Thefuture of the economy has two and only two scenarios. The table below gives the returns in the next month of the market portfolio and two individual stocks under each scenario. Probability Market Return Aggressive Stock Defensive Stock 0.3 5% -2% 6% 0.7 25% 38% 12% Assume that the T-bill rate is 5%. Are these two stocks fairly priced? Explain your results based on the Capital Asset Pricing Model.
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.
- Thefuture of the economy has two and only two scenarios. The table below gives the returns in the next month of the market portfolio and two individual stocks under each scenario.
|
Probability |
Market Return |
Aggressive Stock |
Defensive Stock |
|
0.3 |
5% |
-2% |
6% |
|
0.7 |
25% |
38% |
12% |
Assume that the T-bill rate is 5%. Are these two stocks fairly priced? Explain your results based on the
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