Question

You have been provided the following data on the securities of three firms, the market portfolio, and the risk-free asset:

a. Fill in the missing values in the table. (Leave no cells blank - be certain to enter 0 wherever required. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)

Security	Expected Return	Standard Deviation	Correlation*	Beta
Firm A	.101	.32	_____	.84
Firm B	.141	_____	.51	1.39
Firm C	.161	.64	.36
The market portfolio	.12	.20	_____
The risk-free asset	.05	_____	_____

*With the market portfolio.

b-1. According to the CAPM, what is the expected return of Firm A's stock? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Expected return _____

b-2. What is your investment recommendation for someone with a well-diversified portfolio?

• ___Sell

• ___Buy

b-3. According to the CAPM, what is the expected return of Firm B's stock? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Expected return _____

b-4. What is your investment recommendation for someone with a well-diversified portfolio?

• ___Sell

• ___Buy

b-5. According to the CAPM, what is the expected return of Firm C's stock? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Expected return _____   

b-6. What is your investment recommendation for someone with a well-diversified portfolio?

• ____Buy

• ____Sell

Answer 1

A	B	C	D	E	F	G	H	I	J	K	L
2		a)
3		Beta can be calculated using following formula:
4		Beta of stock i, βi	=Cov(Rm,Ri)/σm2
5		Where Cov(Rm,Ri) is the covariance of market return (Rm) and stock return (Ri) and σm2 is the variance of the market.
6
7		Corr(Rm,Ri)	=Cov(Rm,Ri)/(σmσi)
8
9		As Per CAPM, required return can be calculated as follows:
10		r(E) = rf + β*(rm-rf)
11
12
13		Security	Expected Return	Standard Deviation	Correlation*	Beta
14		Firm A	0.101	0.32	0.525	0.84
15		Firm B	0.141	0.55	0.51	1.39
16		Firm C	0.161	0.64	0.36	1.15	=(F16*E16*E17)/(E17^2)
17		The market portfolio	0.12	0.2	1
18		The risk-free asset	0.05	0
19
20		*With market portfolio
21
22		b-1)
23		As Per CAPM, required return can be calculated as follows:
24		r(E) = rf + β*(rm-rf)
25		Using the Following data
26		Beta (β)	0.84
27		Risk free rate ( rf )	5.00%
28		Market Return (rm)	12.00%
29
30		Cost of equity can be calculated as follows:
31		Cost of equity	= rf + β*(rm-rf)
32			=5%+0.84*(12%-5.0%)
33			10.88%	=D27+D26*(D28-D27)
34
35		Hence required return for Firm A as per CAPM is	10.88%
36
37		b-2)
38
39		Expected Return of Firm A	10.10%
40		Required return of Firm A as per CAPM	10.88%
41
42		Since the expected return is less than the required return as per CAPM, therefore the Firm A is overvalued.
43
44		Hence Firm A should be sold.
45

Formula sheet