(Partial) Practice Problems for Prelim III

Prof. Q. Ma, HAdm 2220

Note: These questions only cover the recent weeks materials. Please review the example
questions in the course packet, homework questions, and in-class discussion questions over
the past weeks as well. All these questions are helpful preparing for the exam. It does not
mean, however, they are sufficient. I suggest that you also carefully review the class notes,
re-read the relevant chapters in the text, and understand well the basic concepts.
1. A stock has an expected return of 13 percent, the risk-free rate is 4.5 percent, and the
market risk premium is 7 percent. What must the beta of this stock be?
Solution:
Using CAPM, we find: E(Ri) = .13 = .045+ .07i; we solve for i = 1.21.
2. A stock has an expected return of 15 percent, its beta is 1.45, and the expected return on
the market is 12 percent. What must the risk-free rate be?
Solution: Here we need to find the risk-free rate using the CAPM. Substituting the values
given, and solving for the risk-free rate, we find: E(Ri) = .15 = Rf + (.12 Rf)(1.45); solve we
have .15 = Rf + .174 1.45Rf; Rf = .0533 or 5.33%.
3. You own a portfolio equally invested in a risk-free asset and two stocks. If one of the
stocks has a beta of 1.65 and the total portfolio is equally as risky as the market, what must
the beta be for the other stock in your portfolio?
Solution:
p = 1.0 = 1/3(0) + 1/3(1.65) + 1/3(X); solve X = 1.35.
4. Suppose you observe the following situation:
Security
Beta
Expected Return
Pete Corp.
1.4
0.150
Repete Co.
.9
.115
Assume these securities are correctly priced. Based on the CAPM, what is the expected
return on the market? What is the risk-free rate?
Solution:
(.15 Rf)/1.4 = (.115 Rf)/.90; we can solve for Rf = .052 or 5.20%.
Now using CAPM to find the expected return on the market with both stocks, we have:
.15=.0520+1.4(RM.0520) or .115=.0520+.9(RM.0520); we have RM=.1220 or 12.20%.
5. Using the CAPM, show that the ratio of the risk premiums on two assets is equal to the
ratio of their betas.
Solution: We know that the reward-to-risk ratios for all assets must be equal. This can be
expressed as: [E(RA) Rf] /A = [E(RB) Rf] /B
The numerator of each equation is the risk premium of the asset, so: RPA/A = RPB/B
We can rearrange this equation to get: B/A = RPB/RPA
If the reward-to-risk ratios are the same, the ratio of the betas of the assets is equal to the ratio
of the risk premiums of the assets.

Hadm 2220, PPP-III, Prof. Q. Ma

1/5

6. Consider the following information about Stocks I and II:

State of
Probability of
Rate of Return if State Occurs
Economy
State of Economy Stock I Stock II
Recession
.25
.09
-.30
Normal
.50
.42
.12
Irrational exuberance .25
.26
.44
The market risk premium is 8 percent, and the risk-free asset is 4 percent. Which stock has
the most systematic risk? Which one has the most unsystematic risk? Which stock is riskier?
Explain.
Solution: The amount of systematic risk is measured by the of an asset. Since we know the
market risk premium and the risk-free rate, if we know the expected return of the asset we
can use the CAPM to solve for the of the asset. The expected return of Stock I is:
E(RI) = .25(.09) + .50(.42) + .25(.26) = .2975 or 29.75%
Using the CAPM to find the of Stock I, we find: .2975 = .04 + .08I; and I = 3.22
The total risk of the asset is measured by its standard deviation, so we need to calculate the
standard deviation of Stock I. Beginning with the calculation of the stocks variance, we
find:
I2 = .25(.09 .2975)2 + .50(.42 .2975)2 + .25(.26 .2975)2
I2 = .01862
I = (.01862)1/2 = .1365 or 13.65%
Using the same procedure for Stock II, we find the expected return to be:
E(RII) = .25(.30) + .50(.12) + .25(.44) = .0950
Using the CAPM to find the of Stock II, we find:
.0950 = .04 + .08II; and II = 0.69
And the standard deviation of Stock II is:
II2 = .25(.30 .0950)2 + .50(.12 .0950)2 + .25(.44 .0950)2
II2 = .06908
II = (.06908)1/2 = .2628 or 26.28%
Although Stock II has more total risk than I, it has much less systematic risk, since its beta
is much smaller than Is. Thus, I has more systematic risk, and II has more unsystematic
and more total risk.
Since unsystematic risk can be diversified away, I is actually the riskier stock despite the
lack of volatility in its returns. Stock I will have a higher risk premium and a greater
expected return.

