Question

You have the following information on a set of investments. Using the SML, which would be considered good investments?

			Expected
		Beta	Return
Company A		0.75	8.50%
Company B		1.1	9.75%
Company C		0.95	8.10%
Company D		1.25	11.50%
Risk free rate of return		3.75%
Required return on market		9.25%

Answer 1

Answer:

Using SML, firstly we will calculate Expected Return using Capital Asset Pricing Model (CAPM) for each investment

According to CAPM model: Expected Return= Risk free rate of return+ (Market Return- Risk Free return)* beta

Therefore,

Company A: 3.75+(9.25-3.75)* 0.75 = 7.875%

Company B: 3.75+(9.25-3.75)* 1.10 = 9.80%

Company C: 3.75+(9.25-3.75)* 0.95 = 8.975%

Company D: 3.75+(9.25-3.75)* 1.25 = 10.625%

We will compare these calculated returns with the expected yield given in the question to derive which investments are good.

In case of Company B and C, the expected returns (9.75% and 8.10%) given in the question is less than their corresponding returns (i.e. 9.80% and 8.975%) which shows that these investments are over-priced and should be sold by the investor.

In case of Company A and D, the expected returns (8.50% and 11.50%) given in the question is more than their corresponding returns (i.e. 7.875% and 10.625%) which shows that these investments are underpriced and the investor should increase their proportion.