Question

Currently under consideration is an investment with a beta, ?, of 1.50. At this time, the risk -free rate of return, Rp is 7%, and the return on the market portfolio of assets, Rm is 10%. You believe that this investment will earn an annual rate of return of 11%.

If the return on the market portfolio were to increase by 10%, what would you expect to happen to the investment’s return? What if the market return were to decline by 10%.

Answer 1

We can use CAPM model to analyze above situation.

Return_Investment = RiskFreeRate + Beta*(R_m - RiskFreeRate) ...(1)

Given, RiskFreeRate = 7%, Beta = 1.5 ...(2)

From (1) & (2),

Return_Investment = 7% + 1.5*(R_m - 7%)

When R_m=10%

Return_Investment = 7% + 1.5*(10%- 7%) = 11.5% (nearer to 11% as given in question)

If R_m to increase 10%, R_m = 10%*1.1 = 11%

Return_Investment = 7% + 1.5*(11%- 7%) = 13%. {we expect investment's return to increase to 13%}

If R_m to fecrease 10%, R_m = 10%*0.9 = 9%

Return_Investment = 7% + 1.5*(9%- 7%) = 10%. {we expect investment's return to decrease to 10%}