# Question: In Problem 19 assume the risk free rate is 3 and

In Problem 19, assume the risk-free rate is 3% and the market risk premium is 7%.

a. What does the CAPM predict the expected return for each stock should be?

b. Clearly, the CAPM predictions are not equal to the actual expected returns, so the CAPM does not hold. You decide to investigate this further. To see what kind of mistakes the CAPM is making, you decide to regress the actual expected return onto the expected return predicted by the CAPM.47 What is the intercept and slope coefficient of this regression?

c. What are the residuals of the regression in (b)? That is, for each stock compute the difference between the actual expected return and the best fitting line given by the intercept and slope coefficient in (b).

d. What is the sign of the correlation between the residuals you calculated in (b) and market capitalization?

e. What can you conclude from your answers to part b of the previous problem and part d of this problem about the relation between firm size (market capitalization) and returns? (The results do not depend on the particular numbers in this problem. You are welcome to verify this for yourself by redoing the problems with another value for the market risk premium, and by picking the stock betas and market capitalizations randomly.48)

a. What does the CAPM predict the expected return for each stock should be?

b. Clearly, the CAPM predictions are not equal to the actual expected returns, so the CAPM does not hold. You decide to investigate this further. To see what kind of mistakes the CAPM is making, you decide to regress the actual expected return onto the expected return predicted by the CAPM.47 What is the intercept and slope coefficient of this regression?

c. What are the residuals of the regression in (b)? That is, for each stock compute the difference between the actual expected return and the best fitting line given by the intercept and slope coefficient in (b).

d. What is the sign of the correlation between the residuals you calculated in (b) and market capitalization?

e. What can you conclude from your answers to part b of the previous problem and part d of this problem about the relation between firm size (market capitalization) and returns? (The results do not depend on the particular numbers in this problem. You are welcome to verify this for yourself by redoing the problems with another value for the market risk premium, and by picking the stock betas and market capitalizations randomly.48)

## Relevant Questions

Using the factor beta estimates in the table shown here and the monthly expected return estimates in Table 13.1, calculate the risk premium of General Electric stock (ticker: GE) using the FFC factor specification. ...Cisoft is a highly profitable technology firm that currently has $5 billion in cash. The firm has decided to use this cash to repurchase shares from investors, and it has already announced these plans to investors. ...In mid-2012, AOL Inc. had $100 million in debt, total equity capitalization of $3.1 billion, and an equity beta of 0.90 (as reported on Yahoo! Finance). Included in AOLâ€™s assets was $1.5 billion in cash and risk-free ...Bay Transport Systems (BTS) currently has $30 million in debt outstanding. In addition to 6.5% interest, it plans to repay 5% of the remaining balance each year. If BTS has a marginal corporate tax rate of 40%, and if the ...PMF, Inc., is equally likely to have EBIT this coming year of $10 million, $15 million, or $20 million. Its corporate tax rate is 35%, and investors pay a 15% tax rate on income from equity and a 35% tax rate on interest ...Post your question