Hadm 2220, PPP-III, Prof. Q. Ma

2/5

7. You have $100,000 to invest in a portfolio containing Stock X, Stock Y, and a risk-free
asset. You must invest all of your money. Your goal is to create a portfolio that has an
expected return of 13 percent and that has only 70 percent of the risk of the overall
market. If X has an expected return of 31 percent and a beta of 1.8, Y has an expected
return of 20 percent and a beta of 1.3, and the risk-free rate is 7 percent, how much
money will you invest in Stock X? How do you interpret your answer?
Solution: We are given the expected return and of a portfolio and the expected return
and of assets in the portfolio. We know the of the risk-free asset is zero. We also
know the sum of the weights of each asset must be equal to one. So, the weight of the riskfree asset is one minus the weight of Stock X and the weight of Stock Y.
Using this relationship, we can express the expected return of the portfolio as:
E(Rp) = .130 = wX(.31) + wY(.20) + (1 wX wY)(.07)
And the of the portfolio is: p = .7 = wX(1.8) + wY(1.3) + (1 wX wY)(0)
We have two equations and two unknowns. Solving these equations, we find that:
wX = 0.16667; wY = 0.76923; wRf = 0.39744
The amount to invest in Stock X is:0.16667($100,000) = $16,666.67
A negative portfolio weight means that your short sell the stock. If you are not familiar
with short selling, it means you borrow a stock today and sell it. You must then purchase
the stock at a later date to repay the borrowed stock. If you short sell a stock, you make a
profit if the stock decreases in value.
8. You own a portfolio that is 50 percent invested in Stock X, 30 percent in Stock Y, and
20 percent in Stock Z. The expected returns on these three stocks are 10 percent, 16
percent, and 12 percent, respectively. What is the expected return on the portfolio?
Solution:
The expected return of a portfolio is the sum of the weight of each asset times the expected
return of each asset. So, the expected return of the portfolio is:
E(Rp) = .50(.10) + .30(.16) + .20(.12) = .1220 or 12.20%.
9. You want a stock portfolio invested 25 percent in Stock Q, 20 percent in Stock R, 15
percent in Stock S, and 40 percent in Stock T. The betas for these four stocks are .75,
1.24, 1.09, and 1.42, respectively. What is the portfolio beta?
Solution:
The beta of a portfolio is the sum of the weight of each asset times the beta of each asset.
So, the beta of the portfolio is: p = .25(.75) + .20(1.24) + .15(1.09) + .40(1.42) = 1.17.
10. A stock has a beta of 1.25, the expected return on the market is 14 percent, and the riskfree rate is 5.2 percent. What must the expected return on this stock be?
Solution:
CAPM states the relationship between the risk of an asset and its expected return. CAPM is:
E(Ri) = Rf + [E(RM) Rf] i
Substituting the values we are given, we find: E(Ri)=.052+(.14.052)(1.25)=.162 or 16.2%.

