CHAPTER 8AN INTRODUCTION TO ASSET PRICING MODELSTRUE/FALSE QUESTIONS(t) 1 One of the assumptions of capital market theory is that investors can borrow or lend at the risk free rate.(f) 2 Since many of the assumptions made by the capital market theory are unrealistic,the theory is not applicable in the real world.(t) 3 A risk-free asset is one in which the return is completely guaranteed, there is no uncertainty.(t) 4 The market portfolio consists of all risky assets.(f) 5 The introduction of lending and borrowing severely limits the available risk/returnopportunities.(t) 6 The capital market line is the tangent line between the risk free rate of return and the efficient frontier.(t) 7 The portfolio on the capital market line are combinations of the risk-free asset and the market portfolio.(t) 8 If you borrow money at the RFR and invest the money in the market portfolio, the rate of return on your portfolio will be higher than the market rate of return.(f) 9 Studies have shown that a well diversified investor needs as few as five stocks. (f) 10 Beta is a measure of unsystematic risk.(f) 11 The betas of those companies compiled by Value Line Investment Services tend tobe almost identical to those compiled by Merrill Lynch.(t) 12 Securities with returns that lie above the security market line are undervalued. (f) 13 Securities with returns that lie below the security market line are undervalued. (t) 14 Under the CAPM framework, the introduction of lending and borrowing at differential rates leads to a non-linear capital market line.(t) 15 Correlation of the market portfolio and the zero-beta portfolio will be linear.(f) 16 There can be only one zero-beta portfolio.(t) 17 The existence of transaction costs indicates that at some point the additional cost of diversification relative to its benefit would be excessive for most investors.(t) 18 Studies have shown the beta is more stable for portfolios than for individual securities.(t) 19 If the market portfolio is mean-variance efficient it has the lowest risk for a given level of return among the attainable set of portfolios.(f) 20 Using the S&P index as the proxy market portfolio when evaluating a portfoliomanager relative to the SML will tend to underestimate the manager'sperformance.(t) 21 If an incorrect proxy market portfolio such as the S&P index is used when developing the security market line, the slope of the line will tend to beunderestimated.(f) 22 Since the market portfolio is reasonable in theory, therefore it is easy toimplement when testing or using the CAPM.(f) 23 The planning period for the CAPM is the same length of time for every investor.MULTIPLE CHOICE QUESTIONS(d) 1 Which of the following is not an assumption of the Capital Market Theory?a) All investors are Markowitz efficient investors.b) All investors have homogeneous expectations.c) There are no taxes or transaction costs in buying or selling assets.d) All investments are indivisible so it is impossible to buy or sell fractionalshares.e) All investors have the same one period time horizon.(a) 2 The rate of return on a risk free asset should equal thea) Long run real growth rate of the economy.b) Long run nominal growth rate of the economy.c) Short run real growth rate of the economy.d) Short run nominal growth rate of the economy.e)Prime rate of interest.