1. Suppose you find, as research indicates, that in the cross-section regression of the CCAPM, the
coefficients of factor loadings on the Fama-French model are significant predictors of average
return factors (in addition to consumption beta). How would you explain this phenomenon?
2. Search the Internet for a recent graph of market volatility. What does this history suggest about
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C H A P T E R
1 3
Empirical Evidence on Security Returns
443
The following annual excess rates of return were obtained for nine individual stocks
and a market index:
Year
Market
Index
Stock Excess Returns (%)
A
B
C
D
E
F
G
H
I
1
29.65
33.88 225.20
36.48
42.89 239.89
39.67
74.57
40.22
90.19
2
2
11.91 249.87
24.70 225.11 254.39
44.92 254.33 279.76 271.58 226.64
3
14.73
65.14 225.04
18.91 239.86
2
3.91
2
5.69
26.73
14.49
18.14
4
27.68
14.46 238.64 223.31
2
0.72
2
3.21
92.39
2
3.82
13.74
0.09
5
5.18
15.67
61.93
63.95 232.82
44.26 242.96
101.67
24.24
8.98
6
25.97 232.17
44.94 219.56
69.42
90.43
76.72
1.72
77.22
72.38
7
10.64 231.55 274.65
50.18
74.52
15.38
21.95 243.95 213.40
28.95
8
1.02 223.79
47.02 242.28
28.61 217.64
28.83
98.01
28.12
39.41
9
18.82
2
4.59
28.69
2
0.54
2.32
42.36
18.93
2
2.45
37.65
94.67
10
23.92
2
8.03
48.61
23.65
26.26
2
3.65
23.31
15.36
80.59
52.51
11
2
41.61
78.22 285.02
2
0.79 268.70 285.71 245.64
2.27 272.47 280.26
12
2
6.64
4.75
42.95 248.60
26.27
13.24 234.34 254.47
2
1.50 224.46
e
X
c e l
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3. Perform the first-pass regressions and tabulate the summary statistics.
4. Specify the hypotheses for a test of the second-pass regression for the SML.
5. Perform the second-pass SML regression by regressing the average excess return of each port-
folio on its beta.
6. Summarize your test results and compare them to the results reported in the text.
7. Group the nine stocks into three portfolios, maximizing the dispersion of the betas of the three
resultant portfolios. Repeat the test and explain any changes in the results.
8. Explain Roll’s critique as it applies to the tests performed in Problems 3 to 7.
9. Plot the capital market line (CML), the nine stocks, and the three portfolios on a graph of aver-
age returns versus standard deviation. Compare the mean-variance efficiency of the three port-
folios and the market index. Does the comparison support the CAPM?
Suppose that, in addition to the market factor that has been considered in Problems
3 to 9, a second factor is considered. The values of this factor for years 1 to 12 were
as follows:
Year
% Change in
Factor Value
Year
% Change in
Factor Value
1
2
9.84
7
2
3.52
2
6.46
8
8.43
3
16.12
9
8.23
4
2
16.51
10
7.06
5
17.82
11
2
15.74
6
2
13.31
12
2.03
10. Perform the first-pass regressions as did Chen, Roll, and Ross and tabulate the relevant sum-
mary statistics. ( Hint: Use a multiple regression as in a standard spreadsheet package. Estimate
the betas of the 12 stocks on the two factors.)
11. Specify the hypothesis for a test of a second-pass regression for the two-factor SML.
12. Do the data suggest a two-factor economy?
13. Can you identify a factor portfolio for the second factor?
14. Suppose you own your own business, which now makes up about half your net worth. On the basis of
what you have learned in this chapter, how would you structure your portfolio of financial assets?
Intermediate
Challenge
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444
P A R T I I I
Equilibrium in Capital Markets
1. Identify and briefly discuss three criticisms of beta as used in the capital asset pricing model.
2. Richard Roll, in an article on using the capital asset pricing model (CAPM) to evaluate portfolio
performance, indicated that it may not be possible to evaluate portfolio management ability if
there is an error in the benchmark used.
a. In evaluating portfolio performance, describe the general procedure, with emphasis on the
benchmark employed.
b. Explain what Roll meant by the benchmark error and identify the specific problem with this
benchmark.
c. Draw a graph that shows how a portfolio that has been judged as superior relative to a “mea-
sured” security market line (SML) can be inferior relative to the “true” SML.
d. Assume that you are informed that a given portfolio manager has been evaluated as superior
when compared to the Dow Jones Industrial Average, the S&P 500, and the NYSE Composite
Index. Explain whether this consensus would make you feel more comfortable regarding the
portfolio manager’s true ability.
e. Although conceding the possible problem with benchmark errors as set forth by Roll, some
contend this does not mean the CAPM is incorrect, but only that there is a measurement
problem when implementing the theory. Others contend that because of benchmark errors the
whole technique should be scrapped. Take and defend one of these positions.
3. Bart Campbell, CFA, is a portfolio manager who has recently met with a prospective client, Jane
Black. After conducting a survey market line (SML) performance analysis using the Dow Jones
Industrial Average as her market proxy, Black claims that her portfolio has experienced supe-
rior performance. Campbell uses the capital asset pricing model as an investment performance
measure and finds that Black’s portfolio plots below the SML. Campbell concludes that Black’s
apparent superior performance is a function of an incorrectly specified market proxy, not superior
investment management. Justify Campbell’s conclusion by addressing the likely effects of an
incorrectly specified market proxy on both beta and the slope of the SML.
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