Question

In: Finance

In the CAPM world, two securities, A and B, are priced efficiently, i.e., they fall on...

In the CAPM world, two securities, A and B, are priced efficiently, i.e., they fall on the SML. The expected return of A is 20%, and its beta is 1.6. The expected return of B is 11%, and its beta is 0.7. The expected return of the market portfolio is ___and the risk free rate is ___.

A.

15% and 6%
B.

15% and 5%
C.

14% and 4%
D.

16% and 6%
E.

18% and 6%

Solutions

Expert Solution

Ans C. 14% and 4%

Stock A
Expected Return = Risk free Return + (Market Risk Premium)* Beta
20% = Risk free Return + (Market Risk Premium)* 1.60 (a)
Stock B
Expected Return = Risk free Return + (Market Risk Premium)* Beta
11% = Risk free Return + (Market Risk Premium)* 0.7 (b)
Solving Equation (a) and (b)
20% = Rf+ (Market Risk Premium)* 1.60
11% = Rf + (Market Risk Premium)* 0.70
9% = (1.60-0.70)* (Market Risk Premium)
Market Risk Premium = 9% / 0.90
10.00%
From (a)
20% = Rf+ (Market Risk Premium)* 1.6
20% = Rf + 10% * 1.6
Rf = 20% - 16%
Rf = 4.00%
Risk Free Rate = 4.00%
Market Return = Market Risk Premium 6 Risk Free Rate
Market Return = 10% + 4%
Market Return = 14%
Expected Return = Risk free Return + (Market Return - Risk free return)* Beta
4% + (14% - 4%) * 1
14.00%

jeff jeffy answered 2 years ago
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