Question

Which of the following statements is TRUE regarding CAPM?

A) This is a model for relating unsystematic risk to the expected return on a risky asset

B) Ceteris paribus, stocks with higher betas should have lower prices.

C) The beta for the market is always zero.

D) Stocks with higher market risk should have lower expected or required rates of return.

Albert purchased Southern Industries stock for $40 per share and sold it one and one half years later for $45 with no dividends being paid. What was Albert's holding period return (HPR), Simple Annualized Return, and Compound Annualized Return, respectively?

A) 8.17%,8.33%,12.50% B) 8.33%, 12.50%, 8.17% C) 12.50%, 8.33%, 8.17% D) 12.50%, 8.17%, 8.33%

Consider two well-diversified portfolios: Portfolio 1 has an expected return of 8% and three-quarters average market risk while Portfolio 2 has an expected return of 12% and a beta of 1.50. If the risk free rate is 2.5% which portfolio would a rational-risk averse investor prefer and why?

A) Portfolio 2 because it has the higher reward to risk ratio. B) Portfolio 1 because it has the lower risk. C) Portfolio 2 because it has the higher reward. D) Portfolio 1 because it has the higher reward to risk ratio.

Answer 1

1. Answer is B

CAPM equation

cost of equity = Risk free rate + Beta*(Market rate - risk free rate)

beta is measure of systemic risk, so 1st option is wrong

As the beta increase, cost of equity will increase and price will decrease

So 2nd is true

Beta of market is always 1

So 3rd is wrong

Higher market risk will have higher cost of equity

So 4th is wrong

2. Answer is C

purchase price = 40

Selling price = 45

HPR = ( 45 - 40 ) / 40 = 5 / 40 = 12.5%

This return is for 1.5 years

So simple annualized return = 12.5 / 1.5 = 8.33%

Compounded annualized return :

45 = 40 * (1+r)^1.5

So r = 8.17%

3. Answer is D

return of 1 = 8%

market risk of 1= 3/4 = 0.75

return of 2 = 12%

market risk of 2= 1.5

risk free rate = 2.5%

Risk to reward of 1 = (return of 1 - risk free rate ) / market risk

Risk to reward of 1 = (8 - 2.5) / 0.75 = 7.33%

Risk to reward of 2 = (return of 2 - risk free rate ) / market risk

Risk to reward of 2 = (12 - 2.5) / 1.5 = 6.33%

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