1. Assume that the CAPM is a good description of stock price returns. The market
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Question
1. Assume that the CAPM is a good description of stock price returns. The market expected return is 7% with 10% volatility and the risk-free rate is 3%. New news arrives that does not change any of these numbers but it does change the expected return of the following stocks:
Green Leaf 12% 20% 1.5
Nat Sam 10% 40% 1.8
HanBel 9% 30% 0.75
Rebecca Automobile 6% 35% 1.2
a. At current market prices, which stocks represent buying opportunities?
b. On which stocks should you put a sell order in?
2. Consider the price paths of the following two stocks over six time periods
1 2 3 4 5 6
Stock 1 10 12 14 12 13 16
Stock 2 15 11 8 16 15 18
a. Which stock(s) would you be inclined to sell? Which would you be inclined to hold on to?
b. How would your answer change if right now is time 6?
c. What if you bought at time 3 instead of 1 and today is time 6?
d. What if you bought at time 3 instead of 1 and today is time 5?
a. What alpha do the informed traders make?
b. What is the alpha of the passive investors?
c. What is the expected return of the fad followers?
d. What alpha do the fad followers make?
Firm Dividend ($ million) Cost of Capital (%/Year)
S1 10 8
S2 10 12
S3 10 14
B1 100 8
B2 100 12
B3 100 14
a. Using the cost of capital in the table, calculate the market value of each firm.
b. Rank the three S firms by their market values and look at how their cost of capital is ordered.
What would be the expected return for a self-financing portfolio that went long on the firm with the largest market value and shorted the firm with the lowest market value? (The expected return of a self-financing portfolio is the weighted average return of the constituent securities.) Repeat using the B firms.
c. Rank all six firms by their market values. How does this ranking order the cost of capital?
What would be the expected return for a self-financing portfolio that went long on the firm with the largest market value and shorted the firm with the lowest market value?
d. Repeat part c but rank the firms by the dividend yield instead of the market value. What can you conclude about the dividend yield ranking compared to the market value ranking?
Stock A 800 1000 0.77
Stock B 750 1000 1.46
Stock C 950 1000 1.25
Stock D 900 1000 1.07
a. Calculate the expected return of each stock.
b. What is the sign of correlation between the expected return and market capitalization of the stocks?
In mid-2012, AOL Inc. had $100 million in debt, total equity capitalization of $3.1 billion, and an equity beta of 0.90 (as reported on Yahoo! Finance). Included in AOL
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