Hadm 2220, PPP-III, Prof. Q. Ma

3/5

11. A stock has an expected return of 10 percent, its beta is .70, and the risk-free rate is 5.5
percent. What must the expected return on the market be?
Solution:
Here we need to find the expected return of the market using the CAPM. Substituting the
values given, and solving for the expected return of the market, we find:
E(Ri) = .10 = .055 + [E(RM) .055](.70)
E(RM) = .1193 or 11.93%.
12. A stock has a beta of 1.30 and an expected return of 17 percent. A risk-free asset
currently earns 5 percent.
a. What is the expected return on a portfolio that is equally invested in the two assets?
b. If a portfolio of the two assets has a beta of .75, what are the portfolio weights?
c. If a portfolio of the two assets has an expected return of 8 percent, what is its beta?
d. If a portfolio of the two assets has a beta of 2.60, what are the portfolio weights?
How do you interpret the weights for the two assets in this case? Explain.
Solution:
a. Again we have a special case where the portfolio is equally weighted, so we can sum the
returns of each asset and divide by the number of assets. The expected return of the
portfolio is:
E(Rp) = (.17 + .05)/2 = .1100 or 11.00%
b. We need to find the portfolio weights that result in a portfolio with a of 0.75. We know
the of the risk-free asset is zero. We also know the weight of the risk-free asset is one
minus the weight of the stock since the portfolio weights must sum to one, or 100 percent.
So:
p = 0.75 = wS (1.3) + (1 wS)(0)
0.75 = 1.3 wS + 0 0 wS
wS = 0.75/1.3
wS = .5769
And, the weight of the risk-free asset is:
wRf = 1 .5769 = .4231
c. We need to find the portfolio weights that result in a portfolio with an expected return of
8 percent. We also know the weight of the risk-free asset is one minus the weight of the
stock since the portfolio weights must sum to one, or 100 percent. So:
E(Rp) = .08 = .17wS + .05(1 wS)
.08 = .17wS + .05 .05wS
wS= .2500
So, the of the portfolio will be:
p = .2500(1.3) + (1 .2500)(0) = 0.325
d. Solving for the of the portfolio as we did in part a, we find:
p= 2.6 = wS (1.3) + (1 wS)(0)
wS = 2.6/1.3 = 2
wRf = 1 2 = 1
The portfolio is invested 200% in the stock and 100% in the risk-free asset. This means
borrowing at the risk-free rate to buy more of the stock.

Hadm 2220, PPP-III, Prof. Q. Ma

4/5

13. Stock Y has a beta of 1.40 and an expected return of 19 percent. Stock Z has a beta
of .65 and an expected return of 10.5 percent. If the risk-free rate is 6 percent and the
market risk premium is 8.8 percent, are these stocks correctly priced?
Solution:
There are two ways to correctly answer this question. We will work through both. First, we
can use the CAPM. Substituting in the value we are given for each stock, we find:
E(RY) = .06 + .088(1.40) = .1832 or 18.32%.
It is given in the problem that the expected return of Stock Y is 19 percent, but according to
the CAPM, the return of the stock based on its level of risk, the expected return should be
18.32 percent. This means the stock return is too high, given its level of risk. Stock Y plots
above the SML and is undervalued. In other words, its price must increase to reduce the
expected return to 18.32 percent.
For Stock Z, we find:
E(RZ) = .06 + .088(0.65) = .1172 or 11.72%.
The return given for Stock Z is 10.5 percent, but according to the CAPM the expected
return of the stock should be 11.72 percent based on its level of risk. Stock Z plots below
the SML and is overvalued. In other words, its price must decrease to increase the expected
return to 11.72 percent. We can also answer this question using the reward-to-risk ratio. All
assets must have the same reward-to-risk ratio. The reward-to-risk ratio is the risk premium
of the asset divided by its . We are given the market risk premium, and we know the of
the market is one, so the reward-to-risk ratio for the market is 0.088, or 8.8 percent.
Calculating the reward-to-risk ratio for Stock Y, we find:
Reward-to-risk ratio Y = (.19 .06) / 1.40 = .0929.
The reward-to-risk ratio for Stock Y is too high, which means the stock plots above the
SML, and the stock is undervalued. Its price must increase until its reward-to-risk ratio is
equal to the market reward-to-risk ratio. For Stock Z, we find:
Reward-to-risk ratio Z = (.105 .06) / .65 = .0692.
The reward-to-risk ratio for Stock Z is too low, which means the stock plots below the
SML, and the stock is overvalued. Its price must decrease until its reward-to-risk ratio is
equal to the market reward-to-risk ratio.

