Assume for parts (a) to (h) that the Capital Asset Pricing Model holds. The market portfolio has an expected return of 5%. Stock A’s return has a market beta of 1.5, an expected value of 7% and a standard deviation of 10%. Stock B’s return has a market beta of 0.5 and a standard deviation of 20%. The correlation between stock A’s and stock B’s return is 0.5. Required: a) Explain the term ‘capital asset pricing model.’ b) What is the risk-free rate? c) What is the expected return on stock B?
Assume for parts (a) to (h) that the
portfolio has an expected return of 5%. Stock A’s return has a market beta of 1.5, an
expected value of 7% and a standard deviation of 10%. Stock B’s return has a
market beta of 0.5 and a standard deviation of 20%. The correlation between stock
A’s and stock B’s return is 0.5.
Required:
a) Explain the term ‘capital asset pricing model.’
b) What is the risk-free rate?
c) What is the expected return on stock B?
d) Draw a graph with expected return on the y-axis and beta on the x-axis. Indicate the approximate position of the risk-free asset, the market portfolio and stocks A and B on this graph. Draw the line, which connects these four points.
e) Explain the term ‘Securities Market Line’, and what is the slope of the SML for this economy?
f) Consider a portfolio with a weight of 50% in stock A and 50% in stock B. What are its variance and expected return?
g) Where would under-priced and over-priced securities plot on the SML?
h) Studies indicate that the SML is too flat relative to the prediction of the CAPM. In the light of this finding, would you expect the realised average return on the portfolio in part (f) to be higher or lower than the average realised return on the market?
i) In the CAPM the price of an asset depends on the risk of an asset measured by its beta rather than the asset’s variance. Briefly explain the difference between beta as a measure of risk and variance as a measure of risk.
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