A.) If the simple CAPM is valid, say whether the situation is possible or not? N

Question

A.) If the simple CAPM is valid, say whether the situation is possible or not?

Not possible_______ or

Possible______

B.) Suppose that there are two independent economic factors, F1 and F2. The risk-free rate is 8%, and all stocks have independent firm-specific components with a standard deviation of 38%. The following are well-diversified portfolios:

What is the expected return–beta relationship in this economy? (Do not round intermediate calculations. Round your answer to the nearest whole number. Omit the "%" sign in your response.)

E(rP) = _____% + (P1 × _____%) + (P2 × ______%)

Portfolio Expected Return Standard
Deviation        Risk-free 7              0        Market 19              31 A 14              16

Explanation / Answer

A.) If the simple CAPM is valid, say whether the situation is possible or not?

Possible

Note : As per CAPM

Expected Return = risk free rate + ( return on market - risk free rate)* beta

Since the Expected return is lower than Return on market & so the Beta & risk should be lower , therefore it is possible of happening

B.) Suppose that there are two independent economic factors, F1 and F2. The risk-free rate is 8%, and all stocks have independent firm-specific components with a standard deviation of 38%. The following are well-diversified portfolios:

What is the expected return–beta relationship in this economy? (Do not round intermediate calculations. Round your answer to the nearest whole number. Omit the "%" sign in your response.)

Expected Return = RF + Beta on F1*Risk of Factor 1 + Beta on F2*Risk of Factor 2

Let Risk of Factor 1 be x

Risk of Factor 2 be y

From Portfolio 1

28 = 8 + P1*x + P2*y

28 = 8 + 1.4x + 1.8y .................................................(i)

From Portfolio 2

25 = 8 + P1*x + P2*y

25 = 8 + 2.3x + -0.18y

Multiply with 10 in above equation

250 = 80 + 23x - 1.8y............................................(ii)

Add the both equation i.e equation (i) &(ii)

278 = 88 + 24.4 x

x = (278-88)/24.4

x = 7.79%

Risk of Factor 1 = 8%

y = (28-8 - 1.4*7.79)/1.8

y = 5.05%

Risk of Factor 2 = 5%

Answer

E(rP) = __8_% + (P1 × _8_%) + (P2 × _5__%)

Portfolio Expected Return Standard
Deviation        Risk-free 7              0        Market 19              31 A 14              16

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