Hadm 2220, PPP-III, Prof. Q. Ma

5/5

(Partial) Practice Problems for Prelim III

Prof. Q. Ma, HAdm 2220
Note: These questions only cover the recent weeks materials. Please review the example
questions in the course packet, homework questions, and in-class discussion questions over
the past weeks as well. All these questions are helpful preparing for the exam. It does not
mean, however, they are sufficient. I suggest that you also carefully review the class notes,
re-read the relevant chapters in the text, and understand well the basic concepts.
1. A stock has an expected return of 13 percent, the risk-free rate is 4.5 percent, and the
market risk premium is 7 percent. What must the beta of this stock be?
Solution:
Using CAPM, we find: E(Ri) = .13 = .045+ .07i; we solve for i = 1.21.
2. A stock has an expected return of 15 percent, its beta is 1.45, and the expected return on
the market is 12 percent. What must the risk-free rate be?
Solution: Here we need to find the risk-free rate using the CAPM. Substituting the values
given, and solving for the risk-free rate, we find: E(Ri) = .15 = Rf + (.12 Rf)(1.45); solve we
have .15 = Rf + .174 1.45Rf; Rf = .0533 or 5.33%.
3. You own a portfolio equally invested in a risk-free asset and two stocks. If one of the
stocks has a beta of 1.65 and the total portfolio is equally as risky as the market, what must
the beta be for the other stock in your portfolio?
Solution:
p = 1.0 = 1/3(0) + 1/3(1.65) + 1/3(X); solve X = 1.35.
4. Suppose you observe the following situation:
Security
Beta
Expected Return
Pete Corp.
1.4
0.150
Repete Co.
.9
.115
Assume these securities are correctly priced. Based on the CAPM, what is the expected
return on the market? What is the risk-free rate?
Solution:
(.15 Rf)/1.4 = (.115 Rf)/.90; we can solve for Rf = .052 or 5.20%.
Now using CAPM to find the expected return on the market with both stocks, we have:
.15=.0520+1.4(RM.0520) or .115=.0520+.9(RM.0520); we have RM=.1220 or 12.20%.
5. Using the CAPM, show that the ratio of the risk premiums on two assets is equal to the
ratio of their betas.
Solution: We know that the reward-to-risk ratios for all assets must be equal. This can be
expressed as: [E(RA) Rf] /A = [E(RB) Rf] /B
The numerator of each equation is the risk premium of the asset, so: RPA/A = RPB/B
We can rearrange this equation to get: B/A = RPB/RPA
If the reward-to-risk ratios are the same, the ratio of the betas of the assets is equal to the ratio
of the risk premiums of the assets.

Hadm 2220, PPP-III, Prof. Q. Ma

1/5

6. Consider the following information about Stocks I and II:

State of
Probability of
Rate of Return if State Occurs
Economy
State of Economy Stock I Stock II
Recession
.25
.09
-.30
Normal
.50
.42
.12
Irrational exuberance .25
.26
.44
The market risk premium is 8 percent, and the risk-free asset is 4 percent. Which stock has
the most systematic risk? Which one has the most unsystematic risk? Which stock is riskier?
Explain.
Solution: The amount of systematic risk is measured by the of an asset. Since we know the
market risk premium and the risk-free rate, if we know the expected return of the asset we
can use the CAPM to solve for the of the asset. The expected return of Stock I is:
E(RI) = .25(.09) + .50(.42) + .25(.26) = .2975 or 29.75%
Using the CAPM to find the of Stock I, we find: .2975 = .04 + .08I; and I = 3.22
The total risk of the asset is measured by its standard deviation, so we need to calculate the
standard deviation of Stock I. Beginning with the calculation of the stocks variance, we
find:
I2 = .25(.09 .2975)2 + .50(.42 .2975)2 + .25(.26 .2975)2
I2 = .01862
I = (.01862)1/2 = .1365 or 13.65%
Using the same procedure for Stock II, we find the expected return to be:
E(RII) = .25(.30) + .50(.12) + .25(.44) = .0950
Using the CAPM to find the of Stock II, we find:
.0950 = .04 + .08II; and II = 0.69
And the standard deviation of Stock II is:
II2 = .25(.30 .0950)2 + .50(.12 .0950)2 + .25(.44 .0950)2
II2 = .06908
II = (.06908)1/2 = .2628 or 26.28%
Although Stock II has more total risk than I, it has much less systematic risk, since its beta
is much smaller than Is. Thus, I has more systematic risk, and II has more unsystematic
and more total risk.
Since unsystematic risk can be diversified away, I is actually the riskier stock despite the
lack of volatility in its returns. Stock I will have a higher risk premium and a greater
expected return.

