Consider the following information about the various states of economy and the returns of various investment alternatives for each scenario. Answer the questions that follow. State of the Economy Recession Below Average Average Above Average Boom Mean Standard Deviation Coefficient of Variation Covariance with MP Correlation with Market Index Beta CAPM Req. Return Valuation (Overvalued/Undervalued/Fairly Valued) Nature of stock (Aggressive/Defensive) Probability 0.2 0.1 0.3 0.3 0.1 % Return on T-Bills, Stocks and Market Index Pay-Rubber- made 10 T- Bills 7 7 7 7 7 Phillips -22 -2 20 35 50 up 28 14.7 0 -10 -20 -10 7 45 30 Market Index -13 1 15 29 43
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Question 1
Fill the parts in the above table that are shaded in yellow. You will notice that there are nine
line items.
Question 2
Using the data generated in the previous question (Question 1)
a) Plot the Security Market Line
b) Superimpose the
c) Indicate which investments will plot on, above and below the SML?
d) If an investment’s expected return (mean return) does not plot on the SML, what does
it show? Identify undervalued/overvalued investments from the graph
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Please show working for Question 1 without using a spreadsheet
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