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    Finance Quiz

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    aoi03
    The document provides data on the expected returns, standard deviations, correlations, and betas of three firms, the market portfolio, and the risk-free asset. It then asks a series of questions to calculate missing values in the table and determine investment recommendations based on the CAPM. [1] Using the CAPM formula and given data, the missing values for correlation, standard deviation, and betas are calculated. [2] The expected returns for each firm are then calculated using the CAPM, finding Firm A and B are overpriced and should be sold, while Firm C is underpriced and should be bought.

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    Finance Quiz

    Uploaded by

    aoi03
    268 views4 pages
    The document provides data on the expected returns, standard deviations, correlations, and betas of three firms, the market portfolio, and the risk-free asset. It then asks a series of questions to calculate missing values in the table and determine investment recommendations based on the CAPM. [1] Using the CAPM formula and given data, the missing values for correlation, standard deviation, and betas are calculated. [2] The expected returns for each firm are then calculated using the CAPM, finding Firm A and B are overpriced and should be sold, while Firm C is underpriced and should be bought.

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    The document provides data on the expected returns, standard deviations, correlations, and betas of three firms, the market portfolio, and the risk-free asset. It then asks a series of questions to calculate missing values in the table and determine investment recommendations based on the CAPM. [1] Using the CAPM formula and given data, the missing values for correlation, standard deviation, and betas are calculated. [2] The expected returns for each firm are then calculated using the CAPM, finding Firm A and B are overpriced and should be sold, while Firm C is underpriced and should be bought.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    268 views4 pages

    Finance Quiz

    Uploaded by

    aoi03
    The document provides data on the expected returns, standard deviations, correlations, and betas of three firms, the market portfolio, and the risk-free asset. It then asks a series of questions to calculate missing values in the table and determine investment recommendations based on the CAPM. [1] Using the CAPM formula and given data, the missing values for correlation, standard deviation, and betas are calculated. [2] The expected returns for each firm are then calculated using the CAPM, finding Firm A and B are overpriced and should be sold, while Firm C is underpriced and should be bought.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    of 4

    Question 1

    You have been provided the following data about the securities of three firms, the market portfolio, and the risk-free asset:

    A- Fill in the missing values in the table.


    (Leave no cells blank - be certain to enter 0 wherever required. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

    Security Expected Return Standard Deviation Correlation * Beta


    Firm A 0.10 0.38 0.43 0.90
    Firm B 0.14 0.56 0.45 1.35
    Firm C 0.15 0.74 0.32 1.32
    The market portfolio 0.12 0.18 1 (always 1) 1 (always 1)
    The risk-free asset 0.04 0 0 0

    * With the market portfolio


    Solution :

    Firm A beta = Correlation between firm A and Market portfolio * Firm A's standard deviation / Market portfolio's standard deviation
    0.90 = Correlation between firm A and Market portfolio * 0.38/0.18
    0.90 x 0.18 = Correlation between firm A and Market portfolio * 0.38
    0.162/0.38 = Correlation between firm A and Market portfolio
    0.42632 = Correlation between firm A and Market portfolio

    Firm C beta = Correlation between firm C and Market portfolio * Firm C's standard deviation / Market portfolio's standard deviation
    Firm C beta = 0.32 x (0.74/0.18)
    Firm C beta = 0.32 x 4.11111
    Firm C beta = 1.31556

    B1 - What is the expected return of Firm A?


    (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

    Expected return = Risk free rate + Beta*(market rate-risk free rate)


    Firm A = 0.04 + (0.12-0.04)0.90
    Firm A = 11.20%

    Expected return 11.20 %

    B2 - What is your investment recommendation regarding Firm A for someone with a well-diversified portfolio?

    Sell
    B3 - What is the expected return of Firm B?
    (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

    Expected return = Risk free rate + Beta*(market rate-risk free rate)


    Firm B = 0.04 + (0.12-0.04)1.35
    Firm B = 14.80%

    Expected return 14.80 %

    B4 - What is your investment recommendation regarding Firm B for someone with a well-diversified portfolio?

    Sell

    B5 - What is the expected return of Firm C?


    (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

    Expected return = Risk free rate + Beta*(market rate-risk free rate)


    Firm C = 0.04 + (0.12-0.04)1.32
    Firm C = 14.56%

    Expected return 14.56 %

    B6 - What is your investment recommendation regarding Firm C for someone with a well-diversified portfolio?

    Buy

    Explanation

    Note: Intermediate answers are shown below as rounded, but the full answer was used to complete the calculation.

    a.
    (i) Using the equation to calculate beta, we find:

    βA = (ρA,M)(σA)/σM
    .90 = (ρA,M)(.38)/.18
    ρA,M = .43

    (ii) Using the equation to calculate beta, we find:

    βB = (ρB,M)(σB)/σM
    1.35 = (.45)(σB)/.18
    σB = .54

    (iii) Using the equation to calculate beta, we find:

    βC = (ρC,M)(σC)/σM
    βC = (.32)(.74)/.18
    βC = 1.32

    (iv) The market has a correlation of 1 with itself.

    (v) The beta of the market is 1.

    (vi) The risk-free asset has zero standard deviation.

    (vii) The risk-free asset has zero correlation with the market portfolio.

    (viii) The beta of the risk-free asset is 0.

    b-1.
    Using the CAPM to find the expected return of the stock, we find:

    Firm A:
    E(RA) = RF + βA[E(RM) − RF]
    E(RA) = .04 + .90(.12 − .04)
    E(RA) = .1120, or 11.20%

    b-2.
    According to the CAPM, the expected return on Firm A’s stock should be 11.20 percent. However, the expected return on Firm A’s stock given in the table is only 10 percent. Therefore, Firm A’s stock is overpriced, and you should sell it.

    b-3.
    Firm B:
    E(RB) = RF + βB[E(RM) − RF]
    E(RB) = .04 + 1.35(.12 − .04)
    E(RB) = .1480, or 14.80%

    b-4.
    According to the CAPM, the expected return on Firm B’s stock should be 14.80 percent. However, the expected return on Firm B’s stock given in the table is 14 percent. Therefore, Firm B’s stock is overpriced, and you should sell it.

    b-5.
    Firm C:
    E(RC) = RF + βC[E(RM) − RF]
    E(RC) = .04 + 1.32(.12 − .04)
    E(RC) = .1452, or 14.52%
    b-6.
    According to the CAPM, the expected return on Firm C’s stock should be 14.52 percent. However, the expected return on Firm C’s stock given in the table is 15 percent. Therefore, Firm C’s stock is underpriced, and you should buy it.

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