final_practice_questions_nosolution - CAPM Question...

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CAPM Question Consider an economy in two periods, t=0 and t=1. At t=0, the market index is trading at a value of $100. At t=1, the index either rises to $130 in case of a boom (with probability 1/2), or falls to $90 in case of a recession (with probability 1/2). A large utility company ABC is in this economy, and its stock price at t=0 is $20. At t=1, the stock price either rises to $22 if the economy is in a boom time, or falls to $19 if the economy is in a recession. Neither the index nor the ABC stock pays dividends during this time, and the risk-free rate is R f = 2%. 1. What are the expected value and the variance of the return on the market index? What are the expected value and the variance of the return on ABC stock? 2. What is the covariance between the index return and the return on ABC stock? What is the market β of the ABC stock? 3. Assuming that CAPM holds, compute the expected return of ABC stock predicted by CAPM. Is it the same as the expected return calculated in (a)? If not, which one is higher? 1
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4. Is this fact that ABC has a different expected return than CAPM prediction consistent with what you’ve learned in the course? 5. Now, consider a more sophisticated asset pricing model than CAPM to correctly predict the expected returns. Let HML = R H - R L denote the excess return of value stocks over growth stocks, and SMB = R S - R B the excess return of small stocks over big stocks. Suppose that ABC has a beta of zero with respect to HML. The beta of ABC and the market index is still what you computed in (b). If the expected value of SMB is E [ SMB ] = 0 . 03(3%). Assuming that this Fama-French 3-factor model correctly prices the stock ABC, what should be the beta of ABC with respect to SMB? Portfolio choice
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This note was uploaded on 01/25/2010 for the course ECON 136 taught by Professor Szeidl during the Fall '08 term at University of California, Berkeley.

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final_practice_questions_nosolution - CAPM Question...

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