Question

We Do Bankruptcies is a law firm that specializes in providing advice to firms in financial distress. It is prospers in recessions when other firms are struggling. Consequently, its beta is negative, minus -0.2.

A. If the interest rate on T-bills is 4% and the expected return on the market portfolio is 14%, what is the expected return on the shares of the law firm according to CAPM?

Answer: Expected return %

B.Suppose you invested 90% of your wealth in the market portfolio and the remainder of your wealth in the shares in the law firm. What would be the beta of your portfolio?

Answer: Beta is?

Answer 1

According to CAPM,

Expected return = Risk free rate + Beta*(Market return-Risk free rate)

Risk free rate = 4% (t-bills are considered risk free)

Beta for law firm= -0.2

Beta for market portfolio = 1

Market return = 14%

A) Expected Return = 4 + (-0.2)*(14-4) = 2%

B) If 90% of wealth is invested in market portfolio and remaining in shares of law firm,

Then portfolio beta = % portflio in market* Market beta + % portfolio in law firm shares * Law firm's beta

=0.9*1 + 0.1*(-0.2) = 0.88