Question

(i) What does the CAPM allow you to calculate? Does it imply that a stock with a beta of
zero will offer a zero expected rate of return? Why? (5marks)

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(ii) Madison was recruited to design and decorate the offices of a large pharmaceutical
company. While there, she accidentally read a report indicating that a new drug had
just been approved by the Therapeutic Goods Administration. She immediately
bought some of the company's shares which doubled in price over the following
week. This outcome is inconsistent with which form of market efficiency and why?

Answer 1

Answer (i)

What does the CAPM allow you to calculate?

~ CAPM, i.e., Capital Asset Pricing Model allows us to calculate the required rate of return on equity.

~CAPM is a single factor model, which includes the relationship between the return on a stock and its systematic risk (market risk).

~ Required Return as per CAPM = Risk Free Rate + Beta (Market Risk Premium)

Does it imply that a stock with a beta of zero will offer a zero expected rate of return? Why?

~ No, it does not imply that a stock with a beta of zero will offer a zero expected rate of return.

~ Expected rate of return as per CAPM is = Risk Free Rate + Beta (Market Risk Premium)

~ Therefore, even if a stock has a beta of zero, and the second term in the equation "Beta x (Market Risk Premium)" will be zero, but the stock will still have a return equal to the Risk Free Rate.

~ Therefore, as per CAPM, a stock with zero beta will have a required rate of return equal to the Risk Free Rate.

Answer (ii)

~ The outcome is inconsistent with the Strong Form of efficient market hypothesis.

~ Strong form of market efficiency suggests that the market price of a stock already incorporates all the public and non-public information. Therefore, no abnormal excess returns can be earned through insider trading also, because all the insider information is already reflected in the stock prices.

~ Therefore, in this case, Madison accidentally read a report indicating that a new drug had
just been approved by the Therapeutic Goods Administration, she bought some shares of the company for insider trading, and also succesfully earned excess return over it when the news must've become public and the stock price doubled. This outcome of insider trading violates Strong Form of market efficiency.

~ Therefore, this outcome is inconsistent with the Strong Form of market efficiency.