Suppose the rate of return on short-term government securities (perceived to be risk-free) is 5%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 12%. According to the CAPM

1. What is the expected rate of return on the market portfolio?

2. Suppose you consider buying a stock which does not pay a dividend. The current price is $50, and in one year, you expect the price to be $57.50, giving a rate of return of 15%. The stock has a ? which you calculate to be 0.75. Assuming your estimate of the stockâ??s price in one year is correct, is the stock currently overpriced or underpriced according to the CAPM? Explain thoroughly, using the ideas and formulas.

Solution Preview

1. According to CAPM
Required return on stock = Rf + (Rm-Rf) beta
In this question
Required return = 12%
Rf = risk free rate = 5%
Rm = Expected rate of return on market which is to be found
beta = 1
12% = 5% + (Rm-5%) X 1
Rm = (12%-5%) + 5% = 12%
Expected return on market portfolio = 12%

2. The beta of stock ...

Solution Summary

Expected rate of return on the market portfolio is calculated.

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