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# Unit 10 (Ch.12) Extra Problems - SOLUTIONS (1).docx

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Lois King
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Unit 10 (Ch.12) – Extra Problems - SOLUTIONS 1. According to CAPM, what two elements are represented in security returns? a) a premium for market risk and for unique risk. b) a premium for unique risk and a premium for firm-specific risk. c) a premium for diversification and a premium for portfolio risk. d) a premium for time value of money and a premium for market risk. Solution: d A security’s return is comprised of the risk free rate, which measures the time value of money (and includes the real return in the economy plus an inflation component) plus a security premium which includes the security’s beta (a measure of market risk). i.e. Rj = Rf + β(Rm- Rf) 2. When the overall market experiences a decline of 8 percent, an investor with a portfolio of aggressive stocks will probably experience: a. negative portfolio returns of less than 8 percent. b. negative portfolio returns of greater than 8 percent. c. positive portfolio returns of less than 8 percent. d. positive portfolio returns of greater than 8 percent. Solution: b Aggressive stocks have a beta of greater than 1.0 and are more sensitive to macroeconomic conditions (as measured by the market portfolio). Therefore if the market goes down by 8%, an aggressive stock portfolio will most likely decline by more than 8%. 3. The line plotted to fit observations of a stock's returns versus the market's returns determines the: a. security market line. b. beta of the stock. c. market risk premium. d. capital asset pricing model. Solution: b The beta of a stock is the percentage change in the stocks’ return divided by the percentage change in the market’s return. 4. Based on the following information, make an estimate of the stock's beta: Month 1 = Stock +1.5%, Market +1.1%; Month 2 = Stock +2.0%, Market +1.4%; Month 3 = Stock -2.5%, Market -2.0%. a. Beta is greater than 1.0. b. Beta is less than 1.0. c. Beta equals 1.0. d. There is no consistent pattern of returns. Solution: a Month 1 beta = 1.5/1.1 = 1.36 Month 2 beta = 2.0/1.4 = 1.43 Month 3 beta = -2.5/-2.0 = 1.25 According to this data, the stock’s beta is greater than 1. 5. If a two-stock portfolio is equally invested in stocks with betas of 1.4 and 0.7, then the portfolio beta is: a. 0.70. b. 1.05. c. 1.40. d. 2.10. Solution: b Portfolio beta is just the weighted average of the betas of
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