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Security and Capital Market Line

A) What are the differences between the Security Market Line and the Capital Market Line? Show their formulas.

B) What are the assumptions of the Capital Asset Pricing Model (CAPM)?

C) What are the differences between the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). Indicate at least 2 other factors affecting stock returns according to Arbitrage Pricing Theory models.

D) Your client has offered a 5-year, $1,000 par value bond with a 10 percent coupon. Interest on this bond is paid quarterly. 1) If your client is to earn a nominal rate of return of 12 percent, compounded quarterly, how much should he pay for the bond? 2) How much should he pay if it is a perpetual bond?

E) What are the differences of the following: required rate of return on a stock, expected rate of return on a stock, actual or realized rate of return on a stock.

F) What does market efficiency mean? Define the 3 forms/levels of market efficiency. Where would the current stock markets fall and why?

G) Is negative free cash flow always bad? Explain why or why not.

H) Describe Market Value Added (MVA) and Economic Value Added (EVA).

I) What is free cash flow? Explain the 3 determinants of free cash flow.

J) Define the determinants of nominal market interest rates.

K) What is the present value of a 5 year ordinary annuity with annual payments of $200, evaluated at a 15 percent interest rate?

L) What is the difference between interest rate risk and reinvestment rate risk?

M) What is the difference between stand-alone risk and market risk? How are they measured?

N) What is the Du Pont Equation? And why is it useful?

Solution Preview

Hello
A) What are the differences between the Security Market Line and the Capital Market Line? Show their formulas.

Solution:-

Capital market is the place where we can buy or sell stock and bonds, financial regulators etc
The companies raise the funds in the place only, capital market is consist of the primary market, where new issues are distributed to investors, Both the private and the public sectors provide market makers in the capital markets.

While security market line is the linear relationship between the expected return of security and its systematic risk, the expected return comparing a risk-free return plus a risk premium.

Security Market Line (SML): r i= rrf + (rm - rrf) bi

B) What are the assumptions of the Capital Asset Pricing Model (CAPM)?

Solution:-

Some of the assumptions behind the CAPM are as following

1. Investors evaluate portfolios by looking at the expected returns and standard deviations of the portfolios over a one period horizon
2. Investors are never satiated so when given a choice between two otherwise identical portfolios they will choose the one with the higher expected return
3. All investors have the same one period horizon
4. the risk free rate is the same for all investors
5. Taxes and transaction costs are irrelevant
6. information is freely and instantly available to all investors

C) What are the differences between the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). Indicate at least 2 other factors affecting stock returns according to Arbitrage Pricing Theory models.

Solution:-

Asset Pricing Model are very useful tools that enable financial analysts or just simply independent investors evaluate the risk in an specific investment and at the same time set a specific rate of return with respect the amount of risk of an individual investment or a portfolio. The CAPM method while simpler than the ATP method takes into consideration the factor of time and does not get too wrapped up over the Systematic risk factors that sometimes we can not control. In this paper, I will explain some of the advantages and disadvantages of the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT).

These are two methods that while different from each other, they try to explain and provide the same type of information in a unique way. As people become more exposed to a highly volatile stock market and try to invest their money in any other type of investment these pricing methods become key elements when evaluating an investment.

D) Your client has offered a 5-year, $1,000 par value bond with a 10 percent coupon. Interest on this bond is paid quarterly. 1) If your client is to earn a nominal rate of return of 12 percent, compounded ...

Solution Summary

This solution helps identify the differences between Security and Capital Market Line

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