Chapter 4

An introduction to asset pricing models

TRUE/FALSE QUESTIONS
(t) 1 One of the assumptions of Capital Market Theory is that investors
can borrow or lend at the risk-free rate.
(f) 2 An assumption of Capital Market Theory is that buying or selling
of assets entails no taxes, but entails significant transaction costs.
(t) 3 A risky asset is an asset with uncertain future returns, and
uncertainty (or risk) is measured by the variance or standard
deviation of returns.
(t) 4 The standard deviation of a portfolio that combines the risk-free
asset with risky assets is the linear proportion of the standard
deviation of the risky asset portfolio.
(t) 5 The Capital Market Line (CML) is the line from the intercept point
that represents the risk-free rate tangent to the original efficient
frontier.
(t) 6 The market portfolio consists of all risky assets.
(f) 7 All portfolios on the CML are perfectly negatively correlated,
which means that all portfolios on the CML are perfectly
negatively correlated with the
completely diversified market portfolio since it lies on the CML.
(t) 8 Diversification reduces the unsystematic risk in a portfolio.
(f) 9 The Capital Asset Pricing Model (CAPM) is a technique for
determining the expected risk on an asset.
(t) 10 Beta is a standardized measure of systematic risk.

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(t) 11 Multifactor models of risk and return can be broadly grouped into
models that use macroeconomic factors and models that use
microeconomic factors.
(f) 12 Arbitrage Pricing Theory (APT) specifies the exact number of risk
factors and their identity
(t) 13. Betas for defensive portfolios are generally less than one.
(f) 14. Using the separation theorem, it is necessary to match each
investor's indifference curves with a particular efficient
portfolio.
(t) 15. The CML indicates the required return for each portfolio risk
level.
(f) 16. A security that plots above the SML would be a good security to
sell short.
(f) 17. Beta is a measure of systematic risk and relates one security's
return to another security's return.
(t) 18. The CML states that all investors should invest in the same
portfolio of risky assets.
(f) 19. Most analysts use the Dow Jones Industrial Average as proxy for
the market portfolio.
(t) 20. Testing of the CAPM suggests the trade-off between expected
return and risk is an upward-sloping straight line.
(t) 21. If the overall market is expected to rise, a portfolio manager
should increase the beta of the portfolio.
(t) 22. Unlike the CAPM, the APT does not assume borrowing and
lending at the risk-free rate.

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(t) 23. With the APT, risk is defined in terms of a stock's sensitivity to
basic economic factors.
(f) 24. Like the CAPM, the APT assumes a single-period investment
horizon.
(t) 25. Both the CAPM and the APT assume that markets are perfect.
(t) 26. The APT is based on the law of one price, which states two
identical assets cannot sell at different prices.

MULTIPLE CHOICE QUESTIONS

(d) 1 Which of the following is not an assumption of the Capital Market

Theory?

a) All investors are Markowitz efficient investors.

b) All investors have homogeneous expectations.
c) There are no taxes or transaction costs in buying or selling
assets.
d) There are no risk-free assets.
e) All investors have the same one period time horizon.
(e) 2 The market portfolio consists of all

a) New York Stock Exchange stocks.

b) International stocks and bonds.
c) Stocks and bonds.
d) U.S. and non-U.S. stocks and bonds.
e) Risky assets.
(c) 3 The separation theorems divide decisions on
from decisions on .

a) Lending, borrowing
b) Risk, return
c) Investing, financing

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 d) Risky assets, risk free assets
e) Buying stocks, buying bonds
(d) 4 When identifying undervalued and overvalued assets, which of the
following statements is false?

a) An asset is properly valued if its estimated rate of return is

equal to its required rate of return.
b) An asset is considered overvalued if its estimated rate of return
is below its required rate of return.
c) An asset is considered undervalued if its estimated rate of
return is above its required rate of return.
d) An asset is considered overvalued if its required rate of return is
below its estimated rate of return.
e) None of the above (that is, all are true statements)
(b) 5 Utilizing the security market line an investor owning a stock with a
beta of (-2) would expect the stock's return to in a market that
was expected to decline 10 percent.

a) Rise or fall an indeterminate amount

b) Rise by 20.0%
c) Fall by 20.0%
d) Rise by 10.2%
e) Fall by 10.2%
(d) 6 The Capital Market Line (CML) refers to the efficient formed by
creating portfolios that

a) Invest solely in the market portfolio M.

b) Lend at the risk free asset and invest in the market portfolio.
c) Borrow at the risk free asset and invest in the market portfolio.
d) Lend and borrow at the risk free rate and invest in the market
portfolio.
e) Short sell the market portfolio.

