Suppose the Capital Asset Pricing Model (CAPM) is valid in a market. PM to ex- plain and answer following questions. Note: There is no relationship between each situation. (a) Can security A exist in the market? (Hint: Security market line) If yes, compute risk premium on security A. If not, is this security underpriced or overpriced? Asset Risk-free Market Beta Expected return 5% 12% 15% 1. 1.3
Suppose the Capital Asset Pricing Model (CAPM) is valid in a market. PM to ex- plain and answer following questions. Note: There is no relationship between each situation. (a) Can security A exist in the market? (Hint: Security market line) If yes, compute risk premium on security A. If not, is this security underpriced or overpriced? Asset Risk-free Market Beta Expected return 5% 12% 15% 1. 1.3
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Concept explainers
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
Transcribed Image Text:Suppose the Capital Asset Pricing Model (CAPM) is valid in a market. Use CAPM to ex-
plain and answer following questions. Note: There is no relationship between each situation.
(a) Can security A exist in the market? (Hint: Security market line) If yes, compute risk
premium on security A. If not, is this security underpriced or overpriced?
Expected return
5%
Asset
Beta
Risk-free
Market
12%
1
A
15%
1.3
(b) Can security B exist in the market? (Hint: Security market line) If yes, compute risk
premium on security B. If not, is this security underpriced or overpriced?
Expected return
6%
Asset
Beta
Risk-free
Market
13%
16.5%
1
1.5
Suppose the expected cash flow can be collected from investment in security B is $1000
at time 1. And an investor thinks the beta of security B is 1.8. But the actual beta is given
in the above table. Then how much more/less (you also need to select "more" or "less") will
he offer for the firm than it is truly worth at time 0? Hint: the present value of the cash
flow =
cash flow
ErB under certain beta"
(c) Can security C exist in the market? (Hint: Capital market line) If yes, compute risk
premium on security C.
Asset
Risk-free
Market
Expected return
7%
Standard deviation
15%
10%
12%
18%
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