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CAPM, SML, and Investors

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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.

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Solution Summary

This solution explains the components of the Capital Asset Pricing Model (CAPM) and graphically illustrates the components in a Security Market Line (SML). The solution also shows the computation using a simple example. Finally, a short discussion on investor approach to CAPM is included.

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The Capital Asset Pricing Model and Security Model Line: Computation of returns and analysis

The capital asset pricing model (CAPM) contends that there is systematic and unsystematic risk for an individual security. Which is the relevant risk variable and why is it relevant? Why is the other risk variable not relevant?

a. You expect an RFR of 10 percent and the market return (RM) of 14 percent. Compute the expected return for the following stocks, and plot them on an SML graph.

Stock Beta E ( Ri )
U 0.85
N 1.25
D -0.20

b. You ask a stockbroker what the firm's research department expects for these three stocks. The broker responds with the following information:

Stock Current Price Expected Price Expected Dividend
U 22 24 0.75
N 48 51 2.00
D 37 40 1.25

Plot your estimated returns on the graph from Part a, and indicate what actions you would take with regard to these stocks. Explain your decisions.

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