Question

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%

Answer 1

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%