Ch 08: Intro to Asset Pricing Models
You have recently been appointed chief investment officer of a major charitable foundation. Its large endowment fund is
currently invested in a broadly diversified portfolio of stocks (60 perce
nt) and bonds (40 percent). The foundation
board of trustees is a group of prominent individuals whose knowledge of modern investment theory and practice is
superficial. You decide a discussion of basic investment principles would be helpful.
a. Explain the concepts of specific risk, systematic
risk, variance, covariance, standard deviation, and beta as they relate to
investment management. You believe that the addition of other asset classes to the endowment portfolio would improve
the portfolio by reducing risk and enhancing return. You are awa
re that depressed conditions in U.S. real estate markets
are providing opportunities for property acquisition at levels of expected return that are unusually high by historical
standards. You believe that an investment in U.S. real estate would be both app
ropriate and timely, and have decided to
recommend a 20 percent position be established with funds taken equally from stocks and bonds. Preliminary
discussions revealed that several trustees believe real estate is too risky to include in the portfolio. The
however, has scheduled a special meeting for further discussion of the matter and has asked you to provide background
information that will clarify the risk issue. To assist you, the following expectation data have been developed:
U.S. Stocks 12.0% 21.0% 1.00
U.S. Bonds 8.0 10.5 0.14 1.00
U.S. Real Estate 12.0 9.0 ?0.04 ?0.03 1.00
U.S. Treasury Bills 4.0 0.0 ?0.05 ?0.03 0.25 1.00
Explain the effect on both portfolio risk and return that would result from the addition of U.S. real estate. Include in
your answer two reasons for any change you expect in portfolio risk. (Note: It is not necessary to compute expected risk
c. Your understanding of capital market theory causes you to doubt the validity of the expected return and risk for U.S.
real estate. Justify your skepticism.
You are evaluating various investment opportunities currentl
y available and you have calculated
expected returns and standard deviations for five different well
diversified portfolios of risky
or each portfolio, calculate the risk premium per unit of risk that you expect to receive ([E(R)
? RFR]/?). Assume that the risk
free rate is 3.0 percent
b. Using your computations in Part a, explain which of these five portfolios is most likely to be
market portfolio. Use your calculations to draw the capital market line (
. c. If you are only willing to make an investment with ? = 7.0%, is it possible for you to earn a
return of 7.0 percent?
d. What is the minimum level of risk that would be necessary for an investment to earn 7.0
nt? What is the composition of the portfolio along the CML that will generate that expected
e. Suppose you are now willing to make an investment with ? = 18.2%. What would be the
investment proportions in the riskless asset and the market portfoli
o for this portfolio? What is
the expected return for this portfolio?
Based on five years of monthly data, you derive the following information for the companies
listed: Company ai (Intercept) ?i riM Intel 0.22 12.10% 0.72 Ford 0.10 14.60 0
Busch 0.17 7.60 0.55 Merck 0.05 10.20 0.60 S&P 500 0.00 5.50 1.00 a. Compute the beta
coefficient for each stock. b. Assuming a risk
free rate of 8 percent and an expected return for
the market portfolio of 15 percent, compute the expected (re
quired) return for all the stocks and
plot them on the SML. c. Plot the following estimated returns for the next year on the SML and
indicate which stocks are undervalued or overvalued.
The following are the historic returns for the Chelle Computer Company:
Year Chelle Computer General Index
1 37 15
2 9 13
5 11 12
6 4 9
Based on this information, compute the following:
a) The correlation coefficient between Chelle
Computer and the General Index.
b) The standard deviation for the company and the index
c) The beta for the Chelle Computer Company
Ch 09: Risk & Return
It is widely believed that changes in certain macroeconomic variables may directly affe
performance of an equity portfolio. As the chief investment officer of a hedge fund employing a
oriented investment strategy, you often consider how various macroeconomic
events might impact your security selection decisions and portfolio p
erformance. Briefly explain
how each of the following economic factors would affect portfolio risk and return:
(a) Industrial production,
(c) Risk premia,
(d) Term structure,
(e) Aggregate consumption,
(f) Oil prices.
er the following questions related to empirical tests of the APT:
Briefly discuss one study that does not support the APT. Briefly discuss a study that does support
the APT. Which position seems more plausible?
b. Briefly discuss why Shanken contends th
at the APT is not testable. What is the contrary view
to Shanken’s position?
You have been assigned the task of estimating the expect
ed returns for three different
TUV, and WXY. Your preliminary analysis has established the histo
rical risk premiums associated
with three risk factors that could potentially be included
in your cal
culations: the excess return
on a proxy for the market portfolio (MKT), and two variables capturing general macroeconomic
exposures (MACRO1 and MACRO2). These values are: λMKT = 7.5%, λMACRO1 =
λMACRO2 = 0.6%. You have also estimate
d the follow
ing factor betas (i.e., loadings) for all
three stocks with respect to each of these potential
a. Calculate expected re
turns for the three stocks using just the MKT risk factor. Assume a risk
free rate of 4.5%.
b. Calculate the expected returns for the three stocks using all three risk factors and the
c. Discuss the differences between the expect
ed return estimates from the single
factor model and
those from the multifactor
model. Which estimates are most likely to be
more useful in practice?
d. What sort of exposure might MACRO2 represent? Given the estimated factor betas, is it really
ble to consider it a common (i.e., systematic) risk
Please see attached file for this problem.
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