A. Annual risk-free rate is 4%. Annual expected return on market portfolio is 12

Question

A. Annual risk-free rate is 4%. Annual expected return on market portfolio is 12% and stock S has a Beta of 0.5. Predict with CAPM the annual expected return on S?

B. The Expected return on S = 10%, if CAPM is correct, is S underpriced or overpriced?

C. Initial wealth is €x,you invest €y<€x at risk free interest rate of rf per year. The remaining €(X-Y) in assets A that has uncertain annual rate return ra, with a standard deviation a. Let V = value of your wealth after one year. Write equation of V and standard deviation V.

Explanation / Answer

Risk free rate of return 4% Expected annula retun on market portfolio 12% Beta 0.5 CAPM = Rf + beta( Rm - Rf ) Where Rf = risk free rate of retun Rm - expected annual return on market porfolio Beta = beta of the asset ie = 4% + .5 (12% - 4%) 8% Expected retun of S as per CAPM 8% B. Expected retun form th stock is 10% As per CAPM its 8% CAPM is used to determine the fair value of the stock As per above proposition stock S is giving a higher retun. It is ondervauled hence it should be bought C. wealth invested Initial wealth X Amount invested at risk free rate of retun y Let y b the weight of risk free rate of security Balance invested in Asset A that has uncertain annual rate of retun ra with std deviation a x-y Hence (x-y) would be other security with uncertain return Return from (x-y) = Ra Value of wealth V V = (y*Rf) + ((x-y)*Ra)

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