(b) 3 Which of the following statements about the risk-free asset is correct?a) The risk-free asset is defined as an asset for which there is uncertaintyregarding the expected rate of return.b) The standard deviation of return for the risk-free asset is equal to zero.c) The standard deviation of return for the risk-free asset cannot be zero,since division by zero is undefined.d) Choices a and be) Choices a and c(a) 4 What does W RF = -0.50 mean?a) The investor can borrow money at the risk-free rate.b) The investor can lend money at the current market rate.c) The investor can borrow money at the current market rate.d) The investor can borrow money at the prime rate of interest.e) The investor can lend money at the prime rate of interest.(e) 5 The market portfolio consists of alla) New York Stock Exchange stocks.b) High grade stocks and bonds.c) Stocks and bonds.d) U.S. and non-U.S. stocks and bonds.e) Risky assets.(c) 6 The separation theorem divides decisions on _______ from decisions on _______.a) Lending, borrowingb) Risk, returnc) Investing, financingd) Risky assets, risk free assetse)Buying stocks, buying bonds(d) 7 When identifying undervalued and overvalued assets, which of the followingstatements is false?a) An asset is properly valued if its estimated rate of return is equal to itsrequired rate of return.b) An asset is considered overvalued if its estimated rate of return is below itsrequired rate of return.c) An asset is considered undervalued if its estimated rate of return is aboveits required rate of return.d) An asset is considered overvalued if its required rate of return is below itsestimated rate of return.e)None of the above (that is, all are true statements)(c) 8 The line of best fit for a scatter diagram showing the rates of return of anindividual risky asset and the market portfolio of risky assets over time is calledthea) Security market line.b) Capital asset pricing model.c) Characteristic line.d) Line of least resistance.e)Market line.(e) 9 Utilizing the security market line an investor owning a stock with a beta of -2would expect the stock's return to________ in a market that was expected todecline 15 percent.a) Rise or fall an indeterminate amountb) Fall by 3%c) Fall by 30%d) Rise by 13%e)Rise by 30%(d) 10 All of the following questions remain to be answered in the real world excepta) What is a good proxy for the market portfolio?b) What happens when you cannot borrow or lend at the risk free rate?c) How good is the capital asset model as a predictor?d) What is the beta of the market portfolio of risky assets?e) What is the stability of beta for individual stocks?(e) 11 The correlation coefficient between the market return and a risk-free asset woulda) be + ∞.b) be - ∞.c) be +1.d) be –1.e) be Zero.(a) 12 As the number of securities in a portfolio increases, the amount of systematic riska) Remains constant.b) Decreases.c) Increases.d) Changes.e) None of the above(b) 13 Theoretically, the correlation coefficient between a completely diversifiedportfolio and the market portfolio should bea) - 1.0.b) + 1.0.c) 0.0.d) - 0.5.e) + 0.5.(a) 14 All portfolios on the capital market line area) Perfectly positively correlated.b) Perfectly negatively correlated.c) Unique from each other.d) Weakly correlated.e)Unrelated except that they contain the risk free asset.(c) 15 The fact that tests have shown the CAPM intercept to be greater than the RFR isconsistent with aa) Zero beta model.b) An unstable beta or a higher borrowing rate.c) Zero beta model or a higher borrowing rate.d) higher borrowing rate.e) An unstable beta.(b) 16 If the assumption that there are no transaction costs is relaxed, the SML will be aa) Straight line.b) Band of securities.c) Convex curve.d) Concave curve.e)Parabolic curve.