Chapter 10: Index Models

3. a. The two figures depict the stocks security characteristic lines (SCL). Stock A has a higher firm-specific risk because the deviations of the observations from the SCL are larger for Stock A than for Stock B. Deviations are measured by the vertical distance of each observation from the SCL.
b. Beta is the slope of the SCL, which is the measure of systematic risk. The SCL for Stock B is steeper; hence Stock Bs systematic risk is greater. The R2 (or squared correlation coefficient) of the SCL is the ratio of the explained variance of the stocks return to total variance, and the total variance is the sum of the explained variance plus the unexplained variance (the stocks residual variance).

b.

R2 =

i2 2 M 2 2 i M + 2 (e i )

Since the explained variance for Stock B is greater than for Stock A (the explained variance is 2 2 , which is greater since its beta B M is higher), and its residual variance 2(eB ) is smaller, its R2 is higher than Stock As. d. Alpha is the intercept of the SCL with the expected return axis. Stock A has a small positive alpha whereas Stock B has a negative alpha; hence, Stock As alpha is larger. The correlation coefficient is simply the square root of R2, so Stock Bs correlation with the market is higher. Firm-specific risk is measured by the residual standard deviation. Thus, stock A has more firm-specific risk: 10.3% > 9.1% Market risk is measured by beta, the slope coefficient of the regression. A has a larger beta coefficient: 1.2 > 0.8 R2 measures the fraction of total variance of return explained by the market return. As R2 is larger than Bs: 0.576 > 0.436

e.

4.

a. b. c.

c.

The average rate of return in excess of that predicted by the CAPM is measured by alpha, the intercept of the SCL. A = 1% which is larger than B = 2%.

e.

Rewriting the SCL equation in terms of total return (r) rather than excess return (R): rA rf = + (rM rf ) rA = + rf (1 ) + r M The intercept is now equal to: + rf (1 ) = 1 + rf (l 1.2) Since rf = 6%, the intercept would be: 1 1.2 = 0.2%

5. The standard deviation of each stock can be derived from the following equation for R2:

R i2 =
Therefore:
2 = A

i2 2 M = 2 i
2 2 0.7 2 20 2 A M = = 980 0.20 R2 A

A = 31.30%

For stock B:
1.2 2 20 2 = 4,800 0.12 B = 69 .28 % 2 = B

6.

The systematic risk for A is:

2 2 = 0.70 2 20 2 = 196 A M

The firm-specific risk of A (the residual variance) is the difference between As total risk and its systematic risk: 980 196 = 784 The systematic risk is:
2 2 = 1.20 2 20 2 = 576 B M

Bs firm-specific risk (residual variance) is: 4800 576 = 4224

13.

a.

Merrill Lynch adjusts beta by taking the sample estimate of beta and averaging it with 1.0, using the weights of 2/3 and 1/3, as follows: adjusted beta = [(2/3) 1.24] + [(1/3) 1.0] = 1.16

b. If you use your current estimate of beta to be t1 = 1.24, then

t

= 0.3 + (0.7 1.24) = 1.168

16. c.

The R2 of the regression is: 0.702 = 0.49 Therefore, 51% of total variance is unexplained by the market; this is nonsystematic risk.

19. b.