Question

If the simple CAPM is valid, is the situation shown below possible?

Portfolio	Expected Return		Beta
Risk-free	7	%	0
Market	19	%	1.2
A	14	%	1.7

a. Possible

b. Not possible

Answer 1

Rf = 7%

E(Rm) = 19%

E(RA) = 14%

The simple CAPM expected return can be calculated as:

Re = Rf + beta(Rm - Rf)

From this equation, one can infer that higher the beta, the higher will be the expected return. As the beta of the market is lower than the stock A, the expected return of market should be lower.In this question it is indicating the contrary so this situation is not possible. The expected return of the market is given as 19% whereas that of stock A is given as 14%, when the beta of the market is lower than the stock A

Hence, the situation is not possible.

Thus, the correct answer is b. Not possible