Question

If the simple CAPM is valid and all portfolios are priced correctly, which of the situations below is possible? Consider each situation independently, and assume the risk-free rate is 5%.

A)

Portfolio	Expected Return			Beta
A		12	%		1.2
Market		12	%		1.0

B)

Portfolio	Expected Return			Standard Deviation
A		15	%		12	%
Market		10	%		20	%

C)

Portfolio	Expected Return			Beta
A		15	%		1.2
Market		10	%		1.0

D)

Portfolio	Expected Return			Beta
A		19.0	%		2.0
Market		12	%		1.0

Answer 1

Solution :-

Risk Free Rate = 5%

(A) Market Return = 12%

Beta of Stock = 1.20

Now Fair return of stock = Rf + Beta * ( Rm - Rf )

= 5% + 1.20 * ( 12% - 5% )

= 13.4%

Expected Return = 12%

As Fair Return > Expected Return Stock is Over Priced

(B) Here in this Part the data As per CAPM not given so we use Coefficient of variation that is

Standard deviation / Avg Return

Stock = 12 / 15 = 0.80

Market = 20 / 10 = 2

It means there is less risk in stock means under priced

(C)

Market Return = 10%

Beta of Stock = 1.20

Now Fair return of stock = Rf + Beta * ( Rm - Rf )

= 5% + 1.20 * ( 10% - 5% )

= 11%

Expected Return = 15%

As Fair Return < Expected Return Stock is Under Priced

(D)

Market Return = 12%

Beta of Stock = 2.0

Now Fair return of stock = Rf + Beta * ( Rm - Rf )

= 5% + 2.0 * ( 12% - 5% )

= 19%

Expected Return = 19%

As Fair Return = Expected Return

Stock is Correctly Valued

Therefore the correct Answer is (D)

In this case the Simple CAPM is valid and all portfolios are priced correctly.

If there is any doubt please ask in comments