PLEASE SHOW ALL WORK FOR FULL CREDIT 1. Define the Capital Asset Pricing Model (

Question

PLEASE SHOW ALL WORK FOR FULL CREDIT

1. Define the Capital Asset Pricing Model (CAPM).

2. Define "beta" as it applies to common stocks.

3. You have two stocks in your portfolio. $20,000 is invested in a stock with a beta of 0.6 and $40,000 is invested in a stock with a beta of 1.4. What is the beta of your portfolio?

4. If the risk-free rate is 2% and the expected rate of return on the stock market is 7%, what is the required rate of return on a stock with a beta of 1.4 according to the CAPM?

Answers:

3: 1.13

4: 9.0%

Explanation / Answer

Hi,

Please find the detailed answer as follows:

Part A:

CAPM = Required Rate of Return = Risk Free Rate + Beta*(Market Rate of Return - Risk Free Rate)

Investors use this model to calculate the required rate of return on any stock. The 2 parts of the above equation represent:

a) Risk Free Rate ( it is the rate which the investors would get by investing in any risk free security). It is also a measure of time value of money)

b) Second Part [(Beta*(Market Rate of Return - Risk Free Rate)], indicates the amount of risk that would be taken by an investor and the value of compensation, he/she would expect over the same. (Market Rate of Return - Risk Free Rate) is also known as Market Risk Premium.

Part B:

Beta is used to measures the movement of a stock's price in comparision to the movement in the overall market. It basically represents ths systemmatic risk associated with any stock which cannot be diverisified by investing into other securities available in the market. It is frequently used in the calculation of Required Rate of Return with the use of CAPM model.

Part C:

Portfolio Beta = Beta of Stock 1* Weight of Stock 1* + Beta of Stock 2*Weight of Stock 2

Weight of Stock 1 = Value of Investment in Stock 1/Total Investment = 20000/(20000 + 40000) = 20000/60000

Weight of Stock 2 = Value of Investment in Stock 2/Total Investment = 40000/(20000 + 40000) = 40000/60000

Portfolio Beta = .6*20000/60000 + 1.4*40000/60000 = 1.13

Part D:

Required Rate of Return = Risk Free Rate + Beta*(Market Rate of Return - Risk Free Rate) = 2 + 1.4*(7-2) = 9%

Thanks.

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