Finance Quiz: The Capital Asset Pricing Model
1) Expected return: hedge fund. What is the average annual (historic) return on the hedge fund? Remember the reported returns are monthly. Multiply by 12 to get annual returns.1 Round to three decimals.
2) Expected return stock market. What is the average annual (historic) return on the stock market? Remember the reported returns are monthly. I am asking for annual returns. Round to three decimals.
3) Expected return: risk-free asset. What is the average annual (historic) return on the risk-free asset? Remember the reported returns are monthly. I am asking for annual returns. Round to three decimals.
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Hedge Fund
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Stock Market
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Risk-Free
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Average Return
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4) Risk: hedge fund. What is the annualized standard deviation of the hedge fund return? Remember, you have been given monthly, not annual, returns, but I am asking for the annual standard deviation. You should use the Excel function STDEV.S( ).
5) Risk: stock market. What is the annualized standard deviation of the stock market return?
6) Risk: risk-free asset. What is the annualized standard deviation of the risk-free return?
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Hedge Fund
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Stock Market
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Risk-Free
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Standard Deviation
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7) Asset allocation. Given that investors like expected return and dislike risk, if standard deviation of return was the correct measure of risk, which of the three assets would you expect investors to choose (if they can choose only one)?
- Hedge Fund
- Stock Market
- Risk-free asset
8) Capital Asset Pricing Model: β. A regression is a statistical method of creating a straight line that best fits the data. It tells us how two variables are related. The CAPM regression is used to partition the risk of an asset (the standard deviation you measured above) into the systematic component and the idiosyncratic component. Run the following regression in Excel for the hedge fund returns:
rHedgeFund - rRisk-free = α + βHedge Fund(rMarket - rRisk-free) + ε
What is the β of the hedge fund? Enter your number to two decimals (e.g. the market has a β of 1.00). The β tells you how much systematic risk the asset has. It will also determine the discount rate we would use in a DCF (for an all-equity company) and is used to calculate the expected return in an efficient market. If you find it useful, you can graph the excess return on the hedge fund against the excess return on the stock market and then draw the regression line through the data.
9) Capital Asset Pricing Model: ε. The stock market was up 2.27% in February of 2005. Given your CAPM regression how did the hedge fund perform? Hint: The expected return according to the CAPM just uses beta and assumes that alpha is zero.
- Better than expected
- As expected
- Worse than expected
- We can't tell given the data
10) Capital Asset Pricing Model: α. What is the annualized α (i.e. the regression coefficient multiplied by 12)? Express it as a decimal (i.e. if the annualized α is 1%, enter your answer as 0.010). In an efficient market and a world without noise, it will be zero. In practice α is not zero because of noise in the data, because money managers have investment skill (positive α), they are lucky (positive α) or unlucky (negative α) or because money managers are incompetent (negative α).
11) Asset allocation revisited. Given your CAPM estimates, what fraction of your financial assets would you allocate to the hedge fund, if you were able to invest in it? Remember, it is an exclusive fund and it not open to all investors. You will get full credit for any reasonable answer. I just want to know what you think.
Attachment:- Assignment File.rar