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When the annualized monthly percentage rates of return for a stock market index were regressed
against the returns for ABC and XYZ stocks over a 5-year period ending in 2013, using an ordinary
least squares regression, the following results were obtained:

Statistic ABC XYZ

Alpha – 3.20% 7.3%
Beta 0.60 0.97
R2 0.35 0.17
Residual standard deviation 13.02%21.45%
Explain what these regression results tell the analyst about risk–return relationships for each stock
over the sample period. Comment on their implications for future risk–return relationships,
assuming both stocks were included in a diversified common stock portfolio, especially in view of
the following additional data obtained from two brokerage houses, which are based on 2 years of
weekly data ending in December 2013.

Brokerage HouseBeta of ABCBeta of XYZ

A .62 1.45
B .71 1.25

Step-by-step solution:

 Step 1 of 1

The annualized monthly percentage rate for a market index was regressed against the return of ABC
and XYZ. The results are given in the problem.

Statistic ABC XYZ

Alpha -3.20% 7.30%
Beta 0.60% 0.97%
R2 0.35% 0.17%
Residual standard deviation13.02%21.45%
Beta of a stock measures the volatility of a stock returns with respect to the beta of the market index
which is considered to be 1. Beta for ABC was 0.60, less than the average stock’s β of 1 inferring that,
when the market index would rise or fall by 1 percentage, ABC’s return would also rise or fall by only
0.60 percentage. Therefore, ABC’s systematic risk was low (since beta is less) compared to the value
for stocks. It is less risky. ABC’s alpha is –3.2%, indicating that when the market return will be 0%,
the differential return on ABC would be –3.2%. ABC’s unsystematic risk is measured by σ(e), is
13.02%. For ABC, R2 was 0.35, showing that it is having more closeness of fit to the linear regression
more than the value of a normal stock.
Beta for XYZ is higher than ABC which is 0.97, which is much closer to the market beta which is 1.
Alpha for XYZ is positive with a higher differential return of 7.3%. Residual risk is 21.45%, indicating
the riskiness of the stock more than the stock of ABC. The fit of the regression model was much less
than that of ABC, consistent with an R2 of only 0.17.
If both the stocks will be included in a portfolio then the effects would be different. If the stock’s beta
remains same over a period of time, then there will be a great difference in the systematic risk of the
portfolio.
If the estimates of ABC’s β are similar, irrespective of the sample period taken for the underlying
data. The range of these estimates is 0.60 to 0.71, which are below the market β of 1. The estimates
of XYZ’s β vary significantly ranging as high as 1.45. It can be concluded that XYZ’s β for the future
would be well above 1 and is hence more volatile and risky.

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