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Kabir Muhammad is a technology stock analyst for Spartan Portfolios, Inc. He is considering adding one or more stocks shown in Exhibit 1 to Spartan's

Kabir Muhammad is a technology stock analyst for Spartan Portfolios, Inc. He is considering adding one or more stocks shown in Exhibit 1 to Spartan's growth portfolios. Exhibit 1 shows Muhammad's estimates of expected return for the three stocks as well as inputs needed to calculate the beta used in the Capital Asset Pricing Model (CAPM). For his work with the CAPM, Muhammad assumes the expected equity risk premium to be 6.70% and uses the yield on 91-day T-bills, currently 4.20%, as a proxy for the risk-free rate.
Exhibit 1-Estimates of Expected Return and Data Needed to Calculate CAPM Beta
Expected Return Correlation with the S&P 500 Standard Deviation of Returns
Clearcut Technology 11.90%0.9022.50%
Bearcat Semiconductor 13.10%0.7539.10%
Spinner Microdevices 11.20%0.8029.30%
S&P 50010.90%1.0020.50%
Muhammad shares his work with his supervisor, Aimee Blanchet, CFA. He tells her any security choices he makes for the growth portfolios will be based on expected alpha calculations using the CAPM to estimate required return. After reviewing Exhibit 1, Blanchet asks Muhammad why he doesn't forego the expected alpha calculations and simply add Bearcat Semiconductor to the portfolio because of its higher expected return. Muhammad offers the following reasons for his approach:
Reason 1-Expected return estimates are subject to forecast error.
Reason 2-Security selection should consider the risk the security adds to the portfolio as well as return potential.
Reason 3-Evidence shows expected return estimates based on the CAPM are highly reliable.
After listening to Muhammad's reasoning, Blanchet wonders if a different pricing model would yield different security choices. She asks Muhammad to repeat his analysis, but this time use the Fama-French 3-Factor Model to determine required return. She asks Muhammad to use the risk premia and risk-free data shown in Exhibit 2 as inputs.
Exhibit 2-Fama-French Risk Premia and Risk-Free Rate Data
Risk Premia Estimates:
Market Factor 6.70%
Size Factor 2.10%
Value Factor 3.20%
Risk-Free Rate Estimate:
Yield on 91-day T-bill 4.20%
Muhammad agrees to use Blanchet's data. He then uses multiple regression analysis to estimate the Fama-French 3-Factor Model factor sensitivities which appear in Exhibit 3.
Exhibit 3-Fama-French Factor Sensitivities
Market Factor Size Factor Value Factor
Clearcut Technology 0.950.900.20
Bearcat Semiconductor 1.400.70-0.30
Spinner Microdevices 1.100.40-0.60
A few days later, Muhammad finishes his analysis and shares it with Blanchet. She notes the conflicting results of the two approaches and asks Muhammad which approach he favors. Muhammad tells Blanchet he now favors the Fama-French 3-Factor Model approach for the following reasons:
Reason 1-Evidence shows the Fama-French 3-Factor Model is a better predictor of expected return than the CAPM.
Reason 2-The inclusion of the size factor and the value factor into the Fama-French 3-Factor Model is based on both being well-known market anomalies.
Reason 3-The Fama-French 3-Factor Model is the best-known statistical factor model.
Blanchet then expresses her concern about Muhammad's risk premia estimates in Exhibit 2. One of her concerns is market valuation and she tells Muhammad the current P/E for the S&P 500 is 24.20 versus the median of 21.60 since year-end 1988. She asks Muhammad to provide his estimates of expected return which appear in Exhibit 4.
Exhibit 4-Estimates of Average Annual Expected Return over the Next 5 Years
Dividend Yield Valuation Change Earnings Growth Expected Return
Clearcut Technology 3.10%1.40%7.40%11.90%
Bearcat Semiconductor 0.80%0.20%12.10%13.10%
Spinner Microdevices 0.40%-0.30%11.10%11.20%
S&P 5001.50%0.009.40%10.90%
Muhammad tries to mitigate some of Blanchet's concerns. He offers the following reasons for optimism regarding the stocks under consideration:
Reason 1-Growth stocks have outperformed value stocks in recent years.
Reason 2-Small-cap stocks have outperformed large-cap stocks in recent years.
Reason 3-An easing of monetary policy would lead to a decline in market interest rates which, in turn, would have a positive impact on the future market risk premium.
After further consideration, Blanchet tells Muhammad he can add his favored stocks to the portfolio.
Question 1(1 point)
Based on the data in Exhibit 1, which of the three stocks has the most market risk as measured by its CAPM beta?
Question 1 options:
Clearcut Technology
Bearcat Semiconductor
Spinner Microdevices
Question 2(1 point)
Based on the data in Exhibit 1, which of the three stocks is the most likely to closely track the returns of the S&P 500?
Question 2 options:
Clearcut Technology
Bearcat Semiconductor
Spinner Microdevices
Question 3(1 point)
Based on the data in Exhibit 1 and using CAPM to determine required return, the expected al

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