QUESTION 5. (17 MARKS)

Robert is a senior financial manager analyzing an Internet stock D Inc. He used monthly excess returns of D Inc. in a single index model as follows:

rD - rF = 0.007 + 0.88(rM - rF) + zD

where z is the error term. The variance of D equals 0.095. Also, the coefficient of determination is 0.72 and the monthly risk-free rate is 0.007.

1. Calculate the systematic variance of D. Interpret your answer. (3 marks)

2. Calculate the variance and standard deviation of the market. Interpret your answer. (3 marks)

3. Calculate the residual standard deviation of D. Interpret your answer. (3 marks)

4. Calculate and interpret the abnormal return of D and discuss the detail of the investment implications/strategy? (4 marks)

5. Consider stock Y which has a correlation of 40% with D, has a beta equals to 0.85, and an expected return 16%. Find the residual variance of stock Y. (4 marks)