3330 PS8 sol - Cornell University Fall 2010 Economics 3330...

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Cornell University Fall 2010 Economics 3330: Problem Set 8 Solutions 1. True/False/Explain State whether each of the following is true or false and explain your answer. Please limit your explanations to no more than two sentences. a. If a company announces an increase in its annual earnings, its share price should appreciate. False. The market may expect a larger increase. b. According to the CAPM model, all securities should lie on the SML. True. In the CAPM model, investors use the same input list and the same risk-return relationships, so all securities will fall on the SML 2. Two-factor APT Suppose that there are two independent economic factors, F 1 and F 2 . The risk-free rate is 3%, and all stocks have independent firm-specific components with a standard deviation of 35%. There are two well-diversified portfolios. Portfolio A has the following characteristics: the beta on F 1 is 1.0 and on F 2 is 2.0. The expected return is 21%. For Portofolio B, the Beta on F 1 is 2.0 and the Beta on F 2 is 1.0, with an expected return of 18%. What is the expected return –beta relationship?
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