Solutions to Lab Problems for Chapter 09

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Unformatted text preview: Solutions to Lab Problems for Chapter 9 17. Section: 9.3 The CAPM and Market Risk Learning Objective: 9.3 Difficulty: Easy A. One would expect RIM to have a higher beta than the Royal Bank. The Royal Bank is a very large, stable firm and its basic business should not be very sensitive to market shocks. One would also expect the beta of the Royal Bank to be closer to 1.0 than RIM. The Royal Bank is a very large firm and therefore a more substantial component of the S&P/TSX than RIM and, therefore, the correlation between the Royal Bank and the Market should be closer to 1. RIM, in contrast, operates in a more volatile industry and the basic business is much more sensitive to economy ­ wide shocks. B. Using Excel: Tools Data Analysis Covariance The Variance ­Covariance Matrix: RIM returns RY returns TSX returns RIM returns 0.033387 RY returns 0.007088 0.00493 TSX returns 0.005018 0.001708 0.002495 The diagonal terms are the variances and the off ­diagonal terms are the covariances. Beta: Royal 0.684456 RIM 2.011269 C. i) Using the monthly returns of the portfolio, the beta is 1.34786. ii) Using the equation for the beta of a portfolio, the beta is 1.34786. iii) As expected, the two betas are identical. 36. Sections: 9.2 The Capital Asset Pricing Model (CAPM) and 9.3 The CAPM and Market Risk Learning Objective: 9.2 and 9.3 Difficulty: Difficult The client doesn’t understand the difference between the Capital Market Line (CML) and the Security Market Line (SML). The CML represents the relationship between the expected return and risk for efficient portfolios while the SML plots the relationship between the returns of individual securities and the market risk (Beta). 1 CML can’t be used to value individual securities because individual securities are not efficient portfolios; an efficient portfolio will be a well diversified portfolio and thereby have relatively little unique risk. A security, in contrast, will potentially have a great deal of idiosyncratic risk. Consequently, as only the market risk is priced (investors receive a reward for accepting this risk), we value securities using the SML. This security has a lot of idiosyncratic risk, but, as long as the client holds a well diversified portfolio, he can remove the effects of this risk and be left with just the market risk. The required return for a stock with this level of market risk is 9 percent (i.e., k = 4 + (8 ­4)(1.25) = 9%; however, you are expecting to earn 12 percent by holding the stock. Therefore, buy the stock. In contrast, if we used the CML, we would determine a required return of 16 percent (i.e., k = 4 + (8 ­4)(9/3) = 16%), which would suggest the stock is overvalued if the expected return is only 12 percent. 2 ...
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