Question

Let's say that you are looking to invest in two stocks A and B. Stock A has a beta of 1.19 and based on your best estimates is expected to have a return of 13%. Stock B has a beta of 1.61 and is expected to earn 7%. If the risk-free rate is currently 2% and the expected return on the market is 12%, which stock(s) should you invest in, if any?

Work by hand no financial calculator

Answer 1

As per CAPM,

required Return = Risk Free Rate + ( Expected Return on Market - Risk Free Rate) *Beta

The CAPM return is the minimum return required on the portfolio. If the stock is giving a return lesser than the minimum return required,the same should not be invested in.

For Stock A:

required Return = 2 % + ( 12 % - 2 %) * 1.19

= 13.90%

Return as per best estimates = 13%

Since the required Return as per CAPM is higher than the Return as per best estimates , the stock is not giving the minimum required return and hence should not be invested in.

For Stock B:

required Return = 2 % + ( 12 % - 2 %) * 1.61

= 18.10%

Return as per best estimates = 7%

Since the required Return as per CAPM is higher than the Return as per best estimates , the stock is not giving the minimum required return and hence should not be invested in.

Hence the correct answer is :

Stock A and Stock B must be not invested in because they are both not giving the minimum required return.