Hadm 2220, PPP-III, Prof. Q. Ma

2/5

7. You have $100,000 to invest in a portfolio containing Stock X, Stock Y, and a risk-free
asset. You must invest all of your money. Your goal is to create a portfolio that has an
expected return of 13 percent and that has only 70 percent of the risk of the overall
market. If X has an expected return of 31 percent and a beta of 1.8, Y has an expected
return of 20 percent and a beta of 1.3, and the risk-free rate is 7 percent, how much
money will you invest in Stock X? How do you interpret your answer?
Solution: We are given the expected return and of a portfolio and the expected return
and of assets in the portfolio. We know the of the risk-free asset is zero. We also
know the sum of the weights of each asset must be equal to one. So, the weight of the riskfree asset is one minus the weight of Stock X and the weight of Stock Y.
Using this relationship, we can express the expected return of the portfolio as:
E(Rp) = .130 = wX(.31) + wY(.20) + (1 wX wY)(.07)
And the of the portfolio is: p = .7 = wX(1.8) + wY(1.3) + (1 wX wY)(0)
We have two equations and two unknowns. Solving these equations, we find that:
wX = 0.16667; wY = 0.76923; wRf = 0.39744
The amount to invest in Stock X is:0.16667($100,000) = $16,666.67
A negative portfolio weight means that your short sell the stock. If you are not familiar
with short selling, it means you borrow a stock today and sell it. You must then purchase
the stock at a later date to repay the borrowed stock. If you short sell a stock, you make a
profit if the stock decreases in value.
8. You own a portfolio that is 50 percent invested in Stock X, 30 percent in Stock Y, and
20 percent in Stock Z. The expected returns on these three stocks are 10 percent, 16
percent, and 12 percent, respectively. What is the expected return on the portfolio?
Solution:
The expected return of a portfolio is the sum of the weight of each asset times the expected
return of each asset. So, the expected return of the portfolio is:
E(Rp) = .50(.10) + .30(.16) + .20(.12) = .1220 or 12.20%.
9. You want a stock portfolio invested 25 percent in Stock Q, 20 percent in Stock R, 15
percent in Stock S, and 40 percent in Stock T. The betas for these four stocks are .75,
1.24, 1.09, and 1.42, respectively. What is the portfolio beta?
Solution:
The beta of a portfolio is the sum of the weight of each asset times the beta of each asset.
So, the beta of the portfolio is: p = .25(.75) + .20(1.24) + .15(1.09) + .40(1.42) = 1.17.
10. A stock has a beta of 1.25, the expected return on the market is 14 percent, and the riskfree rate is 5.2 percent. What must the expected return on this stock be?
Solution:
CAPM states the relationship between the risk of an asset and its expected return. CAPM is:
E(Ri) = Rf + [E(RM) Rf] i
Substituting the values we are given, we find: E(Ri)=.052+(.14.052)(1.25)=.162 or 16.2%.

