Chapter 10 Exercise

1. Classify the following events as mostly systematic or mostly unsystematic. Is the distinction clear in very case?

a. Short-term interest rates increase unexpectedly.

b. The interest rate a company pays on its short-term debt borrowing is increased by its bank.

c. Oil prices unexpectedly decline.

d. An oil tanker ruptures, creating a large oil spill.

e. A manufacturer loses a multimillion-dollar product liability suit.

f. A Supreme Court decision substantially broadens producer liability for injuries suffered by product users.

2. Is it possible that a risky asset could have a beta of zero? Explain. Based on the CAPM, what is the expected return on such an asset? Is it possible that a risky asset could have a negative beta? What does the CAPM predict about the expected return on such an asset? Can you give an explanation for your answer?

3. Consider the following quotation from a leading investment manager: “The shares of Southern Co. have traded close to $12 for most of the past three years. Since Southern’s stock has demonstrated very little price movement, the stock has a low beta. Texas Instruments, on the other hand, has traded as high as $150 and as low as its current $75. since IT’s stock has demonstrated a large amount of price movement, the stock has a very high beta.” Do you agree with this analysis? Explain.

4. A broker has advised you not to invest in oil industry stocks because they have high standard deviations. Is the broker’s advice sound for a risk-adverse investor like yourself? Why or why not?

5. You want to create a portfolio equally as risky as the market and you have $1,000,000 to invest. Given this information, fill in the rest of the following table:

6. Security F has an expected return of 10% and a standard deviation of 26% per year. Security G has an expected return of 17% and a standard deviation of 58% per year.

a. What is the expected return on a portfolio composed of 30% of security F and 70% of security G?

b. If the correlation between the returns of security F and security G is 0.25, what is the standard deviation of the portfolio described in part a?

7. Suppose the risk-free rate is 4.8% and the market portfolio has an expected return of 11.4%. The market portfolio has a variance of 0.0429. Portfolio Z has a correlation coefficient with the market of 0.39 and a variance of 0.1783. According to the CAPM, what is the expected return on portfolio Z?

8. According to CAPM, whether the investors would have a higher expectation on portfolio A? Suppose portfolio A and B are both well – diversified.

9 - 15. Suppose CAPM is effective, which of the following situation is possible? Give you explanations. Consider each situation independently.

9.

10

11

12

13

14.

15.

16. According to CAPM, the expected return on a risky asset depends on three components. Describe each component and explain its role in determining expected return. 
 

10 Exercise on CAPM