CHAPTER 8
AN INTRODUCTION TO ASSET PRICING MODELS
Answers to Questions
1. It can be shown that the expected return function is a weighted average of the individual
returns. In addition, it is shown that combining any portfolio with the risk-free asset, that
the standard deviation of the combination is only a function of the weight for the risky
asset portfolio. Therefore, since both the expected return and the variance are simple
weighted averages, the combination will lie along a straight line.
2. Expected Rate
of Return
M
C
B
A
RF
Expected Risk ( of return)
This figure indicates what happens as a risk-free asset is combined with risky portfolios
higher and higher on the efficient frontier. In each case, as you combine with the higher
return portfolio, the new line will dominate all portfolios below this line. This program
continues until you combine with the portfolio at the point of tangency and this line
becomes dominant over all prior lines. It is not possible to do any better because there are
no further risky asset portfolios at a higher point.
3. In a capital asset pricing model (CAPM) world the relevant risk variable is the security’s
systematic risk - its covariance of return with all other risky assets in the market. This
risk cannot be eliminated. The unsystematic risk is not relevant because it can be
eliminated through diversification - for instance, when you hold a large number of
securities, the poor management capability, etc., of some companies will be offset by the
above average capability of others.
4. For plotting, the SML the vertical axis measures the rate of return while the horizontal
axis measures normalized systematic risk (the security’s covariance of return with the
market portfolio divided by the variance of the market portfolio). By definition, the beta
(normalized systematic risk) for the market portfolio is 1.0 and is zero for the risk-free
asset. It differs from the CML where the measure of risk is the standard deviation of
return (referred to as total risk).
8-1
Answers to Problems
5. E(Ri) = RFR + i(RM - RFR)
= .10 + i(.14 - .10)
= .10 + .04i
Stock Beta (Required Return) E(Ri) = .10 + .04i
U 85 .10 + .04(.85) = .10 + .034 = .134
N 1.25 .10 + .04(1.25)= .10 + .05 = .150
D -.20 .10 + .04(-.20) = .10 - .008 = .092
8-2
6.
Current Expected Expected
Stock Price Price Dividend Estimated Return
24 22 0.75
U 22 24 0.75 .1250
22
51 48 2.00
N 48 51 2.00 .1042
48
40 37 1.25
D 37 40 1.25 .1149
37
Stock Beta Required Estimated Evaluation
U .85 .134 .1250 Overvalued
N 1.25 .150 .1042 Overvalued
D -.20 .092 .1149 Undervalued
If you believe the appropriateness of these estimated returns, you would buy stocks D
and sell stocks U and N.
E(R)
N
14% U
*U’
* N’
*D’
D
-0.2 .085 1.25
-0.5 0.5 1.0
8-3