(e) 17 Which of the following is not a relaxation of the assumptions for the CAPM?a) Differential lending and borrowing ratesb) A zero beta modelc) Transaction costsd) Taxese)Homogeneous expectations and fixed planning periods(d) 18 Which of the following variables were found to be important in explaining returnbased upon a study of Fama and French (covering the period 1963 to 1990)?a)Sizeb)Book-to-market valuec)Betad)Choices a and b onlye)All of the above(e) 19 Which of the following would most closely resemble the true market portfolio?a) Stocksb) Stocks and bondsc) Stocks, bonds and foreign securitiesd) Stocks, bonds, foreign securities and optionse) Stocks, bonds, foreign securities options and coins(c) 20 The error caused by not using the true market portfolio has become known as thea) Portfolio deviation.b) CAPM shift.c) Benchmark error.d) Market error.e)Beta error.(b) 21 The _________ the number of stocks in a portfolio and the _________ the timeperiod the ________ the portfolio beta.a) Larger, longer, less stableb) Larger, longer, more stablec) Larger, shorter, less stabled) Larger, shorter, more stablee) Smaller, longer, more stable(b) 22 A completely diversified portfolio would have a correlation with the marketportfolio that isa)Equal to zero because it has only unsystematic risk.b)Equal to one because it has only systematic risk.c)Less than zero because it has only systematic risk.d)Less than one because it has only unsystematic tisk.e)Less than one because it has only systematic risk.(c) 23 In the presence of transactions costs, the SML will bea) A single straight line.b) A kinked line.c) A set of lines rather than a single straight line.d) A curve rather than a single straight line.e)Impossible to determine.(d) 24 If the wrong benchmark (or market portfolio) is selected thena)Computed betas would be wrong.b)The SML would be wrong.c)Computed betas would be correct.d)a) and b).e)b) and c).MULTIPLE CHOICE PROBLEMS(e) 1 Calculate the expected return for A Industries which has a beta of 0.75 when therisk free rate is 0.07 and you expect the market return to be 0.18.a) 11.13%b) 11.97%c) 12.25%d) 13.00%e) 15.25%(c) 2 Calculate the expected return for B Services which has a beta of 0.71 when therisk free rate is 0.09 and you expect the market return to be 0.13.a) 11.13%b) 11.47%c) 11.84%d) 13.00%e) 15.25%(c) 3 Calculate the expected return for C Inc. which has a beta of 0.8 when the risk freerate is 0.04 and you expect the market return to be 0.12.a) 8.10%b) 9.60%c) 10.40%d) 11.20%e) 12.60%(e) 4 Calculate the expected return for D Industries which has a beta of 1.0 when therisk free rate is 0.03 and you expect the market return to be 0.13.a) 8.6%b) 9.2%c) 11.0%d) 12.0%e) 13.0%(d) 5 Calculate the expected return for E Services which has a beta of 1.5 when the riskfree rate is 0.05 and you expect the market return to be 0.11.a) 10.6%b) 12.1%c) 13.6%d) 14.0%e) 16.2%(c) 6 Calculate the expected return for F Inc. which has a beta of 1.3 when the risk freerate is 0.06 and you expect the market return to be 0.125.a) 12.65%b) 13.55%c) 14.45%d) 15.05%e) 16.34%USE THE FOLLOWING INFORMATION FOR THE NEXT FIVE PROBLEMSRates of ReturnYear RA Computer Market Index1 11 152 9 133 -11 144 10 -95 11 126 6 9(c) 7 Compute the beta for RA Computer using the historic returns presented above.a) 0.7715b) 0.2195c) -0.2195d) 0.1023e) -0.7715(c) 8 Compute the correlation coefficient between RA Computer and the Market Index.a) -0.3200b) 0.0012c) -0.2300d) 0.2300e) 0.3200(a) 9 Compute the intercept of the characteristic line for RA Computer.a) 7.98b) 11.63c) 4.92d) -4.92e) -7.98(c) 10 The equation of the characteristic line for RA isa) R RA = - 7.98 + 0.2195R MIb) R RA = 7.98 + 0.2195R MIc) R RA = 7.98 - 0.2195R MId) R RA = - 7.98 - 0.2300R MIe) None of the above(a) 11 If