quiz_solve04

quiz_solve04 - 6. Given $1000, describe how to construct a...

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FNCE 3010 (Durham). Fall 2007. Quiz 4. CAPM relationship R A - R f = β ( R M - R f ) + ² and obtain β = 1 . 5, and the standard deviation of the residuals is 0.9. 1. Using a market risk premium of 8% and risk-free rate of 5%, what is CDE’s risk premium? What is CDE’s expected return? 2. If the market goes down by 2% next month, what is the expected change in CDE’s stock? 3. If CDE actually goes down by 3%, what is CDE’s idiosyncratic return for that period? 4. If the standard deviation of the monthly market return is 1.5%, what are CDE’s systematic risk, idiosyncratic risk, and total risk (expressed as monthly standard deviations)? 5. What range would I expect CDE’s monthly return to fall within 95% of the time?
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Unformatted text preview: 6. Given $1000, describe how to construct a portfolio with a beta of 2 comprised of CDE stock and the risk-free asset. What is the expected annual return for this portfolio? Solution: 1. Risk premium = 1.5 x 8 = 12%. Expected return = 5 + (1.5 x 8) = 17%. 2. 5/12 + 1.5 x (-2 - 5/12)= -3.21% 3. CDEs idiosyncratic return was -3 - (-3.21) = .21%. 4. Systematic risk = 1.5 x 1.5 = 2.25. Idiosyncratic risk = 0.9. Total risk = sqrt(2 . 25 2 + 0 . 9 2 ) = 2.42%. 5. Between 17/12 - (2 x 2.42) = -3.42% and 17/12 + (2 x 2.42) = 6.26%. 6. 2 = w * 1 . 5+(1-w ) * 0, solve for w. You should get w=4/3. So, borrow $333.33 at the risk-free rate and put $1333.33 in CDE. The expected return for this portfolio should be 5+2*8 = 21%....
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