Question

Suppose investors believe that the standard deviation of the market-index portfolio has increased by 50%. Speculate on two potential implications of the Security Market Line (SML) and CAPM regarding the effect of this change on the required rate of return for a company’s investment projects

Answer 1

Capital Asset Pricing Model is a most commonly and widely used model in the field of Finance. This investment analysis model predicts the correlation between risk and expected returns from risky asset. Under a perfect capital market scenario, the CAPM model predicts that and individual is likely to hold a portfolio of risky assets along with those assets whose returns are not related with market returns.

As per the question, there are two things that standout in relation to this potential project. A spike of 50% in standard deviation would ultimately reflect in the organization’s expected rate of return. Since the risk is higher therefore a higher premium would be expected and this in turn would drive up the expected rate of return for the organization. The company’s Internal Rate of return should at least be equal to its WACC (working average cost of capital) so as to create a Net present value of 0 or higher. This would help in determining a profitable forecast. Since SD can work in both the directions therefore the chances of things going unexpectedly good or poor cannot be said with certainity.