you expected return on the Market Index to be 12%, what would you expect thereturn on RA Computer to be?a) 5.34%b) 6.00%c) 8.00%d) 10.00%e) 21.95%USE THE FOLLOWING INFORMATION FOR THE NEXT THREE PROBLEMSYou expect the risk-free rate (RFR) to be 5 percent and the market return to be 9 percent.You also have the following information about three stocks.CURRENT EXPECTED EXPECTED STOCK BETA PRICE PRICE DIVIDENDX 1.50 $ 22 $ 23 $ 0.75Y 0.50 $ 40 $ 43 $ 1.50Z 2.00 $ 45 $ 49 $ 1.00(b) 12 What are the expected (required) rates of return for the three stocks (in the order X,Y, Z)?a) 16.50%, 5.50%, 22.00%b) 11.00%, 7.00%, 13.00%c) 7.95%, 11.25%, 11.11%d) 6.20%, 2.20%, 8.20%e) 15.00%, 3.50%, 7.30%(a) 13 What are the estimated rates of return for the three stocks (in the order X, Y, Z)?a) 7.95%, 11.25%, 11.11%b) 6.20%, 2.20%, 8.20%c) 16.50%, 5.50%, 22.00%d) 11.00%, 7.00%, 13.00%e) 15.00%, 3.50%, 7.30%(e) 14 What is your investment strategy concerning the three stocks?a) Buy stock Y, it is undervalued.b) Buy stock X and Z, they are undervalued.c) Sell stocks X and Z, they are overvalued.d) Sell stock Y, it is overvalued.e) Choices a and c(b) 15 Recently you have received a tip that the stock of Bubbly Incorporated is going torise from $10.00 to $12.00 per share over the next year. You know that the annualreturn on the S&P 500 has been 12% and the 90-day T-bill rate has been yielding4% per year over the past 10 years. If beta for Bubbly is 1.2, will you purchasethe stock?a) Yes, because it is overvalued.b) Yes, because it is undervalued.c) No, because it is undervalued.d) No, because it is overvalued.e) Yes, because the expected return equals the estimated return.(b) 16 Your broker has advised you that he believes that the stock of Brat Inc. is going torise from $22.00 to $25.00 per share over the next year. You know that the annualreturn on the S&P 500 has been 12% and the 90-day T-bill rate has been yielding4% per year over the past 10 years. If beta for Brat is 0.8, will you purchase thestock?a) Yes, because it is overvaluedb) Yes, because it is undervaluedc) No, because it is undervaluedd) No, because it is overvaluede) Yes, because the expected return equals the estimated return(d) 17 Recently you have received a tip that the stock of Buttercup Industries is going torise from $76.00 to $85.00 per share over the next year. You know that the annualreturn on the S&P 500 has been 13% and the 90-day T-bill rate has been yielding3% per year over the past 10 years. If beta for Buttercup is 1.0, will you purchasethe stock?a) Yes, because it is overvalued.b) Yes, because it is undervalued.c) No, because it is undervalued.d) No, because it is overvalued.e) Yes, because the expected return equals the estimated return.(b) 18 A friend has some reliable information that the stock of Puddles Company isgoing to rise from $43.00 to $50.00 per share over the next year. You know thatthe annual return on the S&P 500 has been 11% and the 90-day T-bill rate hasbeen yielding 5% per year over the past 10 years. If beta for Puddles is 1.5, willyou purchase the stock?a) Yes, because it is overvalued.b) Yes, because it is undervalued.c) No, because it is undervalued.d) No, because it is overvalued.e) Yes, because the expected return equals the estimated return.(b) 19 Recently your broker has advised you that he believes that the stock of CaseyIncorporated is going to rise from $55.00 to $70.00 per share over the next year.You know that the annual return on the S&P 500 has been 12.5% and the 90-dayT-bill rate has been yielding 6% per year over the past 10 years. If beta for Caseyis 1.3, will you purchase the stock?a) Yes, because it is overvalued.b) Yes, because it is undervalued.c) No, because it is undervalued.d) No, because it is overvalued.e) Yes, because the expected return equals the estimated return.