Solutions to Lab Problems for Chapter 09

# Solutions to Lab Problems for Chapter 09 - Solutions to...

This preview shows page 1. Sign up to view the full content.

This is the end of the preview. Sign up to access the rest of the document.

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 ...
View Full Document

{[ snackBarMessage ]}

### What students are saying

• As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

Kiran Temple University Fox School of Business ‘17, Course Hero Intern

• I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

Dana University of Pennsylvania ‘17, Course Hero Intern

• The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

Jill Tulane University ‘16, Course Hero Intern