You believe that security Z has an expected rate of return (r) of 15 percent. It

Question

You believe that security Z has an expected rate of return (r) of 15 percent. It has a beta (B) of 1.5. The risk-free rate of return (r) is 5 percent and the market expected rate of return (rm) is 9 percent. a) Is this security priced correctly according to the Capital Asset Pricing Model? Explain your answer in detail. (b) Suppose now that the market portfolio has a standard deviation equal to "1-4, and that your utility function is U = -2, where re and , are the expected rate of return and standard deviation of your portfolio, where x is the share of your portfolio invested in the market portfolio and (1-x) is the share invested in the risk-free asset. What is the optimal (utility- maximizing value forx?

Explanation / Answer

(a) Required Rate of Return (as per CAPM) = RF + x RM = 5% + 1.5 x 9% = 18.50%

Expected Rate of Return on security is 15%. However required rate of return is 18.5% as per CAPM.

Therefore, security is over priced.

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