Consider the following information: Stock A Stock B T-bills Beta 0.6 1.2 0.0 Exp
ID: 2621592 • Letter: C
Question
Consider the following information:
Stock A
Stock B
T-bills
Beta
0.6
1.2
0.0
Expected return, %
5.0
8.0
2.0
(a) Assuming that all stocks are priced correctly according to the CAPM, compute the expected return on the market portfolio.
(b) Stocks are generally regarded as being risky investments. According to the CAPM, is it possible for a stock to have an expected return that is less than the risk-free rate? Explain.
(c) Is it possible for a stock to have a negative standard deviation in returns? Explain.
(d) Consider two separate stocks: the returns on the stock of AppleCo have a standard deviation of 32% and a beta of 0.9; the returns on the stock of BananaCo have a standard deviation of 20% and a beta of 1.2. Which company
Stock A
Stock B
T-bills
Beta
0.6
1.2
0.0
Expected return, %
5.0
8.0
2.0
Explanation / Answer
rf = return on T-bills = 2%
5% = 2% + 0.6(rm-2%)
return on market portfolio = rm = 7%
8% = 2% + 1.2(7%-2%)
According to CAPM, ri = rf + beta(rm-rf)
During the period when the stock market is performing well, if a stock is negatively correlated with the stock market it will have a expected return less than the risk free rate
However, in times of crisis, the market premium is negative, and during this time the stocks postitively correlated with the stock market have expected return less than the risk free rate
The standard deviation can be restriced to find the deviation only when the returns are less than certain threshold value(i.e. negative deviation of returns). However, the value of standard devaiatioon is always positive.
The stock of BananaCo as it has higher value of beta, hence will have greater return according to the CAPM and also has lesser variablity of returns.
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