FINANCIAL MANAGEMENT 2

CAPITAL ASSET PRICING MODEL AND MODERN PORTFOLIO THEORY

Problem 1

Using the CAPM (capital asset pricing model) and SML (security market line), what is
the expected rate of return for an investment with a Beta of 1.8, a risk free rate of
return of 4%, and a market rate of return of 10%.

E(Ri) = RF + i × (E(RM) - RF)

E(Ri) = 0.04 + 1.8 (0.10 - 0.04) = 0.148 (14.8%)

Problem 2

Suppose the rate of return of the market has an expected value 14% and a standard
deviation of 15%, let the risk free rate be 10%. Consider an asset has covariance of
.045 with the market. Using the capital asset pricing model formula calculate an
expected rate of return.

(1) 𝛽 = 𝑐𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 ÷ 𝑆𝑡𝑎𝑛𝑑𝑎𝑟𝑑 𝐷𝑒𝑣𝑖𝑎𝑡𝑖𝑜𝑛2

𝛽 = 0.045 ÷ 0.152
𝛽=2

(2) 𝑟𝑖 = 𝑟𝑓 + 𝑏𝑖 (𝑟𝑚 − 𝑟𝑓 )
𝑟𝑖 = 10% + 2(14% − 10%)
𝑟𝑖 = 18%

Problem 3

Consider that you have P30,000 in the following 4 stocks.

The risk free rate is 4% and the expected return on the market portfolio is 15%. Using
the capital asset pricing market, what is the expected return on the above portfolio?

𝛽𝑝𝑓 = 𝑤1 ∙ 𝛽1 + 𝑤2 ∙ 𝛽2 + 𝑤3 ∙ 𝛽3 + 𝑤4 ∙ 𝛽4
= (5/30)(0.75) + (10/30)(1.10) + (8/30)(1.36) + (7/30)(1.88)
= 1.29

Capital asset pricing model equation is

𝑟𝑖 = 𝑟𝑓 + 𝑏𝑖 (𝑟𝑚 − 𝑟𝑓 )
= .04 + (1.29) (.15-.04)
= .04 + 0.15
= 0.19.

Problem 4

If we compute the reward-to-risk ratios, we get (22% − 7%) / 1.8 = 8.33% for Earth,
Inc. versus 8.4% for Fire Company. Relative to that of Earth, Fire’s expected return is
too high, so its price is too low.

If they are correctly priced, then they must offer the same reward-to-risk ratio. The
risk-free rate would have to be such that:

(22% − Rf) / 1.8 = (20.44% − Rf) / 1.6

With a little algebra, we find that the risk-free rate must be 8 percent:

22% − Rf = (20.44% − Rf)

(1.8/1.6)
22% − 20.44% x 1.125 = Rf − Rf x 1.125
Rf = 8%
Problem 5
Because the expected return on the market is 16 percent, the market risk premium is
16% − 8% = 8%.

The first stock has a beta of .7, so its expected return is:

8% + .7 x 8% = 13.6%

For the second stock, notice that the risk premium is:

24% − 8% = 16%

Because this is twice as large as the market risk premium, the beta must be exactly
equal to 2. We can verify this using the CAPM:

E (Ri) = Rf + [E (RM) − Rf] x βi

24% = 8% + (16% − 8%) x βi

βi = 16%/8%

= 2.0

Problem 6

The beta of a portfolio is the sum of the weight of each asset times the beta of each
asset. So, the beta of the portfolio is:

p = .25(.84) + .20(1.17) + .15(1.11) + .40(1.36)

= 1.15

Problem 7

The beta of a portfolio is the sum of the weight of each asset times the beta of each
asset. If the portfolio is as risky as the market it must have the same beta as the
market. Since the beta of the market is one, we know the beta of our portfolio is one.
We also need to remember that the beta of the risk-free asset is zero. It has to be
zero since the asset has no risk. Setting up the equation for the beta of our portfolio,
we get:

p = 1.0 = 1/3 (0) + 1/3 (1.38) + 1/3 (X)

Solving for the beta of Stock X, we get:

X = 1.62