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(e) 7 As the number of stocks in a portfolio increases

a) The expected return of the portfolio increases because

systematic risk decreases.
b) The expected return of the portfolio increases because
unsystematic risk decreases.
c) The standard deviation of the portfolio increases because
systematic risk increases.
d) The standard deviation of the portfolio decreases because
systematic risk increases.
e) The standard deviation of the portfolio decreases because
unsystematic risk decreases.
(a) 8 The Security Market Line (SML) represents the relation between

a) Risk and required return on an asset.

b) Systematic risk and required return on an asset.
c) Risk and return on a diversified portfolio of assets.
d) Unsystematic risk and required return on an asset
e) Systematic risk and required return on a diversified portfolio of
assets.
(a) 9 In a macro-economic based risk factor model the following
factor would be one of many appropriate factors

a) Confidence risk.
b) Maturity risk.
c) Expected inflation risk.
d) Call risk.
e) Return difference between small capitalization and large
capitalization stocks.

(d) 10 In a multifactor model, confidence risk represents

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 a) Unanticipated changes in the level of overall business activity.
b) Unanticipated changes in investors’ desired time to receive
payouts.
c) Unanticipated changes in short term and long term inflation
rates.
d) Unanticipated changes in the willingness of investors to take on
investment risk.
e) None of the above.

(b) 11 In a multifactor model, time horizon risk represents

a) Unanticipated changes in the level of overall business activity.

b) Unanticipated changes in investors’ desired time to receive
payouts.
c) Unanticipated changes in short term and long term inflation
rates.
d) Unanticipated changes in the willingness of investors to take on
investment risk.
e) None of the above.
(e) 12 In a micro-economic based risk factor model the following factor
would be one of many appropriate factors

a) Confidence risk.
b) Maturity risk.
c) Expected inflation risk.
d) Call risk.
e) Return difference between small capitalization and large
capitalization stocks.

(d) 13 A less restrictive form of the Single Index Model is the:

a. Risk-free Model.
b. CAPM.
c. CML.

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 d. Market Model.

(c) 14 Under the Market Model, the regression line that results when the
return of a security is plotted against the market index return is the:

a. SML.
b. CML.
c. characteristic line.
d. slope.

(b) 15 Which of the following is not one of the reasonable conclusions of

the CAPM reached by a consensus of the empirical results?

a. The intercept term is generally higher than the RF.

b. The SML appears to be non-linear.
c. The slope of the CAPM is generally less steep than suggested by
the theory.
d. All of the above are supported by empirical tests.

(c) 16 The arbitrage pricing theory (APT) and the CAPM both assume all
except which of the following?

a. Investors have homogeneous beliefs.

b. Investors are risk-averse utility maximizers.
c. Borrowing and lending can be done at the rate RF.
d. Markets are perfect.

(a) 17 Risk factors in the APT must possess all of the following the
characteristics except:

a. Factors must be readily observable in risk/return space.

b. Each factor must have a pervasive influence on stock returns
c. The factors must influence expected return.
d. Factors must be unpredictable.

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(c) 18 Which of the following might be used as a factor in an APT factor
model?

a. The risk-free rate

b. Expected inflation
c. Unanticipated deviations from expected inflation
d. Loss by fire at a company’s manufacturing plant

(b) 19 The arbitrage pricing theory (APT)

a. considers only one factor and is a narrower model than the

CAPM.
b. considers more factors than the CAPM and is a broader model.
c. is useful only for well-diversified portfolios of common stock.
d. is easy to practice because the factors are readily observable.

(d) 20 The APT is based on the:

a. law of averages.
b. law of attraction.
c. law of accelerating return.
d. law of one price.

(b) 21 The Capital Asset Pricing Model:

a. has serious flaws because of its complexity.
b. measures relevant risk of a security and shows the relationship
between risk and expected return.
c. was developed by Markowitz in the 1930s.
d. discounts almost all of the Markowitz portfolio theory.

