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

Exercises for
Financial Economics
Course Code: AS2109/CT8a
7 CAPM
Question 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 a
security, the relevant measure of risk is the beta of the security and not the
variance of the return on that security.
(iii) Two securities have expected returns of 3% and 5% and betas of 0.2 and 0.4
respectively. 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 covariance
of 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:
R
1
= 6% , β
1
= 0 . 5 , R
2
= 12% , β
2
= 1 . 5
Assume 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 and
which lies on the Security Market Line.
(c) Explain whether an investor should buy or sell a security which has an
average return of 16% and beta of 2.
1

8 Single Index Model
Question 1 You are given the following information for returns on two stocks I
and Z .
I Z
α 0.04 0.09
β 1.20 1.50
σ
e
0.25 0.40
The returns generating process is assumed to be as follows:
R =