(d) 20 A friend has information that the stock of Zip Incorporated is going to rise from$62.00 to $65.00 per share over the next year. You know that the annual return onthe S&P 500 has been 10% and the 90-day T-bill rate has been yielding 6% peryear over the past 10 years. If beta for Zip is 0.9, will you purchase the stock?a) Yes, because it is overvalued.b) Yes, because it is undervalued.c) No, because it is undervalued.d) No, because it is overvalued.e) Yes, because the expected return equals the estimated return.(a) 21 Assume that as a portfolio manager the beta of your portfolio is 1.2 and that yourperformance is exactly on target with the SML data under condition 1. If the trueSML data is given by condition 2, how much does your performance differ fromthe true SML?1) RFR = .08 R m(proxy) = .122) R K = .06 R m(true) = .15a) 4% lowerb) 6% lowerc) 8% lowerd) 4% highere) 6% higher(c) 22 Assume that as a portfolio manager the beta of your portfolio is 1.4 and that yourperformance is exactly on target with the SML data under condition 1. If the trueSML data is given by condition 2, how much does your performance differ fromthe true SML?1) RFR = .07 R m(proxy) = .132) R K = .08 R m(true) = .16a) 4.4% lowerb) 3.6% lowerc) 3.8% lowerd) 4.4% highere) 3.6% higher(a) 23 Assume that as a portfolio manager the beta of your portfolio is 1.3 and that yourperformance is exactly on target with the SML data under condition 1. If the trueSML data is given by condition 2, how much does your performance differ fromthe true SML?1) RFR = .08 R m(proxy) = .112) R K = .07 R m(true) = .14a) 4.2% lowerb) 3.6% lowerc) 3.8% lowerd) 4.2% highere) 3.6% higher(b) 24 Assume that as a portfolio manager the beta of your portfolio is 1.2 and that yourperformance is exactly on target with the SML data under condition 1. If the trueSML data is given by condition 2, how much does your performance differ fromthe true SML?1) RFR = .09 R m(proxy) = .122) R K = .10 R m(true) = .13a) 2% lowerb) 1% lowerc) 5% lowerd) 1% highere) 2% higher(d) 25 Assume that as a portfolio manager the beta of your portfolio is 1.1 and that yourperformance is exactly on target with the SML data under condition 1. If the trueSML data is given by condition 2, how much does your performance differ fromthe true SML?1) RFR = .07 R m(proxy) = .152) R K = .06 R m(true) = .12a) 3.2% lowerb) 6.4% lowerc) 4.9% lowerd) 3.2% highere) 6.4% higher(d) 26 Assume that as a portfolio manager the beta of your portfolio is 1.4 and that yourperformance is exactly on target with the SML data under condition 1. If the trueSML data is given by condition 2, how much does your performance differ fromthe true SML?1) RFR = .06 R m(proxy) = .122) R K = .05 R m(true) = .11a) 2.0% lowerb) 0.5% lowerc) 0.5% lowerd) 1.0% highere) 2.0% higherUSE THE FOLLOWING INFORMATION FOR THE NEXT SEVEN PROBLEMSReturn Proxy TruePeriod of Radtron Specific Index General Index(Percent) (Percent) (Percent)1 10 12 152 12 10 133 -10 -8 -84 -4 -10 0(e) 27 The average true return isa) 1%b) 2%c) 3%d) 4%e) 5%(b) 28 The average proxy return isa) 1%b) 2%c) 3%d) 4%e) 5%(a) 29 The average return for Radtron isa) 1%b) 2%c) 3%d) 4%e) 5%(c) 30 The covariance between Radtron and the proxy index isa) 57.30b) 86.50c) 88.00d) 92.50e) 107.90(b) 31 The covariance between Radtron and the true index isa) 57.30b) 86.50c) 88.00d) 92.50e) 107.90(a) 32 What is the beta for Radtron using the proxy index?a) 0.87b) 