Chapter 12, Problem 37P

Summary Introduction

Capital Asset Pricing Model:

The CAPM or the Capital Asset Pricing Model says about the required return of a security that an investor must expect on any investment must be the risk-free rate of return and the risk premium that is proportional to the amount of systematic risk of a security. The risk premium is the market risk premium multiplied by the beta (ß) of a security. The market risk premium is equal to the expected market return less the return earned from risk-free security.

The formula used to calculate the expected return according the CAPM is given below:

Where,

• is the expected return on the stock investment.
• is the risk free rate of return.
• is the beta of the asset.
• is the expected return of the market.

Beta:

Beta is the covariance of a security with the market upon the variance of the market. It measures the change in percentage in the excess return of a particular security for 1% change in the excess return of a market portfolio or a benchmark portfolio. The beta of a portfolio is the weighted average beta of the overall stocks in a portfolio.

It can be calculated using the formula given below.

Where,

• is the beta of a portfolio.
• is the weight of a stock.

To determine:

The amount to be invested in stocks of BC and CI.