Question

QUESTION 2 (35 MARKS) The following are expected returns on two shares: PRICEWORTH INTERNATIONAL BERHAD (PWORTH) and RIMBUNAN SAWIT BERHAD (RSAWIT) and for the markets for two months (January and February): Month Return on FBM KLSE CI Return on Stock PWORTH -2.40% 45.60% Return on Stock RSAWIT 6.60% 13.20% January February 6.25% * 31.25% (a) Calculate the betas for the two stocks. (5 marks) (b) Discuss the problems encountered when testing the CAPM empirically. (10 marks) In light of the problems of the CAPM, the APT model was proposed as an alternative. Explain how does the APT overcome the shortcoming of the CAPM. (10 marks) ASSIGNMENT 1 BBF306/05 PORTFOLIO MANAGEMENT (d) Examine the shortcomings of the APT. (10 marks 2020 TOTAL MARKS: 35 MARKSI

Answer 1

Beta = Covarinace (return of stock, return from the market)/Variance of market RSAWIT (%) January February PWORTH (%) FBM KLSE CI (%) -2.40 6.25 45.60 31.25 January February 6.60 13.20 FBM KLSE CI (%) 6.25 31.25 Covariance 600 Covariance 82.5 Variance (Market) 312.50 Variance (Market) 312.50 Beta (PWORTH) = 600/312.5 Beta (RSAWIT) = 82.5/312.5 1.92 0.264

b) There are many issues associated with using the CAPM model. One of the major issues associated with using this model is that it assumes that all the risk is covered with the beta in a diversified portfolio which is not always the case in the real world. Having a portfolio which is fully diversified might come at a huge cost of transaction. The risk rate that is used in the CAM model is the treasury yield but the yield on these instruments changes daily. The volatility in market return used in the model can also be an issue. Market return is used in the model to determine the risk premium but if the market return is negative then the output may not really be useful. The determination of beta is based on historical data which might not really be applicable in future. c) In CAPM model beta is the only factor which is used to measure the risk but in APT model, the risk can be segregated into multiple factors. APT model was proposed as an alternative because it overcome the challenge of relying on only one factor to measure risk. The formula for APT model is E(R) = rf + B1 * RP1 + B2 * RP2+ ....Bn * RPn Here in calculation of the expected rate of return, rf is the risk-free rate and B1 is the sensitivity to the factor 1 and RP1 is the risk premium associated with factor 1. Similarly, the risk can be segregated into multiple factors like economic growth, inflation and many other factors. d) The APT model despite having certain advantages over CAPM model does have certain shortcomings, The number of data inputs used in the APT model is large and gathering of that much data is not always feasible. The data used in the calculation of required rate of return has to be accurate because if they are not then the output will not be reliable. APT model takes into account all the factors that can affect the return of a security. In real world scenario it is very difficult to anticipate all the scenario. Despite having advantage over other models, the output from this model are not always reliable.