0.97c) 1.02d) 1.15e) 1.28(b) 33 What is the beta for Radtron using the true index?a) 0.87b) 0.97c) 1.02d) 1.15e) 1.28(b) 34 Consider an asset that has a beta of 1.5. The return on the risk-free asset is 6.5%and the expected return on the stock index is 15%. The estimated return on theasset is 20%. Calculate the alpha for the asset.a) 19.25%b) 0.75%c) –0.75%d) 9.75%e) 9.0%(c) 35 The variance of returns for a risky asset is 25%. The variance of the error term,Var(e) is 8%. What portion of the total risk of the asset, as measured by variance,is systematic?a) 32%b) 8%c) 68%d) 25%e) 75%(a) 36 An investor wishes to construct a portfolio consisting of a 70% allocation to astock index and a 30% allocation to a risk free asset. The return on the risk-freeasset is 4.5% and the expected return on the stock index is 12%. The standarddeviation of returns on the stock index 6%. Calculate the expected standarddeviation of the portfolio.a) 4.20%b) 25.20%c) 3.29%d) 10.80%e) 5.02%(b) 37 An investor wishes to construct a portfolio by borrowing 35% of his originalwealth and investing all the money in a stock index. The return on the risk-freeasset is 4.0% and the expected return on the stock index is 15%. Calculate theexpected return on the portfolio.a) 18.25%b) 18.85%c) 9.50%d) 15.00%e) 11.15%(d) 38 An investor wishes to construct a portfolio consisting of a 70% allocation to astock index and a 30% allocation to a risk free asset. The return on the risk-freeasset is 4.5% and the expected return on the stock index is 12%. Calculate theexpected return on the portfolio.a) 8.25%b) 16.50%c) 17.50%d) 9.75%e) 14.38%(d) 39 A stock has a beta of the stock is 1.25. The risk free rate is 5% and the return onthe market is 6%. The estimated return for the stock is 14%. According to theCAPM you shoulda) Sell because it is overvalued.b) Sell because it is undervalued.c) Buy because it overvalued.d) Buy because it is undervalued.e) Short because it is undervalued.(b) 40 Consider a risky asset that has a standard deviation of returns of 15. Calculate thecorrelation between the risky asset and a risk free asset.a) 1.0b) 0.0c) -1.0d) 0.5e) -0.5(a) 41 The expected return for a stock, calculated using the CAPM, is 10.5%. Themarket return is 9.5% and the beta of the stock is 1.50. Calculate the impliedrisk-free rate.a) 7.50%b) 13.91%c) 17.50%d) 21.88%e) 14.38%(e) 42 The expected return for a stock, calculated using the CAPM, is 25%. The risk freerate is 7.5% and the beta of the stock is 0.80. Calculate the implied return on themarket.a) 7.50%b) 13.91%c) 17.50%d) 21.88%e) 14.38%(c) 43 The expected return for Zbrite stock calculated using the CAPM is 15.5%. Therisk free rate is 3.5% and the beta of the stock is 1.2. Calculate the implied marketrisk premium.a) 5.5%b) 6.5%c) 10.0%d) 15.5%e) 12.0%CHAPTER 8ANSWERS TO PROBLEMS1 k = 0.07 + 0.75 (0.18 - 0.07) = 0.1525 = 15.25%2 k = 0.09 + 0.71 (0.13 - 0.09) = 0.1184 = 11.84%3 k = 0.04 + 0.8 (0.12 - 0.04) = 0.1040 = 10.40%4 k = 0.03 + 1.0 (0.13 - 0.03) = 0.1300 = 13.00%5 k = 0.05 + 1.5 (0.11 - 0.05) = 0.1400 = 14.00%6 k = 0.06 + 1.3 (0.125 - 0.06) = 0.1445 = 14.45%7 RA Computer (RA) Market Index (MI)11 159 13-11 1410 -911 126 9∑RA i = 36 ∑MI i = 54MEAN(RA) = 36/6 = 6 MEAN(MI) = 54/6 = 9The covariance between RA and the Market Index (COV RA,MI) is:COV RA,MI = ∑(RA i - MEAN(RA))(MI i - MEAN(MI))/N(RA - MEAN(RA)) x (MI - MEAN(MI))(11.0 - 6.0) x (15.0 - 9.0) = 30.0(9.0 - 6.0) x (13.0 - 9.0) = 12.0(-11.0 - 6.0) x (14.0 - 9.0) = - 85.0(10.0 - 6.0) x (- 9.0 - 9.0) = - 72.0(11.0 - 6.0) x (12.0 - 9.0) = 15.0(6.0 - 6.0) x (9.0 - 9.0)= 0.0∑ = - 90COV RA,MI = -90 ÷ 6 = -15.00The variance of