The tendency of a stock\'s price to move up and down with the market is reflecte

Question

The tendency of a stock's price to move up and down with the market

is reflected in its beta coefficient. Therefore, beta is a measure of an

investment's market risk, and is a key element of the CAPM.

In this exercise, you get financial information using Yahoo!Finance

(found at

http://finance.yahoo.com). To find a company's beta, enter

the desired stock symbol and request a basic quote. Once you have

the basic quote, scroll down the summary page to find the stock's

beta.

a.

From Yahoo!Finance, identify the beta listed for the stocks of

four companies: a food service (restaurant) company called

Denny's Corporation (stock symbol DENN), Amazon (AMZN),

Caterpillar Inc. (CAT), and Waste Management (WM). Which

company (or companies) has higher beta (greater than 1.0)? And

which company (or companies) has lower beta (less than 1.0)?

Why?

b.

If you made an equal dollar investment in each of the four

stocks, Denny’s Corporation, Amazon, Caterpillar Inc., and Ford

Motor Company, what would be the beta of your portfolio?

c. Apply the Capital Asset Pricing Model (CAPM) Security Market

Line to estimate the required return on Caterpillar stock.

Assumptions and Data: Note that you will need an estimate of

the risk-free rate, r

RF

, and the market risk premium. Assume a

5% market risk premium and use the current yield on 10-year

Treasury securities as an estimate of the risk-free rate. You can

yields on Treasury securities from the section of “Market Data”

on Finance!Yahoo’s frontpage.

d.

Compare the required return of Caterpillar against its return

over the last 52 weeks (Click on “Statistics” once you get the

firm’s quote page, and find the “52-Week Change”). Is there a

difference between these returns? Why is there a difference?

(Hint: Think about the limitations of the CAPM model)

Explanation / Answer

a) DENN and WM have beta less than 1 and AMZN and CAT has beta higher than 1. Beta implies the market risk of the stock. Beta > 1 means that the stock will return higher than the market when the market goes up, but it also means that those stocks will fall more than the overall market when the market goes down.

b) Beta of the portfolio is the arithmetic average of the four betas = 1.035

c) Using CAPM, Required Return = Rf + beta x MRP

Here, Rf = 2.35%, MRP = 5%, For CAT, beta = 1.6

=> Required Return = 2.35% + 1.6 x 5% = 10.35%

d) 52-week change for CAT is 144.44 and 90.34, i.e Return = 144.34 / 90.34 - 1 = 55.46%

The difference between CAPM and actual could be due a variety of factors - Change in interest rates, change in market environment, amongst others.

If CAT was underpriced a year back, it might have just regained its lost ground in the last one year. However, over a long period of time, returns are likely to be around the CAPM required returns.

Stock Beta DENN 0.46 AMZN 1.42 CAT 1.6 WM 0.66 Portfolio 1.035

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