Question

Consider the two (excess return) index model regression results for A and B:

R_A = 0.8% + 1R_M

R-square = 0.588

Residual standard deviation = 10.8%

R_B = –1.2% + 0.7R_M

R-square = 0.452

Residual standard deviation = 9%

a. Which stock has more firm-specific risk?

• Stock A

• Stock B

b. Which stock has greater market risk?

• Stock A

• Stock B

c. For which stock does market movement has a greater fraction of return variability?

• Stock A

• Stock B

d. If r_f were constant at 4.5% and the regression had been run using total rather than excess returns, what would have been the regression intercept for stock A? (Negative value should be indicated by a minus sign. Round your answer to 2 decimal places.)

=

Answer 1

Solution to part a

Firm Specific risk is measured by Residual Standard Deviation

Stock A Residual Standard Deviation = 10.80%

Stock B Residual Standard Deviation = 9%

Therefore, Stock A has the more firm specific risk

Answer to part a - Stock A

Solution to part b

Market risk is measured by Beta

Beta can be find from the equation of R_Stock

Stock A Beta = 1

Stock B Beta = 1.70

Therefore, Stock A has the more market risk

Answer to part b - Stock A

Solution to part c

Greater fraction of return variability is measured by R-square

Stock A R-square = 0.588

Stock B R-square = 0.452

Therefore, Stock A has the greater R-square

Answer to part c - Stock A

Solution to part d

Alpha of Stock A can be seen from R_Stock

Intercept of Stock A = Alpha + Risk Free * (1 - Beta)

= 0.80% + 4.50% * (1 - 1)

= 0.80%