You have analyzed the following four securities and have estimated each security
ID: 2658321 • Letter: Y
Question
You have analyzed the following four securities and have estimated each security?s beta and what you expect each security to return next year. The expected return on the market portfolio is 12%, and the relevant risk-free rate is 5%.
Security
Beta
Expected return (based on your analysis)
A
-0.25
3.25%
B
1.10
12.10%
C
0.75
9.75%
D
2.00
19.50%
Refer to the information above. Based on your analysis, which of the securities is correctly priced?
A) Security A
B) Security B
C) Security C
D) Security D
Security
Beta
Expected return (based on your analysis)
A
-0.25
3.25%
B
1.10
12.10%
C
0.75
9.75%
D
2.00
19.50%
Explanation / Answer
As per CAPM assumption,
E(R) = Rf + ß x (Rm – Rf)
Where,
E(R) = Expected return
Rf = Risk free rate = 5 % or 0.05
Rm = Expected return on market = 12 % or 0.12
ß = Beta of portfolio
Computation of E(R) for each security:
Security
Rf
Rm
Rm - Rf
ß
ß x (Rm - Rf)
E(R)
E(R) in %
A
0.05
0.12
0.07
-0.25
-0.0175
0.0325
3.25
B
0.05
0.12
0.07
1.1
0.077
0.1270
12.70
C
0.05
0.12
0.07
0.75
0.0525
0.1025
10.25
D
0.05
0.12
0.07
2
0.14
0.1900
19.00
Expected return of security A is found to be 3.25 % which matches with given value.
Hence option “A) security A” is correct answer.
Security
Rf
Rm
Rm - Rf
ß
ß x (Rm - Rf)
E(R)
E(R) in %
A
0.05
0.12
0.07
-0.25
-0.0175
0.0325
3.25
B
0.05
0.12
0.07
1.1
0.077
0.1270
12.70
C
0.05
0.12
0.07
0.75
0.0525
0.1025
10.25
D
0.05
0.12
0.07
2
0.14
0.1900
19.00
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