Question

"CAPM" Please respond to the following: Suppose investors believe that the standard deviation of the market-index portfolio has increased by 50%. Speculate on two potential implications of the Security Market Line (SML) and CAPM regarding the effect of this change on the required rate of return for a company's investment projects. Compare the returns of the two selected funds for the past 10 years. Determine whether you believe that the Fama-French (FF) three factor model should or should not be rejected. Explain why or why not.

Answer 1

A] The Capital Market Line equation is as under:

........................eq(1)

Where:

E(Rc) : Expected return of a portfolio

Rf: Risk Free Rate

SDc: Standard Deviation of the Portfolio

E(Rm) : Expected return of Market Portfolio

SDm : Standard Deviation of the Market Portfolio

In the equation (1), keeping all other things constant, if their is an increase in SDm by 50%, the expected return of a portfolio will reduce.

B] The Security Market Line equation is as under:

................................................................eq(2)

Where,

E(Ri) : Expected return of a security

Rf: Risk Free Rate

E(Rm) : Expected Market return

B: Beta of the security.

Beta of the security is computed as =

Beta represents only the Systematic Risk of the security. An increase in standard deviation will increase the Variance but as the effective Covariance is unknown, the overall impact on the beta cannot be specified and hence impact on Expected return as well.

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