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ANSWERS

9-2. (a) CML slope = (12-8)/20 = .2

(b) Affiliated 8 + .2 (14) = 10.8%


Omega 8 + .2 (16) = 11.2%
Ivy 8 + .2 (20) = 12.0%
Value Line 8 + .2 (25) = 13.0%
New Horizons 8 + .2 (30) = 14.0%

(c) The rank order is the same as in (b), which is from low risk to high risk.

(d) Ivy does because it has the same risk as measured by the standard
deviation.

9-3. (a) From the SML:

Stock 1 8 + .9(4) = 11.6%


2 8 + 1.3(4) = 13.2%
3 8 + .5(4) = 10.0%
4 8 + 1.1(4) = 12.4%
5 8 + 1.0(4) = 12.0%

(b) This is the SML, with the formula

Ri = 8 + 4bi

(c) Funds 1, 3, and 4 are undervalued because each has an expected return
greater than its required return as given by the SML.

(d) The slope of the SML, or (12-8) = 4.

9-4. (a) In order to calculate the beta for each stock, it is necessary to calculate
each of the covariances with the market, using the correlation coefficient for the
stock with the market, the standard deviation of the stock, and the standard
deviation of the market.

Stock A cov = (.8)(25)(20) = 400

beta = 400/(20)2 = 1.0

Stock B cov = (.6)(30)(20) = 360

beta = 360/(20)2 = .9
(b) From the SML, Ri = 8 + (12-8)bi

Stock A = 8 + (12-8)(1.0) = 12%


Stock B = 8 + (12-8)(.9) = 11.6%

9-5. E(Ri) = 7.0 + (13.0-7.0)bi = 7.0 + 6.0bi

GF 7 + 6( .8) = 11.8% < 12% undervalued


PepsiCo 7 + 6( .9) = 12.4% < 13% undervalued
IBM 7 + 6(1.0) = 13.0% < 14% undervalued
NCNB 7 + 6(1.2) = 14.2% > 11% overvalued
EG&G 7 + 6(1.2) = 14.2% < 20% undervalued
EAL 7 + 6(1.5) = 16.0% > 10% overvalued

9-6. If Exxon is in equilibrium, the relationship is:

.14 = RF + [E(RM - RF] ß

= 6 + [E(RM - 6] 1.1

Therefore,

a. the slope of the SML must be [E(RM - 6] or approximately 7.3% in order


for the relationship to hold on both sides

b. the expected return on the market is 7.3% + 6% or 13.3% (approximately)

CFA
9-7. d