You Use the Single-Factor Model $R _ { i t } = \alpha _ { i } + \beta _ { i } R _ { m t } + e _ { i t }$

question 42

Essay

You use the single-factor model $R _ { i t } = \alpha _ { i } + \beta _ { i } R _ { m t } + e _ { i t }$
and have obtained the following estimates for stock A and stock B:
$\begin{array} { l l l l } \text { Stock } & \alpha & \beta & \sigma _ { e } \\\text { A } & 2 \% & 1.3 & 30 \% \\\text { B } & 10 \% & 1.2 & 40 \%\end{array}$
You also estimate that the expected return on the market portfolio is 16%,the standard deviation of the market portfolio is 20%,and the riskless rate is 8%.
a. Based on the single-factor model, what are the expected returns and standard deviations of stock A and stock B?
b. Based on the single-factor model, the Security Market Line, and the Capital Market Line, state whether each of the following statements is completely true, completely false, or uncertain. Explain your answers.
1) In any given year, stock B is certain to outperform stock A.
2) An investor would consider stock B to be riskier than stock A.
3) Stock A is undervalued.
4) If an investor had to select one investment to combine with the riskless asset, the investor would prefer stock A to the market portfolio.

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Definitions:

Deposits In Transit

Deposits made and recorded by a company but not yet reflected on the bank statement.

Outstanding Checks

Checks that have been issued by a company but have not yet been cleared or cashed by the recipient.

Discounted Note

A short-term debt security sold for less than its face value that will pay the face value at maturity; it reflects the discounted present value of the future cash flow.

Proceeds

The total amount of money received from a transaction, such as the sale of an asset, before any deductions.