Suppose the risk-free is 5 %, the average investor has a risk aversion co-efficient of A = 2, and the standard deviation of the market portfolio is 20 %. What is the equilibrium value of the market risk premium? What is the expected return on the market? If the average degree of risk aversion were 3, what would be the market risk premium, and expected return? 2. Historical data for the S & P 500 Index show an average excess return over Treasury bills of about 8.5 % with standard deviation of about 20 %. To the extent that these averages approximate investor expectations for the sample period, what must have been the co-efficient of risk aversion of the average investor? If the co-efficient of risk aversion were 3.5, what risk premium would have been consistent with the market’s historical standard deviation? 3. If only some investors perform security analysis while all others hold the market portfolio (M), would the CML still be the efficient CAL for investors who do not engage in security analysis? Explain.
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
1. Suppose the risk-free is 5 %, the average investor has a risk aversion co-efficient of A = 2, and the standard deviation of the market portfolio is 20 %. What is the equilibrium value of the market risk premium? What is the expected return on the market? If the average degree of risk aversion were 3, what would be the market risk premium, and expected return?
2. Historical data for the S & P 500 Index show an average excess return over Treasury bills of about 8.5 % with standard deviation of about 20 %. To the extent that these averages approximate investor expectations for the sample period, what must have been the co-efficient of risk aversion of the average investor? If the co-efficient of risk aversion were 3.5, what risk premium would have been consistent with the market’s historical standard deviation?
3. If only some investors perform security analysis while all others hold the market portfolio (M), would the CML still be the efficient CAL for investors who do not engage in security analysis? Explain.
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