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How are betas calculated? Run a regression with returns on the stock in question plotted on the Y axis and returns on the market portfolio plotted on the X axis. The slope of the regression line, which measures relative volatility, is defined as the stocks beta coefficient, or b.
Use the historical stock returns to calculate the beta for KWE.
Year 1 2 3 4 5 6 7 8 9 10 Market 25.7% 8.0% -11.0% 15.0% 32.5% 13.7% 40.0% 10.0% -10.8% -13.1% KWE 40.0% -15.0% -15.0% 35.0% 10.0% 30.0% 42.0% -10.0% -25.0% 25.0%
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kKWE
kM 0% 20% 40%
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How is beta interpreted? If b = 1.0, stock has average risk. If b > 1.0, stock is riskier than average. If b < 1.0, stock is less risky than average. Most stocks have betas in the range of 0.5 to 1.5. Can a stock have a negative beta?
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Use the SML to calculate each alternatives required return. The Security Market Line (SML) is part of the Capital Asset Pricing Model (CAPM). SML: ki = kRF + (RPM)bi . Assume kRF = 8%; kM = kM = 15%. ^ RPM = (kM - kRF) = 15% - 8% = 7%.
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= 8.0% + (7%)(1.29) = 8.0% + 9.0% = 17.0%. = = = = 8.0% + (7%)(1.00) 8.0% + (7%)(0.68) 8.0% + (7%)(0.00) 8.0% + (7%)(-0.86) = 15.0%. = 12.8%. = 8.0%. = 2.0%.
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Calculate beta for a portfolio with 50% HT and 50% Collections bp = Weighted average = 0.5(bHT) + 0.5(bColl) = 0.5(1.29) + 0.5(-0.86) = 0.22.
kM = 15 kRF = 8 Coll. -1
. T-bills
. .
HT
.
USR
Market
Risk, bi
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What is the required rate of return on the HT/Collections portfolio? kp = Weighted average k = 0.5(17%) + 0.5(2%) = 9.5%. Or use SML: kp = kRF + (RPM) bp = 8.0% + 7%(0.22) = 9.5%.
New SML
18 15 11 8
0.5
1.0
1.5
2.0
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SML1
RPM = 3%
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