Representative investors average degree of risk aversion

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Reference no: EM13539550

Q1: Index Models:

Construct the following on a spreadsheet:

1. Calculate 60 months of returns for the S&P 500 index, Apple and Exxon. (Please compute simple monthly returns not continuously compounded returns.) Use December 2009 to November 2014. Note this means you need price data for November 2009. On the answer sheet report the average monthly returns for the S&P 500 index, Apple and Exxon, as well as the average monthly risk-free rate.

2. Calculate excess returns for the S&P 500 index, Apple and Exxon. Note you must divide the annualized risk-free rate (^IRX) by 1200 to approximate the monthly rate in in decimal form. On the answer sheet report the average monthly excess returns for the S&P 500 index, Apple and Exxon.

3. Regress excess Apple returns on the excess S&P 500 index returns and report, on the answer sheet, α, β, the r-square and whether α and β are different from zero at the 10% level of significance. Briefly explain your inference.

4. Use equation 8.10 to decompose total risk for Apple into systematic risk and firm-specific risk. That is, calculate total risk, systematic risk and firm-specific risk for Apple.

5. Regress excess Exxon returns on the excess S&P 500 index returns and report, on the answer sheet, α, β, the r-square and whether α, β are different from zero at the 10% level of significance. Briefly explain your inference.

6. Use equation 8.10 to decompose total risk for Exxon into systematic risk and firm-specific risk. That is, calculate total risk, systematic risk and firm-specific risk for Exxon.

7. Use equation 8.10 to estimate the covariance and correlation of Apple and Exxon excess returns.

Q2: CAPM and APT:

1. The expected rate of return on the market portfolio is 8.25% and the risk-free rate of return is 1.50%. The standard deviation of the market portfolio is 18%. What is the representative investor's average degree of risk aversion?

2. Stock A has a beta of 1.75 and a standard deviation of return of 32%. Stock B has a beta of 2.95 and a standard deviation of return of 56%. Assume that you form a portfolio that is 60% invested in Stock A and 40% invested in Stock B. Using the information in question 1, according to CAPM, what is the expected rate of return on your portfolio?

3. Using the information in questions 1 and 2, what is your best estimate of the correlation between stocks A and B?

4. Your forecasting model projects an expected return of 14.50% for Stock A and an expected return of 26.50% for Stock B. Using the information in questions 1 and 2 and your forecasted expected returns, what is your best estimate of the alpha of your portfolio when using CAPM to determine a fair level of expected return?

5. A different analyst uses a two-factor APT model to evaluate expected returns and risk. The risk premiums on the factor 1 and factor 2 portfolios are 4.50% and 2.95%, respectively, while the risk-free rate of return remains at 1.50%. According to this APT analyst, your portfolio formed in question 2 has a beta on factor 1 of 2.35 and a beta on factor 2 of 3.50. According to APT, what is the expected return on your portfolio if no arbitrage opportunities exist?

6. Now assume that your forecasting model of question 4 accurately projects the expected return of Stocks A and B and therefore your portfolio, and that the APT model of question 5 describes the fair rate of return for your portfolio. Do any arbitrage opportunities exist? If yes, would you invest long or short in your portfolio constructed in question 2?

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