2. Beta is often estimated by linear regression. A model commonly used is called the market model, which is:

Rt − Rft = αi + βi [RMt − Rft] + εt In this regression, Rt is the return on the shares and Rft is the risk-free rate for the same period. RMt is the return on a share market index such as the All Ordinaries index; αi is the regression intercept; βi is the slope

(and the shares’ estimated beta); and εt represents the residuals for the regression. What do you think is the motivation for this particular regression? The intercept, α, is often called Jensen’s alpha. What does it measure? If an asset has a positive Jensen’s alpha, where would it plot with respect to the SML? What is the financial interpretation of the residuals in the regression? Joey Moss, a recent finance graduate, has just begun his job with the investment firm of Covili and Wyatt. Paul Covili, one of the firm’s founders, has been talking to Joey about the firm’s investment portfolio.

As with any investment, Paul is concerned about the risk of the investment as well as the potential return. More specifically, because the company holds a diversified portfolio, Paul is concerned about the systematic risk of current and potential investments. One such position the company currently holds is shares in Rio Tinto Ltd. Rio Tinto is the well-known UK and Australia registered mining and exploration company.

Covili and Wyatt currently uses a commercial data vendor for information about its positions. Because of this, Paul is unsure exactly how the numbers provided are calculated. The data provider considers its methods proprietary, and it will not disclose how share betas and other information are calculated. Paul is uncomfortable with not knowing exactly how these numbers are being computed and also believes that it could be less expensive to calculate the necessary statistics in-house. To explore this question, Paul has asked Joey to do the following assignments.