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Q.1. Explain the difference between systematic and unsystematic risk?
Answer. Systematic risk refers to that portion of total variability of returns caused
by factors affecting the prices of all securities, e.g., economic, political and
sociological changes -factors that are uncontrollable, external, and broad in their
effect on all securities.
Unsystematic risk refers to factors that are internal and “unique” to the industry
or company, e.g., management capability, consumer preferences, labor strikes,
etc. Notably, it is not possible to get rid of the overall systematic risk, but it is
possible to eliminate the “unique” risk for an individual asset in a diversified
portfolio.

Q.2. The CAPM contends that there is a systematic and unsystematic risk for an
individual security? Which is the relevant risk variable and why is it relevant? Why
is the other risk variable not relevant?
Answer. 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.

Q.3. What are the similarities and dissimilarities between SML and CML as models
of the risk-return trade-off?
Answer. For plotting, the SML the vertical axis measures the rate of return while
the horizontal axis measures normalized systematic risk (the security’s covariance

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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).

Q.4. Identify and briefly discuss three criticisms of beta as used in the CAPM.
Answer. Any three of the following are criticisms of beta as used in CAPM.
1. Theory does not measure up to practice. In theory, a security with a zero beta
should give a return exactly equal to the risk-free rate. But actual results do not
come out that way, implying that the market values something besides a beta
measure of risk.
2. Beta is a fickle short-term performer. Some short-term studies have shown risk
and return to be negatively related. For example, Black, Jensen and Scholes found
that from April 1957 through December 1965, securities with higher risk produced
lower returns than less risky securities. This result suggests that (1) in some short
periods, investors may be penalized for taking on more risk, (2) in the long run,
investors are not rewarded enough for high risk and are overcompensated for
buying securities with low risk, and (3) in all periods, some unsystematic risk is
being valued by the market.
3. Estimated betas are unstable. Major changes in a company affecting the
character of the stock or some unforeseen event not reflected in past returns may
decisively affect the security’s future returns.
4. Beta is easily rolled over. Richard Roll has demonstrated that by changing the
market index against which betas are measured, one can obtain quite different
measures of the risk level of individual stocks and portfolios. As a result, one
would make different predictions about the expected returns, and by changing
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indexes, one could change the risk-adjusted performance ranking of a manager.

Q.5. Briefly explain whether investors should expect a higher return from holding
portfolio A versus portfolio B under CAPM. Assume that both portfolios are fully
diversified.
Answer. Under CAPM, the only risk that investors should be compensated for
bearing is the risk that cannot be diversified away (systematic risk). Because
systematic risk (measured by beta) is equal to one for both portfolios, an investor
would expect the same return for Portfolio A and Portfolio B.

Since both portfolios are fully diversified, it doesn’t matter if the specified risk for
each individual security is high or low. The specific risk has been diversified away
for both portfolios.

Q.6. Explain the concepts of specific risk, systematic risk, variance, covariance,
standard deviation, and beta as they relate to investment.

Answer. Systematic risk is market-related risk that cannot be diversified away.

Because systematic risk cannot be diversified away, investors are rewarded for
assuming this risk.

The variance of an individual security is the sum of the probability-weighted

average of the squared differences between the security’s expected return and its
possible returns. The standard deviation is the square root of the variance. Both
variance and standard deviation measure total risk, including both systematic and
specific risk. Assuming the rates of return are normally distributed, the likelihood
for a range of rates may be expressed using standard deviations. For example, 68
percent of returns may be expressed using standard deviations. Thus, 68 percent

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of returns can be expected to fall within + or -1 standard deviation of the mean,
and 95 percent within 2 standard deviations of the mean.

Covariance measures the extent to which two securities tend to move, or not
move, together. The level of covariance is heavily influenced by the degree of
correlation between the securities (the correlation coefficient) as well as by each
security’s standard deviation. As long as the correlation coefficient is less than 1,
the portfolio standard deviation is less than the weighted average of the
individual securities’ standard deviations. The lower the correlation, the lower the
covariance and the greater the diversification benefits (negative correlations
provide more diversification benefits than positive correlations).

