Calculate the betas for portfolio A and B.

Portfolio B:

Portfolio Weighted Beta

Asset Asset Beta Weights (%) (Beta*Weights)
Portfolio B
1 1.20 30 0.36
2 0.60 10 0.06
3 1.24 20 0.248
4 1.10 20 0.22
5 0.80 20 0.16
Portfolio Beta   1.048
b) Compare the risks of each portfolio to the market as well as to each
other and identify which portfolio is risker.

 The systematic risk of each portfolio to the market is measured by beta which Portfolio A with a
lower beta is less risky than Portfolio B.

 A lower beta indicates lower risk on the asset and provides a lower potential return. While a
higher beta indicates higher risk but also higher returns. In this case, Portfolio B is riskier as the
beta for Portfolio B (1.048) is higher than Portfolio A (0.854)
c) Calculate the required return for each portfolio using the Capital
Asset Pricing Model (CAPM) if the risk-free is 3% and the market
return is 10%.

 Portfolio A  Portfolio B
 E(RA) = RFR + βA ( Rm –RFR)   E(RA) = RFR + βA ( Rm –RFR) 
          = 0.03 +  0.854 (0.1 -0.03)           = 0.03 +  1.048 (0.1 -0.03)
          = 0.08978 or 8.978%           = 0.10336 or 10.336%
d) Calculate the expected return on Portfolio A and B.

Portfolio A:
Portfolio Weights Expected Return
Asset Return % (%) (Return*Weights)
Portfolio A
1 15.5 10 1.55
2 13.0 30 3.9
3 14.0 10 1.4
4 12.0 10 1.2
5 8.00 40 3.2
Expected Portfolio   11.25%
Return
d) Calculate the expected return on Portfolio A and B.

Portfolio B:
Portfolio Weights Expected Return
Asset Return % (%) (Return*Weights)
Portfolio B
1 15.5 30 4.65
2 13.0 10 1.3
3 14.0 20 2.8
4 12.0 20 2.4
5 8.00 20 1.6
Expected Portfolio   12.75%
Return
6. Consider the following data for two risk factors (1 and 2) and two
securities (J and L):

l0 =0.05
l1=0.02
l2=0.04
bj1=0.80
bj2=1.40
bL1= 1.60
bL2=2.25
a) Compute the expected returns for both securities.

 Using the APT model,

E(Rj ) E(RL)
= l0 + l1bj1 + l2bj2 = l0 + l1bL1 + l2bL2

= 0.05 + (0.02*0.80) + (0.04*1.40) = 0.05 + (0.02*1.60) + (0.04*2.25)

= 0.05 + 0.016 + 0.056 = 0.05 + 0.032 + 0.09

= 0.122 = 0.172
b) Suppose that Security J is currently priced at $25 while the price of
Security L is $20.00. Further, it is expected that both securities will pay
a dividend of $0.80 during the coming year. What is the expected price
of each security one year from now?
 Expected Price
 = Current Price (1 + Expected Return) – Expected Dividend

 E(Pj ) = $25(1.122) - $0.80 = $27.25

E(PL ) = $20(1.172) - $0.80 = $22.64