Question

Four of your best friends from college are now mutual fund managers (maybe you should have kept in touch after graduation).  The risk-free rate was 2 percent and the S&P 500 market risk premium was 10 percent for 2019.  Using the Capital Asset Pricing Model, provide the benchmark Security Market Line predicted return for each fund in 2019 and place them in the table below.

Fund Manager	2019 Performance	BETA	StdDev	Corr.	SML Predicted Return
Devo	8%	0.55	11%	25%
Grodge	11	0.70	7	50
MsMo	13	1.20	12	50
SpaceMan	18	1.60	10	80

a. Which of your friends has the fund with the highest market risk?  The highest total risk?

Highest Market Risk  _______

  Highest Total Risk ______

b. Compared to the SML benchmark, which of your friends had the best performance?   The worst?

Best Performance______

Worst Performance______

c.You have estimated that MsMo will provide a return of 12% for investors in 2020, while the risk-free rate is 3 percent and the S&P 500 market risk premium is 8.0 percent for 2020. Given these estimates, do you feel that MsMo will out-perform or under-perform the market benchmark?  (Circle 0ne)

Out-Perform  Under-Perform

Market Benchmark _________

d. What is the implied standard deviation of the returns for the Standard & Poor 500 (market return) used to compute the betas in the table above?

e. You have decided to invest 25% of your funds with each of your friends.  What will be the beta of your investment portfolio adopting this strategy?

Beta ______

Answer 1

a. CAPM Return = Risk Free + Beta * Market Risk Premium

a. Which of your friends has the fund with the highest market risk?  The highest total risk?

Highest Market Risk  Space man (Highest Beta)

  Highest Total Risk MsMo (Highest Standard Deviation)

b. Compared to the SML benchmark, which of your friends had the best performance?   The worst?

Best Performance Grodge (because performance is greater than SML return)

Worst Performance Msmo (because performance is lesser than SML return)

c.You have estimated that MsMo will provide a return of 12% for investors in 2020, while the risk-free rate is 3 percent and the S&P 500 market risk premium is 8.0 percent for 2020. Given these estimates, do you feel that MsMo will out-perform or under-perform the market benchmark?  (Circle 0ne)

CAPM return = Risk Free + Beta * Market Risk Premium = 3% + 1.2 * 8% = 12.60%

Under-Perform (Because Actual return is lesser than CAPM Return)

Market Benchmark 12.60%

d. What is the implied standard deviation of the returns for the Standard & Poor 500 (market return) used to compute the betas in the table above?

Implied Standard Deviation = Correlation * Standard Deviation of individual fund / Beta

Implied Standard Deviation = 0.25 * 0.11 / 0.55 = 5.00% (we can get same result even for remaining three funds)

e. You have decided to invest 25% of your funds with each of your friends.  What will be the beta of your investment portfolio adopting this strategy?

Beta = respective Weight * respective Beta

Beta = 0.25 * (0.55 + 0.70 + 1.20 + 1.60)

Beta = 1.013

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