Consider the two (excess return) index-model regression results for stocks A and B. The risk-free rate over the period was 6%, and the market’s average return was 13%. Performance is measured using an index model regression on excess returns. Stock A Stock B Index model regression estimates 1% + 1.2(rM − rf) 2% + 0.8(rM − rf) R-square 0.588 0.442 Residual standard deviation, σ(e) 10.5% 19.3% Standard deviation of excess returns 21.8% 25.3% a. Calculate the following statistics for each stock: (Round your answers to 4 decimal places.) stock A (%) Stock B (%) i. Alpha ii. Information ratio iii. Sharpe ratio iv. Treynor measure b. Which stock is the best choice under the following circumstances? i. This is the only risky asset to be held by the investor ii. This stock will be mixed with the rest of the investors' portfolio, currently composed solely of holdings in the market-index fund. iii. This is one of many stocks that the investor is analyzing to form an actively managed stock portfolio.
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Consider the two (excess return) index-model regression results for stocks A and B. The risk-free rate over the period was 6%, and the market’s average return was 13%. Performance is measured using an index model regression on excess returns.
| Stock A | Stock B | |
| Index model regression estimates | 1% + 1.2(rM − rf) | 2% + 0.8(rM − rf) |
| R-square | 0.588 | 0.442 |
| Residual standard deviation, σ(e) | 10.5% | 19.3% |
| Standard deviation of excess returns | 21.8% | 25.3% |
a. Calculate the following statistics for each stock: (Round your answers to 4 decimal places.)
| stock A (%) | Stock B (%) | ||
| i. | Alpha | ||
| ii. | Information ratio | ||
| iii. | Sharpe ratio | ||
| iv. | Treynor measure | ||
b. Which stock is the best choice under the following circumstances?
| i. | This is the only risky asset to be held by the investor | |
| ii. | This stock will be mixed with the rest of the investors' portfolio, currently composed solely of holdings in the market-index fund. | |
| iii. | This is one of many stocks that the investor is analyzing to form an actively managed stock portfolio. |
Trending now
This is a popular solution!
Step by step
Solved in 2 steps with 2 images