The capital asset pricing model (CAPM) asserts that investors will hold only fully
diversified portfolios. Hence, total risk as measured by the standard deviation is
not relevant because it includes specific risk (which can be diversified away).

Under the CAPM, beta measures the systematic risk of an individual security or
portfolio. Beta is the slope of the characteristic line that relates a security’s
returns to the returns of the market portfolio. By definition, the market itself has
a beta of 1.0. The beta of a portfolio is the weighted average of the betas of each
security contained in the portfolio. Portfolios with betas greater than 1.0 have
systematic risk higher than that of the market; portfolios with betas less than 1.0
have lower systematic risk. By adding securities with betas that are higher (lower),
the systematic risk (beta) of the portfolio can be increased (decreased) as desired.

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Q.7. What changes would you expect in the standard deviation for a portfolio of
between 4 and 10 stocks, between 10 and 20 stocks, and between 50 and 100
stocks?

Answer. Standard deviation would be expected to decrease with an increase in

stocks in the portfolio because an increase in number will increase the probability
of having more inversely correlated stocks. There will be a major decline from 4 to
10 stocks, a continued decline from 10 to 20 but at a slower rate. Finally, from 50
to 100 stocks, there is a further decline but at a very slow rate because almost all
unsystematic risk is eliminated by about 18 stocks.

Q.8. Some studies related to the efficient market hypothesis generated results
that implied additional factors beyond beta should be considered to estimate
expected returns. What are these other variables and why should they be
considered?

Answer. Studies of the efficient markets hypothesis suggest that additional

factors affecting estimates of expected returns include firm size, the price-
earnings ratio, and financial leverage. These variables have been shown to have
predictive ability with respect to security returns.

Q.9. In the tests of the relationship between systematic risk (beta) and return,
what are you looking for?

Answer. Is there a positive linear relationship between the systematic risk of risky
assets and the rates of return on these assets? Are the coefficients positive and
significant? Is the intercept close to the risk-free rate of return?

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Q.10. In the empirical testing of the CAPM, what are two major concerns? Why
are they important?

Answer. First, the stability of beta: It is important to know whether it is possible

to use past betas as estimates of future betas. Second, is there a relationship
between beta and rates of return? This would indicate whether the CAPM is a
relevant pricing model that can explain rates of return on risky assets.

Q.11. Briefly discuss why it is important for beta coefficients to be stationary over
time.

Answer. Given that beta is the principal risk measure, stable betas make it easier
to forecast future beta measures of systematic risk - i.e., can betas measured
from past data be used in making investment decisions?

Q.12. Discuss the empirical results relative to beta stability for individual stocks
and portfolios of stocks.

Answer. The results of the stability of beta studies indicate that betas for
individual stocks are generally not stable, but portfolios of stocks have stable
betas.

Q.13. Discuss leverage and its effect on the CML.

Answer. Leverage indicates the ability to borrow funds and invest these added
funds in the market portfolio of risky assets. The idea is to increase the risk of the
portfolio (because of the leverage), and also the expected return from the
portfolio. It is shown that if you can borrow at the RFR then the set of leveraged
portfolios is simply a linear extension of the set of portfolios along the line from

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the RFR to the market portfolio. Therefore, the full CML becomes a line from the
RFR to the M portfolio and continuing upward.

Q.14. Discuss and justify a measure of diversification for a portfolio in terms of

capital market theory.

Answer. You can measure how well diversified a portfolio is by computing the
extent of correlation between the portfolio in question and a completely
diversified portfolio - i.e., the market portfolio. The idea is that, if a portfolio is
completely diversified and, therefore, has only systematic risk, it should be
perfectly correlated with another portfolio that only has systematic risk.

Q.15. Given the CML, discuss and justify the relevant measure of risk for an
individual security.

Answer. The relevant risk variable for an individual security in a portfolio is its
average covariance with all other risky assets in the portfolio. Given the CML,
however, there is only one relevant portfolio and this portfolio is the market
portfolio that contains all risky assets. Therefore, the relevant risk measure for an
individual risky asset is its covariance with all other assets, namely the market
portfolio.

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Q.1. You expect an RFR of 10 percent and the market return (RM) of 14 percent.
Compute the expected(required) return for the following stocks.

