Question

An investor is considering the following three stocks to invest. Suppose that the current T-bill rate is 5% and the market rate of return is 13%

	Stock A	Stock B	Stock C
Beta	1.3	1.0	0.7

Which of the following statements is FALSE based on CAPM?

a) None of the alternatives is false.

b) If the investor puts equal amount of money in each of the three stocks, he/she is expected to earn 13% from the portfolio.

c) The current market price of stock B is such that it is expected to earn 15%. Therefore, the stock is currently undervalued.

d) On average, stock C moves in the same direction as the S&P 500 index.

e) Stock A is more risky than the market portfolio.

Answer 1

The answer is A- None of the alternatives is false.

CAPM equation -
E(Ri) = Rf + ( E(Rm) - Rf ) * beta of security

where,
E(Ri) = Expected return on security i
rf = risk free return
E(Rm) = Expected market return

Based on above equation, expected return of all stocks have been calculated which are Stock A- 15.4 % , Stock B - 13% and stock C - 10.6.

Based on these returns is If the investor puts equal amount of money in each of the three stocks, he/she is expected to earn 13% from the portfolio. Hence option B is correct.

C) Stock B required rate of return based on CAPM is 13 % and its expected actual return is 15 % as the required rate is less than the expected return the stock is currently undervalued. Hence it is correct.

D)The beta (systematic risk) of market portfolio is 1. As the the expected market rate of return is based on the historic rate of return of an index such as the S&P 500, S&P 500 index is market portfolio and its beta will be 1.

When beta is positive it implies security return will move in positive direction of market return. A security which has negative beta implies that security return will move in opposite direction of market return. A security which has a beta of 1 has a perfect positive correlation with its market.

Here stock C beta is 0.7 it implies it has has less systematic risk and less volatility than the market but still it will move in same direction with market. Hence this option is also correct.

E) Stock A is more risky than the market portfolio as it has beta of 1.3 which is more than beta of market. This security has more systematic risk and more volatility than the market. Hence this option is also correct.