Hadm 2220, PPP-III, Prof. Q. Ma

3/5

11. A stock has an expected return of 10 percent, its beta is .70, and the risk-free rate is 5.5
percent. What must the expected return on the market be?
Solution:
Here we need to find the expected return of the market using the CAPM. Substituting the
values given, and solving for the expected return of the market, we find:
E(Ri) = .10 = .055 + [E(RM) .055](.70)
E(RM) = .1193 or 11.93%.
12. A stock has a beta of 1.30 and an expected return of 17 percent. A risk-free asset
currently earns 5 percent.
a. What is the expected return on a portfolio that is equally invested in the two assets?
b. If a portfolio of the two assets has a beta of .75, what are the portfolio weights?
c. If a portfolio of the two assets has an expected return of 8 percent, what is its beta?
d. If a portfolio of the two assets has a beta of 2.60, what are the portfolio weights?
How do you interpret the weights for the two assets in this case? Explain.
Solution:
a. Again we have a special case where the portfolio is equally weighted, so we can sum the
returns of each asset and divide by the number of assets. The expected return of the
portfolio is:
E(Rp) = (.17 + .05)/2 = .1100 or 11.00%
b. We need to find the portfolio weights that result in a portfolio with a of 0.75. We know
the of the risk-free asset is zero. We also know the weight of the risk-free asset is one
minus the weight of the stock since the portfolio weights must sum to one, or 100 percent.
So:
p = 0.75 = wS (1.3) + (1 wS)(0)
0.75 = 1.3 wS + 0 0 wS
wS = 0.75/1.3
wS = .5769
And, the weight of the risk-free asset is:
wRf = 1 .5769 = .4231
c. We need to find the portfolio weights that result in a portfolio with an expected return of
8 percent. We also know the weight of the risk-free asset is one minus the weight of the
stock since the portfolio weights must sum to one, or 100 percent. So:
E(Rp) = .08 = .17wS + .05(1 wS)
.08 = .17wS + .05 .05wS
wS= .2500
So, the of the portfolio will be:
p = .2500(1.3) + (1 .2500)(0) = 0.325
d. Solving for the of the portfolio as we did in part a, we find:
p= 2.6 = wS (1.3) + (1 wS)(0)
wS = 2.6/1.3 = 2
wRf = 1 2 = 1
The portfolio is invested 200% in the stock and 100% in the risk-free asset. This means
borrowing at the risk-free rate to buy more of the stock.

Hadm 2220, PPP-III, Prof. Q. Ma

4/5

13. Stock Y has a beta of 1.40 and an expected return of 19 percent. Stock Z has a beta
of .65 and an expected return of 10.5 percent. If the risk-free rate is 6 percent and the
market risk premium is 8.8 percent, are these stocks correctly priced?
Solution:
There are two ways to correctly answer this question. We will work through both. First, we
can use the CAPM. Substituting in the value we are given for each stock, we find:
E(RY) = .06 + .088(1.40) = .1832 or 18.32%.
It is given in the problem that the expected return of Stock Y is 19 percent, but according to
the CAPM, the return of the stock based on its level of risk, the expected return should be
18.32 percent. This means the stock return is too high, given its level of risk. Stock Y plots
above the SML and is undervalued. In other words, its price must increase to reduce the
expected return to 18.32 percent.
For Stock Z, we find:
E(RZ) = .06 + .088(0.65) = .1172 or 11.72%.
The return given for Stock Z is 10.5 percent, but according to the CAPM the expected
return of the stock should be 11.72 percent based on its level of risk. Stock Z plots below
the SML and is overvalued. In other words, its price must decrease to increase the expected
return to 11.72 percent. We can also answer this question using the reward-to-risk ratio. All
assets must have the same reward-to-risk ratio. The reward-to-risk ratio is the risk premium
of the asset divided by its . We are given the market risk premium, and we know the of
the market is one, so the reward-to-risk ratio for the market is 0.088, or 8.8 percent.
Calculating the reward-to-risk ratio for Stock Y, we find:
Reward-to-risk ratio Y = (.19 .06) / 1.40 = .0929.
The reward-to-risk ratio for Stock Y is too high, which means the stock plots above the
SML, and the stock is undervalued. Its price must increase until its reward-to-risk ratio is
equal to the market reward-to-risk ratio. For Stock Z, we find:
Reward-to-risk ratio Z = (.105 .06) / .65 = .0692.
The reward-to-risk ratio for Stock Z is too low, which means the stock plots below the
SML, and the stock is overvalued. Its price must decrease until its reward-to-risk ratio is
equal to the market reward-to-risk ratio.

Hadm 2220, PPP-III, Prof. Q. Ma

5/5