14 - When applying the Capital Asset Pricing Model to the real world, all of the following questions remain to be answered EXCEPT: What is the best proxy for the “market” portfolio? What happens when investors cannot borrow and lend at the risk-free rate? How good the Capital Asset Pricing Model is at forecasting? What the Beta of the market portfolio of risky assets is? What the stability of individual stock betas is?

Capital Asset Pricing Model is used to determine the cost of equity or the required rate of return on the investment. It is determined using the equation: Here, Rf = risk free rate RM =Market rate of return rA = required rate of return In order to determine the return using CAPM, a good proxy of the market is required. The best proxy for the asset is used to find the market risk premium on the investment. Hence, option A is correctCapital Asset Pricing Model helps in determining the relationship between the risk return of an asset. It helps in estimating an appropriate rate of return which further helps in accurate forecasting of risk and their yield. It plays a key role in financial modelling and valuation of an investment. It helps to understand if the investment is fairly valued or not. Option 3 is correct. It is important to understand the beta of the portfolio of risky asset as beta measures the volatility of the asset with respect to the market index. A beta with value more than 1, is more volatile than a beta with value less than 1. Also, the stability of beta of the asset is important. If the beta changes, the risk of the investment changes and hence the minimum required return or cost of equity changes. Therefore, Option 4 and 5 are correct CAPM is based on some assumption one of it is investors borrow and lend at risk free rate. Since, this is assumption, when investors are unable to borrow and lend at risk free rate in real world then the model becomes redundant and is no more applicable. Hence, correct option is Option 2. Answer: Option 2: What happens when investors cannot borrow and lend at the risk-free rate?

Answered: When applying the Capital Asset Pricing…

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

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