Problems 10 to 16: If the simple CAPM is valid, which of the following situation

Question

Problems 10 to 16: If the simple CAPM is valid, which of the following situations For ossible? Explain. Consider each situation independently are p Expected Return 20 25 10. Portfolio Beta 1.4 1.2 Standard Deviation 35 25 Standard Portfolio Expected Return 30 40 Expected ReturnDeviation Portfolio Risk-free Market 10 18 16 24 12 Standard Deviation 13. Expected Return 10 18 20 Portfolio Risk-free Market 24 Beta 4 Portfolio Risk-free Market Expected Return 10 18 16 1.0 1.5 Beta Expected Return 10 18 16 15. Portfolio Risk-free Market 1.0 Standard Deviation 16. PortfolioExpected Return Risk-free Market 10 24

Explanation / Answer

1) Solution: Not possible.

Explanation: Portfolio A has a higher beta than Portfolio B, but the expected return for Portfolio A is lower in comparison to the expected return for Portfolio B. Therefore we can conclude that these two portfolios cannot exist in equilibrium.

2) Solution: Possible.

Explanation: If the CAPM is valid, the expected rate of return compensates only for systematic (market) risk, represented by beta, rather than for the standard deviation, which includes nonsystematic risk. Therefore we can conclude that as long as A’s beta is less than B’s, Portfolio A’s lower rate of return can be paired with a higher standard deviation.

3) Solution:Not possible.

Explanation: The reward-to-variability ratio for Portfolio A is better if we compare in the market. Thus according to the CAPM it will be impossible because the CAPM predicts that the market is the most efficient portfolio. Now Using the numbers supplied we can conclude tha Portfolio A gives a better risk-reward tradeoff comapred to the market portfolio

4) Solution:Not possible.

Explanation: The SML in this case is: E(r) = 10 + b(18 – 10)

Portfolios when beta = 1.5 have an expected return equal to: E(r) = 10 + [1.5 * (18 – 10)] = 22%

The expected return for Portfolio A is computed as 16%; thus Portfolio A plots below the SML (a A = –6%), and hence is an overpriced portfolio. To conclude it is inconsistent with the CAPM.

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