Consider the following two scenarios for the economy and the expected returns in each scenario for the market portfolio, an aggressive stock A, and a defensive stock D. Rate of Return Scenario Market Aggressive Stock A Defensive Stock D Bust -10 % -13 % –4 % Boom 30 38 17 Required: a. Find the beta of each stock. b. If each scenario is equally likely, find the expected rate of return on the market portfolio and on each stock. c. If the T-bill rate is 4%, what does the CAPM say about the fair expected rate of return on the two stocks?
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.
Consider the following two scenarios for the economy and the expected returns in each scenario for the market portfolio, an aggressive stock A, and a defensive stock D.
| Scenario | Market | Aggressive Stock A |
Defensive Stock D |
||||||||||
| Bust | -10 | % | -13 | % | –4 | % | |||||||
| Boom | 30 | 38 | 17 | ||||||||||
Required:
a. Find the beta of each stock.
b. If each scenario is equally likely, find the expected rate of return on the market portfolio and on each stock.
c. If the T-bill rate is 4%, what does the
d. Which stock seems to be a better buy on the basis of your answers to (a) through (c)?
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