Documente Academic
Documente Profesional
Documente Cultură
the
the
the
the
Cov (Ri , Rm )
.
Var (Rm )
Answer (d) is wrong because only measures the quantity of risk. Only
when multiplied by the market risk premium (expected excess return on
the market) can you conclude what the compensation for systematic risk
is.
2
8. The CAPM asserts that expected returns on individual securities are best
explained by
(a) economic factors, such as covariance of returns with GDP growth
(b) idiosyncratic risk
(c) systematic risk, captured by covariance with the market return
(d) diversification
Answer: The correct answer is (c).
According to the CAPM, different betas explain all differences in expected returns across securities. As mentioned above, beta measures
the covariance of the asset with the market return. Hence answer (c) is
correct.
9. The security characteristic line is
(a) the straight line of all efficient portfolios that investors are confronted with in
equilibrium
(b) the straight line that links the expected excess return of a security to its beta.
(c) the straight line that we get from regressing the securitys actual excess return on
the actual market excess return.
(d) the investment opportunity set of the risk-free asset and the market portfolio.
Answer: The correct answer is (c).
The definition of the security characteristic line was given in the lecture.
Answer (c) is correct.
10. Suppose the expected market return is 14%, the volatility of the market is
.25, the risk-free rate is 4% and the beta of Yahoo is 3.3. What return does
the CAPM predict for Yahoo?
(a) E[RYahoo ] = 0.04 + (0.14 0.04)/0.25 3.3
(b) E[RYahoo ] = (0.14 0.04)/0.25 3.3
(c) E[RYahoo ] = (0.14/.25) 3.3
(d) E[RYahoo ] = 0.04 + (0.14 0.04) 3.3
Answer: The correct answer is (d).
see the equation in the answer to question 6.
11. Suppose the CAPM-predicted expected return on Yahoo is 37%, but when
you run a regression of the return of Yahoo on the market return, you find
that the data imply that the expected return ought to be 40%. Which
statement is correct?
(a) Yahoo has a negative alpha. It is overpriced compared to the CAPM.
(b) Yahoo has a negative alpha. It is underpriced compared to the CAPM.
(c) Yahoo has a positive alpha. It is overpriced compared to the CAPM.
(d) Yahoo has a positive alpha. It is underpriced compared to the CAPM.
Answer: The correct answer is (d).
Since the return that you find in the data is higher, must be positive.
The relationship is given by the regression equation
Ri Rf = i + i [Rm Rf ] + ei .
A higher return means that the price is lower. This inverse relationship
between prices and returns can be seen from the definition of returns
R=
P1 D1
1
P0
where P stands for the price of the asset in the corresponding period and
D for the dividend. A low price then means that the asset is underpriced.
12. You are the manager of a firm and have to decide whether or not to undertake the following project. The project has an internal rate of return
(IRR) of 10%. Your companys beta is 0.5, the expected market return is
.10 and the risk-free rate is zero. Which is the correct decision.
(a) Undertake the project because the IRR of the project is lower than the cost of
capital.
(b) Undertake the project because the IRR of the project is greater than the cost of
capital.
(c) Dont undertake the project because the cost of capital is greater than the IRR
of the project.
(d) Dont undertake the project because the cost of capital is lower than the IRR of
the project.
Answer: The correct answer is (b).
The cost of capital is the required rate of return that we use in the
calculation of the net present value. We can compute it for the project
i as
E[Ri ] = Rf + E[Rm Rf ] =
1
0.1 = 0.05 < IRR = 10%.
2
Since the cost of capital is lower than the internal rate of return, you
undertake the project. To put it differently, the project compensates you
enough in return for taking on the amount of systematic risk.