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Details:

Ch 08: Intro to Asset Pricing Models

Questions: 7

You have recently been appointed chief investment officer of a major charitable foundation. Its large endowment fund is

currently invested in a broadly diversified portfolio of stocks (60 perce

nt) and bonds (40 percent). The foundation

�

s

board of trustees is a group of prominent individuals whose knowledge of modern investment theory and practice is

superficial. You decide a discussion of basic investment principles would be helpful.

a. Explain the concepts of specific risk, systematic

risk, variance, covariance, standard deviation, and beta as they relate to

investment management. You believe that the addition of other asset classes to the endowment portfolio would improve

the portfolio by reducing risk and enhancing return. You are awa

re that depressed conditions in U.S. real estate markets

are providing opportunities for property acquisition at levels of expected return that are unusually high by historical

standards. You believe that an investment in U.S. real estate would be both app

ropriate and timely, and have decided to

recommend a 20 percent position be established with funds taken equally from stocks and bonds. Preliminary

discussions revealed that several trustees believe real estate is too risky to include in the portfolio. The

board chairman,

however, has scheduled a special meeting for further discussion of the matter and has asked you to provide background

information that will clarify the risk issue. To assist you, the following expectation data have been developed:

Asset Cl

ass Return

Standard

Deviation

U.S.

Stocks

U.S.

Bonds

CORRELATION MATRIX

U.S.

Real Estate

U.S.

T

–

Bills

U.S. Stocks 12.0% 21.0% 1.00

U.S. Bonds 8.0 10.5 0.14 1.00

U.S. Real Estate 12.0 9.0 ?0.04 ?0.03 1.00

U.S. Treasury Bills 4.0 0.0 ?0.05 ?0.03 0.25 1.00

b.

Explain the effect on both portfolio risk and return that would result from the addition of U.S. real estate. Include in

your answer two reasons for any change you expect in portfolio risk. (Note: It is not necessary to compute expected risk

and return.)

c. Your understanding of capital market theory causes you to doubt the validity of the expected return and risk for U.S.

real estate. Justify your skepticism.

Comments

Expert Answer

Problems:

3

You are evaluating various investment opportunities currentl

y available and you have calculated

expected returns and standard deviations for five different well

–

diversified portfolios of risky

assets:

portfolio

Expected return

Standard deviation

q

7.8%

10.5

r

10

14.0

s

4.6

5.0

t

11.7

18.5

u

6.2

7.5

a. F

or each portfolio, calculate the risk premium per unit of risk that you expect to receive ([E(R)

? RFR]/?). Assume that the risk

–

free rate is 3.0 percent

b. Using your computations in Part a, explain which of these five portfolios is most likely to be

the

market portfolio. Use your calculations to draw the capital market line (

CML

)

. c. If you are only willing to make an investment with ? = 7.0%, is it possible for you to earn a

return of 7.0 percent?

d. What is the minimum level of risk that would be necessary for an investment to earn 7.0

perce

nt? What is the composition of the portfolio along the CML that will generate that expected

return?

e. Suppose you are now willing to make an investment with ? = 18.2%. What would be the

investment proportions in the riskless asset and the market portfoli

o for this portfolio? What is

the expected return for this portfolio?

Problems:

5

Based on five years of monthly data, you derive the following information for the companies

listed: Company ai (Intercept) ?i riM Intel 0.22 12.10% 0.72 Ford 0.10 14.60 0

.33 Anheuser

Busch 0.17 7.60 0.55 Merck 0.05 10.20 0.60 S&P 500 0.00 5.50 1.00 a. Compute the beta

coefficient for each stock. b. Assuming a risk

–

free rate of 8 percent and an expected return for

the market portfolio of 15 percent, compute the expected (re

quired) return for all the stocks and

plot them on the SML. c. Plot the following estimated returns for the next year on the SML and

indicate which stocks are undervalued or overvalued.

�

Intel

�

20%

�

Ford

�

15%

�

Anheuser Busch

�

19%

�

Merck

�

10%

Proble

ms:

6

The following are the historic returns for the Chelle Computer Company:

Year Chelle Computer General Index

1 37 15

2 9 13

3

–

11 14

4 8

–

9

5 11 12

6 4 9

Based on this information, compute the following:

a) The correlation coefficient between Chelle

Computer and the General Index.

b) The standard deviation for the company and the index

c) The beta for the Chelle Computer Company

Ch 09: Risk & Return

Questions:

6

It is widely believed that changes in certain macroeconomic variables may directly affe

ct

performance of an equity portfolio. As the chief investment officer of a hedge fund employing a

global macro

–

oriented investment strategy, you often consider how various macroeconomic

events might impact your security selection decisions and portfolio p

erformance. Briefly explain

how each of the following economic factors would affect portfolio risk and return:

(a) Industrial production,

(b) Inflation,

(c) Risk premia,

(d) Term structure,

(e) Aggregate consumption,

(f) Oil prices.

Q

uestion 9

Consid

er the following questions related to empirical tests of the APT:

a.

Briefly discuss one study that does not support the APT. Briefly discuss a study that does support

the APT. Which position seems more plausible?

b. Briefly discuss why Shanken contends th

at the APT is not testable. What is the contrary view

to Shanken’s position?

Problems:

3

You have been assigned the task of estimating the expect

ed returns for three different

stocks: QRS,

TUV, and WXY. Your preliminary analysis has established the histo

rical risk premiums associated

with three risk factors that could potentially be included

in your cal

–

culations: the excess return

on a proxy for the market portfolio (MKT), and two variables capturing general macroeconomic

exposures (MACRO1 and MACRO2). These values are: λMKT = 7.5%, λMACRO1 =

–

0.3%, and

λMACRO2 = 0.6%. You have also estimate

d the follow

–

ing factor betas (i.e., loadings) for all

three stocks with respect to each of these potential

risk factors:

FACTOR

LOADING

Stock

MKT

MACRO1

MACRO2

QRS

1.24

–

0.42

0.00

TUV

0.91

0.54

0.23

WXY

1.03

–

0.09

0.00

a. Calculate expected re

turns for the three stocks using just the MKT risk factor. Assume a risk

–

free rate of 4.5%.

b. Calculate the expected returns for the three stocks using all three risk factors and the

same 4.5%

risk

–

free rate.

c. Discuss the differences between the expect

ed return estimates from the single

–

factor model and

those from the multifactor

model. Which estimates are most likely to be

more useful in practice?

d. What sort of exposure might MACRO2 represent? Given the estimated factor betas, is it really

reasona

ble to consider it a common (i.e., systematic) risk

factor?

Problems:

4

Please see attached file for this problem.