Question

1.5. Explain why you either agree or disagree with this assertion: “According to the Capital Asset Pricing Model, zero-beta stocks have a zero expected return.” (3)

1.6. Briefly explain how the weight given to a particular stock in a portfolio can exceed 100 percent (2)

Answer 1

1.5. Capital Asset Pricing Model:

• The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk and expected return for assets, particularly stocks.
• CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.

Zero-Beta Stock:

• A zero-beta portfolio is a portfolio constructed to have zero systematic risk, or in other words, a beta of zero. A zero-beta portfolio would have the same expected return as the risk-free rate.
• Such a portfolio would have zero correlation with market movements, given that its expected return equals the risk-free rate or a relatively low rate of return compared to higher-beta portfolios.
• A zero-beta portfolio is quite unlikely to attract investor interest in bull markets, since such a portfolio has no market exposure and would therefore underperform a diversified market portfolio.
• It may attract some interest during a bear market, but investors are likely to question whether merely investing in risk-free, short-term treasuries is a better and cheaper alternative to a zero-cost portfolio.

A portfolio constructed to have a 0 systematic risk i.e. zero Beta portfolio would have the same expected return as the risk free rate.

For example: Suppose there are two stocks in a portfolio with weights = 50 % each and returns are same for each security.

Risk free rate= 9%

Market return= 10%

Beta of stock= 0

Then, Expected return on stock (CAPM MODEL)= Risk free rate + Beta (return of market – risk free rate).

= 9+0 (10-9)

  So Return on stock = 9%.

Thus it is possible to have expected return equals to risk free rate.

Yes it is A possible to construct a portfolio of stocks that has an expected return equal to the risk-free rate. Such kind of portfolios are also called zero beta portfolio that have zero systematic risk. There shall be a zero correlation with market.

A zero-beta portfolio is used in bull markets, because such a portfolio has no market riskand perform worse than a diversified market portfolio.

Therefore, I am disagreed with this assertion: “According to the Capital Asset Pricing Model, zero-beta stocks have a zero expected return.” We understood that zero-beta stocks has an expected return equal to the risk-free rate.

1.6. Weights in an investment portfolio:

The weight of an asset in an investment portfolio is a representation of what percentage of the portfolio's total value is tied up in that specific asset. Calculating the weights of each asset in a portfolio is the crucial first step in assessing the portfolio's past or expected future risk as well as return.

• Financial analysts give their opinions of the future performance of the security.
• They can give performance ratings of underweight, overweight, or market perform to a security.
• If analysts give a particular stock 100 percent weight, they expect the stock to outperform its industry in the market.
• Analysts may give a particular stock 100 percent due to a steady stream of positive news, good earnings, and raised guidance.
• An overweight rating on a stock usually means that it deserves a higher weighting than the benchmark's current weighting for that stock.
• An overweight rating on a stock means that an equity analyst believes the company's stock price should perform better in the future.
• However, an analyst's rating needs to be taken into context with the investor's time horizon and risk tolerance.

If an analyst believes that a stock price should appreciate, the analyst will likely indicate the time frame and an expected price target within that time frame. For example, assume company ABC is in the biotech sector, has a drug for lung cancer, and is currently trading at $100 per share. The company releases positive data and receives FDA approval leading to a stock price increase by 25%. Analysts may give their opinion based on this news and rate the stock as overweight with a price target of $175 for the next 12 months.

So, in this way weight given to a particular stock in a portfolio can exceed 100 percent.