Robert and Mabel are using the CAPM for making recommendations to their clients.

Question

Robert and Mabel are using the CAPM for making recommendations to their clients. Their research department has developed the information shown in the following table.

Forecasted returns, Standard deviations and Betas

Stock

Forecasted Return

Standard Deviation

Betas

X

14%

36%

0.8

Y

17%

25%

1.5

Market Index

14%

15%

1.0

Risk Free rate

5%

Calculate the expected return using the CAPM for each stock.

Estimate the alpha (difference between expected return and market actual return) for each stock.

Identify and justify which stock would be more appropriate for an investor.

Forecasted returns, Standard deviations and Betas

Stock

Forecasted Return

Standard Deviation

Betas

X

14%

36%

0.8

Y

17%

25%

1.5

Market Index

14%

15%

1.0

Risk Free rate

5%

Explanation / Answer

For stock X, the expected return = 5% + 0.8 * 14% = 16.2%

For stock Y, the expected return = 5% + 1.5 * 14% = 26%

Alpha for X = 16.2% - 14% = 2.2%

Alpha for Y = 26% - 17% = 9%

Ideally the investor shoud not invest in any of the stock as the Forcasted Return < Expected Return.

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