You have a large, well-diversified investment portfolio, and you have some exces

Question

You have a large, well-diversified investment portfolio, and you have some excess cash to invest that would represent a relative small percentage of your total portfolio. Your trusted financial advisor has recommended you invest your excess cash on one of the following two financial assets, which we will dub "Asset A' and "Asset B". She has provided the following information about them. Asset a is a high-yield bond issued by Shale Oil Entrepreneurs, Inc. (SOEI); it has an Expected Return of 15%, a beta of 1.2 and a Market Risk Premium of 6%. The Risk- Free Rate is 2% What is the Required Return of Asset A? What is the Required Return of Asset B? Which Financial Asset should you buy, "Asset A" or "Asset B"? Please be SURE to enter exactly either "Asset A" or Asset B", without the quotation marks of course.

Explanation / Answer

Required Rate of Return – CAPM

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 5%, the beta (risk measure) of the stock is 3 and the expected market return over the period is 10%, the stock is expected to return 12% (5%+3(10%-5%)).

Here,

Stock A - A - 1.2, Rp - 7% (Rm-Rf), E(rA) - 15%

Stock B- B - 1.6, Rp - 6%(Rm-Rf), E(rB) - 13%

Rf - 2%

Required rate of return for stock A = Rf+A*Rp = 2%+1.2 *(7%) = 10.40%

Required rate of return for stock B = Rf+B*Rp = 2%+1.6 *(6%) = 11.60%

According to the CAPM, a positive indicates a positive risk -adjusted abnormal return: after correcting for market risk, the advisor “beat the market.”

Here we can say that,

A = 15% – 10.40% = 4.60%.

B = 13% – 11.60% = 1.40%.

Although both advisors earned positive CAPM risk-adjusted excess returns, the first advisor is the superior stock picker. The first advisor achieved a greater return than the second advisor by incurring less risk (lower ).

In other words: According to the CAPM, the first advisor should have earned 10.40% but earned15%, for a risk-adjusted excess return of 4.60%. The second advisor should have earned 11.60% but earned 13%, for a risk-adjusted excess return of 1.40%.

So we should advice to Buy “Asset A” financial asset.

Related Questions

Navigate

• Browse (All)
• Browse Y
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.