Stock Beta E(Ri)

U 0.85
N 1.25
D –0.20

Solution. E(Ri) = RFR + βi(RM - RFR)

= .10 + βi (.14 - .10)
= .10 + .04βi
Stock Beta (Required Return) E(Ri) = .10 + .04βi
U 85 .10 + .04(0.85) = .10 + .034 = .134
N 1.25 .10 + .04(1.25) = .10 + .05 = .150
D -.20 .10 + .04(-.20) = .10 - .008 = .092

Q.2. You ask a stockbroker what the firm’s research department expects for these
stocks. The broker responds with the following information:

Stock Current Price Expected Price Expected Dividend

U 22 24 0.75
N 48 51 2.00
D 37 40 1.25

Indicate what actions you would take with regard to these stocks. Discuss your
decisions.
Solution.
Stock Current Price Expected Price Expected Dividend Estimated Return
U 22 24 0.75 24 - 22 + 0.75
---------------------= .1250
22
N 48 51 2.00 51 - 48 + 2.00
--------------------- = 0.1042
48
D 37 40 1.25 40 - 37 + 1.25
--------------------- = 0.1149
37

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Stock Beta Required Estimated Evaluation
U 0.85 0 .134 0.1250 Overvalued
N 1.25 0.150 0.1042 Overvalued
D - 0.20 0 .092 0.1149 Undervalued

If you believe the appropriateness of these estimated returns, you would buy
stocks D and sell stocks U and N.

Q.3. Based on five years of monthly data, you derive the following information for
the companies listed:

Company ai (Intercept) σi r iM

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 (required) return for all the stocks.

Solution.
a.
Cov i,m Cov i,m
βi = -------------- and ri,m = -------------
σ 2m (σi) (σm)
then Cov i,m = (ri,m) (σi) (σm)
For Intel:
Cov i,m = (0.72)(0.1210)(0.0550) = 0.00479
Beta = 0.00479 / (0.055)2 = 0.00479/0.0030 = 1.597
For Ford:
COV i,m = (0.33)(0.1460)(0.0550) = 0.00265
Beta = 0.00265/ 0.0030 = 0.883

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For Anheuser Busch:
COV i,m = (0.55)(0.0760)(0.0550) = 0.00230
Beta = 0.00230/ 0.0030 = 0.767
For Merck:
COV i,m = (0.60)(0.1020)(0.0550) = 0.00337
Beta = 0.00337/ 0.0030 = 1.123

b. E(Ri) = RFR + βi (RM - RFR)

= 0.08 + βi (0.15 - 0.08)
= 0.08 + 0.07 βi

Stock Beta E(Ri) = .08 + .07 βi

Intel 1.597 0.08 + 0.1118 = 0.1918
Ford 0.883 0.08 + 0.0618 = 0.1418
Anheuser Busch 0.767 0.08 + 0.0537 = 0.1337
Merck 1.123 0.08 + 0.0786 = 0.1586

Q.4. 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.

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Solution.
Chelle Computer General (R 1 - E(R1) x
Year (R1) Index (RM) R1 - E(R1) RM - E(RM) RM - E(RM)
1 37 15 27.33 6 163.98
2 9 13 -.67 4 -2.68
3 -11 14 -20.67 5 -103.35
4 8 -9 -1.67 -18 30.06
5 11 12 1.33 3 3.99
6 4 9 -5.67 0 0.00
∑ = 58 ∑= 54 ∑ = 92.00
E(R1) = 58/6 E(M) = 54/6
E(R1) = 9.67 E(M) = 9

Var1 = [R1 - E(R1)]2 /N VarM = [RM - E(RM)]2/N

Var1 = 1211.33/6 = 201.89 VarM = 410/6 = 68.33
σ1 = √201.89 = 14.21 σM = √ 68.33 = 8.27

COV 1,M = 92.00/6 = 15.33

(a). The correlation coefficient can be computed as follows:

r1.M = COV 1, M / σ1 σM = 15.33/ (14.21) (8.27) = 15.33/117.52 = 0.13

(b). The standard deviations are: 14.21% for Chelle Computer and 8.27% for
index, respectively.

(c). Beta for Chelle Computer is computed as follows:

β1 = COV 1, M /VarM = 15.33/68.33 = 0.2244

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