Department of Finance

University of Basel
Fall 2009
Finanzmarkttheorie 1
Exercises: Capital Asset Pricing Model (SOLUTIONS)
Exercise 1
a) This is the case since the risk free rate is assumed to be constant and known. This is quite
realistic in a one period setting (buy a zero-coupon sovereign bond with maturity equal to
investment period). As our models have been dealing with one period investment problems
this is not a problematic assumption. An issue might be whether we need investments to be
risk free in nominal or real terms.
Zero volatility is not realistic for investment strategies over more than one period as rein-
vestment rates become an issue. Still, it might be a reasonable approximation to reality.
b) graphs on the overhead projector
c) graphs on the overhead projector
Note: the assumptions of the CAPM imply an equation in terms of expected returns of the
form E(R
i
) = R
f
+
i
(E(R
M
R
f
)). This directly shows the linearity in (, ) space (the
slope is R
M
R
f
).
d) Our theory implies that only systematic risk is priced and compensated for, but not
unsystematic risk. Furthermore, systematic risk is represented by the Beta of an asset. Now,
the SML holds for any asset as we use the assets Beta on the x-axis. Contrarily, the CML
is only a representation for well-diversied portfolios because we plot total risk and not only
systematic risk on the x-axis.
Exercise 2
a) The central result of the Capital Asset Pricing Model is that only the non-diversiable
risk will to be rewarded by the market. This non-diversiable risk is quantied by the Beta,
which is the sensitivity of the stock expected return as a function of the expected return of
the market portfolio. The CAPM gives the following formula for the beta of an asset i:

i
=
Cov(r
i
, r
M
)

2
M
,
where Cov(r
i
, r
M
) is the covariance of the returns of asset i with the returns of the market
and
2
M
V ar(r
M
) is the variance of the returns of the market portfolio.
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b) The expected excess return on the market is
M
r
f
= 8%, thus the risk premium is

M
r
f

2
M
=
8%

2
M
.
c) The security market line obeys the following linear equation:

j
= 0.04 +
j
(0.12 0.04) = 0.04 + 0.08
j
.
d) Given r r
f
= (r
M
r
f
) and given r
f
= 0.04, = 1.5 it follows that the the required
return on an investment with a beta of 1.5 is 16 percent.
e) Using the value r = 0.112 and r
f
= 0.04 we can obtain
Z
= 0.9 using the basic CAPM
equation.
Exercise 3
a) Denote the lower and upper level of variable X as X

for the lower bound and X

for the
upper bound. Then

i
=
Cov

(r
i
, r
M
)

M
=
0.0168
0.4 0.21
= 0.2
Conversely,

i
=
0.03
0.2 0.21
= 0.71.
For the beta of the risky asset we obtain the interval borders

i
=
Cov(r
i
, r
M
)

2
M
=
0.0168
0.21
2
= 0.38.
and

i
=
0.03
0.21
2
= 0.68
Hence we nd that the values of
i,M
and
i
satisfy
i,M
[0.2, 0.71] and
i
[0.38, 0.68].
b) We would expect that r
f
[0, ). From the basic CAPM equation
i
=
i
(
M
r
f
) +r
f
we obtain upon solving for r
f
r
f
=

i

M
1
i
.
This yields upper and lower bounds for r
f
as r
f
[0.019, 0.034]. Thus, the implied rates
(implied by the CAPM) are consistent with our intuition.
c) Generally, one should always assess whether methods are generally applicable to the
problem at hand or whether they require special care in certain situations. In this case, if
we imagine the market portfolio in (, ) space and we only do have the market portfolio
and no more information, then we cannot unambiguously draw a straight line. This case
corresponds to = 1. That is, any risk-free rate is consistent with a market equilibrium, as
long as we do not have more information on the economy than assets with = 1. In that
sense the invalidity of = 1 is a good thing rather than a loss of methodological generality.
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d) Consider some asset k. Then, if k has the same risk characteristics (whatever this may
be) as i it follows that it must have the same expected rate of return, thus
k
=
i
. This
statement does not depend on the validity of the CAPM. Assets are priced as the present
value of expected futures cash ows (where the discount factors include the expected rate of
return on asset k.)
e) Ex-ante version of the CAPM is stated in terms of expected values:
E(R
i
) = R
f
+
i
(E(R
M
R
f
)) ,
where E denotes the expectation operator. Note that
i
is also an expectation, the expected
value of
i
over the next period (which does not have to be equal to the historical beta).
This model is not directly testable because expectations are not observable.
In the ex-post version the expectation operator is replaced by past (known) values at time
t, and usually stated in terms of a regression with a constant:
R
i,t
R
f,t
=
i
+
i
(R
M,t
R
f,t
) +
i,t
.
Exercise 4
a) From the basic formula of beta we obtain

P
=
Cov(r
P
, r
M
)

2
M
=

P,M

2
M
=

P,M

M
=
0.8 0.3
0.15
= 1.6
From the decomposition of variance
2
P
=
2
P

2
M
+
2
unsyst,P
follows

2
syst,P
=
2
P

2
M
= 0.0576
and

2
unsyst,P
=
2
P

2
syst,P
= 0.0324
b*) We need to use discretely compounded returns for calculating the second moments in
order to be able to build portfolios. Otherwise, there will be an inconsistency in the proof.
We have
i
=
Cov(R
i
,R
M
)

2
M
. This should also hold for any portfolio, which we will denote by P.
We also know that R
P
=

N
i=1
w
i
R
i
. Thus,

P
=
Cov(R
P
, R
M
)

2
M
=
Cov(

N
i=1
w
i
R
i
, R
M
)

2
M
=

N
i=1
w
i
Cov(R
i
, R
M
)

2
M
=
N

i=1
w
i

i
.
A problem may arise because usually we caculate the variance and covariance using conti-
nuously compounded rates of return (because they tend to be normally distributed).
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Exercise 5
First, we need to calculate R
f
and E(R
M
) R
f
. According to the CAPM we can set up the
following equations:
I) 0.15 R
f
= 0.5(E(R
M
) R
f
) for security A
II) 0.25 R
f
= 1.5(E(R
M
) R
f
) for security B
Subtracting I) from II) yields
E(R
M
) R
f
= 0.1
inserting in equation II) and solving for R
f
gives R
f
= 0.1. With these implied numbers we
can solve a) and b).
a) E(R
C
) = 0.1 + 1.8 0.1 = 0.28
b) E(R
D
) = 0.1 + 1.2 0.1 = 0.22
c) I would put more condence in result b) as the Beta is in between the Betas for the
given assets which we used when estimating the implied parameters. The result in a) is an
extrapolation which may hold but is less likely to do so as in b).
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