Question

Consider the two (excess return) index model regression results for stock A and B RA = 0.01 + 1.2RM R2 of 0.576; Std deviation of error term of 10.3% RB = -0.02 + 0.8RM R2 of 0.436; Std deviation of error term of 9.1%

a) Which stock has more firm-specific risk? Explain [4 points]

b) Which has greater market risk? Explain [4 points]

c) For which stock does market movement explain a grater fraction of return variability? Explain [4 points]

d) Which stock had an average return in excess of that predicted by the CAPM. Explain [3 points]

Answer 1

a) Residual standard deviation measure firm specific risk. More the Residual Standard deviation, more the firm specific risk.

Residual standard deviation of stock A =10.3%

Residual standard deviation of stock B =9.1%

Hence stock A has more firm-specific risk.

b) Beta measure market risk of a stock. Larger the Residual Standard deviation, more the market risk.

Beta here is the slop of the coefficient of regression

Beta of Stock A= 1.2

Beta of Stock B= .8

Hence stock A has greater market risk.

c) Fraction of return variability explained by market movement is measures by R2. Larger theR2, greater the Fraction of return variability

Beta of Stock A= .576

Beta of Stock = .436

Hence stock A has greater Fraction of return variability explained by market movement.

d) Stock A. Since Stock A has high risk compared to Stock B, the average return in excess of predicted by CAPM will also be high. This is because the investor will be willing to take the risk.