# Exercises 5B.pdf - Exercises for Financial Economics Course...

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Exercises forFinancial EconomicsCourse Code: AS2109/CT8a7CAPMQuestion 1(i) Define the beta of a security in the Capital Asset Pricing Model.(ii) Explain carefully why, when an investor determines the expected return on asecurity, the relevant measure of risk is the beta of the security and not thevariance of the return on that security.(iii) Two securities have expected returns of 3% and 5% and betas of 0.2 and 0.4respectively. Assuming that the Capital Asset Pricing Model holds, calculate(a) the expected return on the market portfolio,(b) the variance of return on the market portfolio, given that the covarianceof returns between the first security and the market portfolio is 0.01.Question 2(i) State two differences between the beta in the CAPM and the beta in the Single-Index Model.(ii) The following is known about securities 1 and 2:R1= 6%,β1= 0.5,R2= 12%,β2= 1.5Assume that securities 1 and 2 are on the Security Market Line.(a) Derive an equation for the Security Market Line.(b) Calculate the expected return on another asset which has a beta of 2 andwhich lies on the Security Market Line.(c) Explain whether an investor should buy or sell a security which has anaverage return of 16% and beta of 2.1
8Single Index ModelQuestion 1You are given the following information for returns on two stocksIandZ.IZα0.040.09β1.201.50σe0.250.40The returns generating process is assumed to be as follows:R=
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Term
Fall
Professor
Joe Stauffer
Tags
6, 5, 3, 16, 12