Consider the following information for three stocks, Stocks X, Y, and Z. The returns on the three stocks are positively correlated, but they are not perfectly correlated. (That is, each of the correlation coefficients is between 0 and 1.)

Stock Expected Return Standard Deviation Beta
X 9.00% 15% 0.8
Y 10.75 15 1.2
Z 12.50 15 1.6

Fund Q has one-third of its funds invested in each of the three stocks. The risk-free rate is 5.5%, and the market is in equilibrium. (That is, required returns equal expected returns.)

a. What is the market risk premium (rM - rRF)?
b. What is the beta of Fund Q?
c. What is the expected return of Fund Q?
d. Would you expect the standard deviation of Fund Q to be less than 15%, equal to 15%, or greater than 15%? Explain.

Solution Preview

a. What is the market risk premium (rM - rRF)?

Use the CAPM equation to calculate the market risk premium
Required return = Rf + (Rm-Rf) beta
using stock X
9% = 5.5% + (Rm-Rf) 0.8
(Rm-Rf) = (9%-5.5%)/0.8 = 4.375%

b. What is the beta of Fund ...

Solution Summary

The solution explains the calculation of market risk premium, beta, expected return and standard deviation

The Capital Asset Pricing Model (CAPM) is a widely used concept in finance. The model is expressed graphically by the Security Market Line (SML). Within the context of investment, explain how CAPM can be useful to investors.

Please use the following (hypothetical) information to calculate the "cost of equity" by using the CAPM model:
RE = RF + Beta(RM - RF)
Nike = 20% + 0.80(7.50% - 20%) =
Sony = 20% + 1.40(8.50% - 20%) =
McDonald's = 20% + 0.30(9.50% - 20%) =

Which assumptions regarding investor behavior are required by the CAPM?
1. Investors try to maximize their wealth
2. Investors consider only risk when making investments
3. Investors are risk averse
4. Investors adopt a long-term perspective

7. Using the CAPM to calculate the cost of capital for a risky project assumes that:
A. using the firm's beta is the same measure of risk as the project.
B. the firm is all-equity financed.
C. the financial risk is equal to business risk.
D. Both A and B.
E. Both A and C.

Breifly describe the capital asset pricing model (CAPM), its practical use, and its limitations.
Does not have to be long and drawn out, just understandable.

CAPM and EXPECTED RETURN: The following table shows betas for several companies. How do I calculate each stock's expected rate of return using the CAPM. Assuming the risk-free rate of interest is 5 percent. Using a 9 percent risk premium for the market portfolio.
Company BETA
Cisco 2.03
CitiGr

Is the following statement True, False, or Ambiguous? Provide a short justification for your
answer (you are evaluated on the justification).
"In the CAPM model, since investors are compensated for holding risk, two securities with the same standard deviation should have the same expected return."

1. You own a stock portfolio invested 25% in stock Q, 20% in stock R, 15% in stock S, and 40% in stock T. The betas for these stocks are .84, 1.17, 1.11, and 1.36 respectively. What is the portfolio beta?
2. (Using CAPM) A stock has a beta of 1.05, the expected return on the market is 11 % and the risk-free rate is 5.2 %.