20. True/False/Depends Questions: Please include brief explanations in your responses: (a) The average return on stocks in the US over the past 30 years has been 12% annually. You find two portfolios, one with an expected return of 14% and another with an expected return of 19%. This contradicts the CAPM. 35 3 2008, Andrew W. Lo and Jiang Wang 1.7 CAPM 1 QUESTIONS (b) All portfolios on the SML have no idiosyncratic risk. 21. Calculating Beta (Part Two): Consider two securities, A and B, along with the market portfolio M. Their variance-covariance matrix is: Security | A VIR] ! A 0.0900 0.0420 0.0525 B 0.1225 0.0437 M 0.0625 (a) Calculate the beta of each stock. (b) Which stock has the highest expected return? 22. Are the following statements true or false? Give brief but precise ex- planations for your answers. (a) Stock A has expected return 10% and standard deviation 15%, and stock B has expected return 12% and standard deviation 13%. Then, no investor will buy stock A. (b) Diversi cation means that the equally weighted portfolio is opti- mal. (c) The CAPM predicts that the expected return on the market port- folio is always greater than the return on the riskless asset. (d) The CAPM predicts that a security with a beta of zero overs zero expected return. (e) The CAPM predicts that all investors hold the same portfolio of risky assets. (f) The CAPM predicts that investors demand higher expected rates of return from stocks that have a high (positive) sensitivity to Puctuations in the stock market. (g) An investor who puts $10000 in T-bills and $20000 in the market portfolio will have a beta of 2.0. 23. Security B has a price of $50 and a beta of 0.8. The risk-free rate is 3% and the market risk premium is 4%. (a) According to the CAPM, what return do investors expect on the security?29. The dividend yield on a stock and the interest rate used to discount the stock's cash flows are both continuously compounded. The dividend yield is less than the interest rate, but both are positive. The following table shows four methods to buy the stock and the total payment needed for each method. The payment amounts are as of the time of payment and have not been discounted to the present date. METHOD TOTAL PAYMENT Outright purchase A Fully leveraged purchase B Prepaid forward contract C Forward contract D Determine which of the following is the correct ranking, from smallest to largest, for the amount of payment needed to acquire the stock. (A) C