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Question 10 You want to use the following asset pricing models to determine the expected return...

Question 10

You want to use the following asset pricing models to determine the expected return on McDonald’s stock.

  • CAPM: βM = 0.48
  • FF3 factor: βM = 0.40, βSMB = -0.41, βHML = 0.54

The info. of the risk-free rate and the risk factors are as follows:

  • The risk-free interest rate is 3%.
  • E(RM) = 9.5%, E(RSMB) = 2.5%, E(RHML) = 6%  

Assume the average annual return on McDonald’s stock is 7.5%. Based on the CAPM, what is its alpha? ______%

Be careful: the beta to the market factor in the CAPM is slight different from the FF3 factor model.

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Answer #1

According to the CAPM,

Expected Return = Risk-free Rate + [Beta * {E(RM) - Risk-free Rate}]

Alpha = E(r) - Return calculated by CAPM

= 7.5% - [3% + [0.48 * (9.5% - 3%)]

= 7.5% - [3% + 3.12%]

= 7.5% - 6.12% = 1.38%

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