the index is ∑(MI - MEAN(MI))2/N and is computed as follows:(15 - 9)2 = 36 (13 - 9)2 = 16 (14 - 9)2 = 25 (-9 - 9)2 = 324 (12 - 9)2 = 9(9 - 9)2= 0∑(MI - MEAN(MI)2 = 410 σMI 2 = 410 ÷ 6 = 68.333∴σMI = 8.2664Beta for RA is (βRA ) = COV RA,MI ÷ σMI 2 = -15.00 ÷ 68.333 = -0.2195Standard deviation (σRA ) of the returns for RA Computer is computed as follows:∑(RA i - (MEAN(RA))2 (11- 6.0)2 = 25 (9 - 6.0)2 = 9(-11 - 6.0)2= 289 (10 - 6.0)2 = 16 (11 - 6.0)2 = 25 (6.0 - 6.0)2 = 0∑(RA i - MEAN(RA))2 = 364σRA 2 = 64 ÷ 6 = 60.67 ∴ σRA = [60.67]1/2 = 7.898 The correlation coefficient between the returns of RA and the Market Index is r RA,MI = COV RA,MI ÷ σRA σMI = (-15.00) ÷ (7.89)(8.2664) = -0.2300 9The equation for the intercept (α) of the characteristic line is: α = MEAN(RA) - βRA MEAN(MI) = 6.0 - (-.2195)(9) = 7.98 10The equation for the of the characteristic line for RA is:R RA = α + βRA R MI = 7.98 - 0.2195R MI11 Return (RA) = 7.9755 - ( 0.2195)(12) = 5.34%For problems 12 -14STOCK REQUIRED ESTIMATED EVALUATIONX .05 + 1.50(.09 - .05) = 11.00% %95.72275.02223=+-OvervaluedY .05 + 0.50(.09 -.05) = 7.00%%25.114050.14043=+-UndervaluedZ .05 + 2.00(.09 - .05) = 13.00%%11.114500.14549=+-Overvalued15Expected Return = 4 + (1.2)(12 - 4) = 13.6% Estimated Return = (12 - 10) ÷ 10 = 20.0%Estimated Return > Expected Return∴ Stock is undervalued and should be purchased.16Expected Return = 4 + (0.8)(12 - 4) = 10.4% Estimated Return = (25 - 22) ÷ 22 = 13.64%Estimated Return > Expected Return∴Stock is undervalued and should be purchased.17 Expected Return = 3 + (1.0)(13 - 3) = 13.0% Estimated Return = (85 - 76) ÷ 76 = 11.84%Estimated Return < Expected Return∴ Stock is overvalued and should not be purchased.18Expected Return = 5 + (1.5)(11 - 5) = 14.0% Estimated Return = (50 - 43) ÷ 43 = 16.28%Estimated Return > Expected Return∴ Stock is undervalued and should be purchased.19 Expected Return = 6 + (1.3)(12.5 - 6) = 14.45% Estimated Return = (70 - 55) ÷ 55 = 27.27%Estimated Return > Expected Return∴ Stock is undervalued and should be purchased.20Expected Return = 6 + (0.9)(10 - 6) = 9.6% Estimated Return = (65 - 62) ÷ 62 = 4.80%Estimated Return < Expected Return∴ Stock is overvalued and should not be purchased.21 Since the market portfolio has a beta of 1, the market premium is .04 under theproxy and .09 under the true. Thus, your return is(proxy) k = .08 + 1.2 (.04) = .128 = 12.8%According to the true SML it should be:(true) K = .06 + 1.2 (.09) = 16.8%You have been underperforming by 4%.22 Since the market portfolio has a beta of 1, the market premium is .06 under theproxy and .08 under the true. Thus, your return is(proxy) k = .07 + 1.4 (.06) = .154 = 15.4%According to the true SML it should be:(true) K = .08 + 1.4 (.08) = 19.2%You have been underperforming by 3.8%.23 Since the market portfolio has a beta of 1, the market premium is .03 under theproxy and .07 under the true. Thus, your return is(proxy) k = .08 + 1.3 (.03) = .119 = 11.9%According to the true SML it should be:(true) K = .07 + 1.3 (.07) = 16.1%You have been underperforming by 4.2%.24 Since the market portfolio has a beta of 1, the market premium is .03 under theproxy and .03 under the true. Thus, your return is(proxy) k = .09 + 1.2 (.03) = .126 = 12.6%According to the true SML it should be:(true) K = .10 + 1.2 (.03) = 13.6%You have been underperforming by 1%.25 Since the market portfolio has a beta of 1, the market premium is .08 under theproxy and .06 under the true. Thus, your return is(proxy) k = .07 + 1.1 (.08) = .158 = 15.8%According to the true SML it should be:(true) K = .06 + 1.1 (.06) = 12.6%You have been overperforming by 3.2%.。
