Question

You are an analyst for a large public pension fund and you have been assigned the task of evaluating two different external portfolio managers (Y and Z). You consider the following historical average return, standard deviation, and CAPM beta estimates for these two managers over the past five years:

PortfolioActual Avg. ReturnStandard DeviationBetaManager Y11.30%13.20%1.20Manager Z8.00%7.80%0.90

Additionally, your estimate for the risk premium for the market portfolio is 4.00 percent and the risk-free rate is currently 5.00 percent.

1. For both Manager Y and Manager Z, calculate the expected return using the CAPM. Round your answers to two decimal places.

   Manager Y:   %

   Manager Z:   %

2. Calculate each fund manager’s average “alpha” (i.e., actual return minus expected return) over the five-year holding period. Round your answers to two decimal places.

   Manager Y:   %

   Manager Z:   %

   Choose the correct SML graph.

Answer 1

a)

Expected return of Manager Y = Risk free rate + Beta of Manager Y * Risk premium for the market portfolio

Expected return of Manager Y = 5% + 1.2 * 4%

Expected return of Manager Y = 9.8%

Expected return of Manager Z = Risk free rate + Beta of Manager Z * Risk premium for the market portfolio

Expected return of Manager Z = 5% + 0.9 * 4%

Expected return of Manager Z = 8.6%

b)

Alpha of Manager Y = Actual Average return of Manager Y - Expected return of Manager Y

Alpha of Manager Y = 11.30% - 9.8%

Alpha of Manager Y = 1.5%

Alpha of Manager Z = Actual Average return of Manager Z - Expected return of Manager Z

Alpha of Manager Z = 8% - 8.6%

Alpha of Manager Z = -0.6%