Below are the total returns for the market and two companies that comprise the entire industry....

Below are the total returns for the market and two companies that comprise the entire industry.

Year	-4	-3	-2	-1	0	Weight
Company A (%)	–23	25	30	20	45	0.40
Company B (%)	–13	35	40	15	40	0.60

Market (%)	-20	30	30	15	30

a. Use the Market Model to estimate the industry beta. Give the equation of the regression line. Briefly explain. (

Expert Solution

REGRESSION EQUATION:

Rj = a + b Rm

For Company A, the equation is 0.003112 + 1.22872 Rm

For Company B, the equation is 0.049787 + 0.965957 Rm

The standard procedure for estimating betas is to regress stock returns (Rj ) against market returns (Rm): Rj = a + b R m where a is the intercept and b is the slope of the regression. The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock. The R squared (R2) of the regression provides an estimate of the proportion of the risk (variance) of a firm that can be attributed to market risk. The balance (1 - R2) can be attributed to firm specific risk. The intercept of the regression provides a simple measure of performance during the period of the regression, relative to the capital asset pricing model. The difference between the intercept and Rf (1-b) is Jensen's alpha. If it is positive, your stock did perform better than expected during the period of the regression.

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