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)

(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

i) Capital Asset Pricing Model, CAPM, is used to calculate the expected returns on assets. It takes into account the risk and cost of capital of that particular asset. It gives an estimate of the return from an investment with respect to the risk of the asset.

Beta measures the sensitivity of the stock price movement to the price movement to a benchmark index. A zero beta stock implies that the expected return on this stock is the same as the risk-free rate. It's is not correlated to the market volatility.

ii) The efficient market hypothesis (EMH) states that the price of shares reflects all information due to which it is not possible to make abnormal returns. There are three forms of market efficiency: Weak Form, Semi- Strong & Strong.

The outcome mentioned in the question is inconsistent with the strong form of efficiency where the market price fully reflect all information, so that even the insiders are not able to make any abnormal return due to some private information available to them.