Corporate Finance
3rd Edition
ISBN: 9780132992473
Author: Jonathan Berk, Peter DeMarzo
Publisher: Prentice Hall
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Chapter 3.A, Problem A.4P
a)
Summary Introduction
To determine: The risk premium.
Introduction:
Risk premium is the difference of investment return and risk free
b)
Summary Introduction
To determine: Security’s market price.
Introduction:
The price at which the goods or securities are sold in the market is market price.
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Expected return
a) Suppose the risk-free rate is 1% and the expected rate of return on the market portfolio is 10%. In your view, the expected rate of return of a security is 12.2%. Given that this security has a beta of 1.4, do you consider it to be overpriced, under-priced or fairly priced according to the Capital Asset Pricing Model? Please provide the details of your calculations and discuss your results
a) Suppose the risk-free rate is `X'% and the expected rate of return on the market portfolio is 10%. In your view, the expected rate of return of a security is 12.2%. Given that this security has a beta of 1.4, do you consider it to be overpriced, under-priced or fairly priced according to the Capital Asset Pricing Model? Please provide the details of your calculations and discuss your results.
b) Using a graph, explain when a security is overpriced, under-priced or fairly priced according to the Capital Asset Pricing Model. Plot your answer from (a) onto this graph.
Chapter 3 Solutions
Corporate Finance
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Need a deep-dive on the concept behind this application? Look no further. Learn more about this topic, finance and related others by exploring similar questions and additional content below.Similar questions
- The market portfolio (M) has the expected rate of return E(rM) = 0.12. Security A is traded in the market. We know that E(rA) = 0.17 and βA = 1.5. (1) What is the rate of return of the risk-free asset (rf)? (2) Security B is also traded in the market. βB = 0.8. Then what is “fair” expected rate of return of security B according to the CAPM? (3) Security C is a third security traded in the market. βC = 0.6, and from the market price, investors calculate E(rC) = 0.1. Is C overpriced or underpriced? What is αC?arrow_forwardplease help with this questionarrow_forwardUnder-valued or over-valuedarrow_forward
- Suppose the market premium is 12%, market volatility is 20% and the risk-free rate is 6%. Suppose a security has a beta of 0.8. Using the CAPM, what is its expected return?arrow_forwardWhat is the equation for the Security Market Line? Define each term. If an asset has a beta of 2.0, what type of return should it realize compared to the market portfolio?arrow_forwardExploring Finance: The Security Market Line and Inflation Changes Security Market Line: Inflation Changes Conceptual Overview: Explore how inflation changes the security market line. The Security Market Line defines the required rate of return for a security to be worth buying or holding. The line, depicted in blue in the graph, is the sum of the risk-free return (rf in the slider) and a risk premium determined by the market-risk premium (RPM) multiplied by the security's beta coefficient for risk. Drag the slider below the graph to change the amount of the risk-free return. These changes reflect changes in inflation. Drag left or right on the graph to move the cursor to evaluate securities with different beta coefficients. In this graph, the market-risk premium is fixed at 5%. r = r_{RF} + RP_M * beta = 6\% + 5\% * 1 = 6\% + 5.00\% = 11.00\%r=rRF+RPM∗beta=6%+5%∗1=6%+5.00%=11.00% 1. If the risk-free return were 4.0% and a security's beta coefficient were 2.0, what would be…arrow_forward
- Suppose you observe the following situation: Security Beta Expected Return Peat Company 1.70 13.60 Re - Peat Company 0.85 10.80 Assume these securities are correctly priced. Based on the CAPM, what is the expected return on the market? What is the risk - free rate?arrow_forwardSuppose the CAPM holds. You know that the average investor has a degree risk aversion of 3.3. The current risk free rate is 0.012, the inflation is estimated 0.017, and the volatility of the market is 0.17. What is the market risk premium? [*.000]arrow_forwardThe risk-free rate and the expected market rate of return and 0.056 and 0.125. Using the CAPM model, the expected rate of return of a security, that you are interested in, has a beta of 1.25 would be equal to Calculate the expected rate of returnarrow_forward
- 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…arrow_forwardConsider a world with only two risky assets, A and B, and a risk-free asset. The two riskyassets are in equal supply in the market, i.e., the market portfolio M = 0.5A + 0.5B. Itis known that R¯M = 11%, σA = 20%, σB = 40% and ρAB = 0.75. The risk-free rate is2%. Assume CAPM holds.(a) What is the beta for each stock?(b) What are the values for R¯A and R¯B?arrow_forward7) The expected impact of unanticipated macroeconomic events on a security's return during the period is: A) included in the security's expected return. B) zero. C) equal to the risk-free rate. D) proportional to the firm's beta. E) infinite.arrow_forward
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