Question

You are trying to decide whether to invest in one or both of two different stocks. The market risk premium and risk-free rate are 6 percent and 4 percent respectively.

Use your knowledge of the CAPM and the SML which you learnt in this course and determine whether you should invest in either, one, or both of these stocks. Provide all workings to support

	Beta	Expected Return (%)
Stock 1	0.8	7.0
Stock 2	1.2	9.5

your answer.

Answer 1

As per CAPM,

E(R) = Rf + (Rm-Rf)beta

Rf = Risk free rate

Rm = Market risk premium

Stock 1 and 2

7 = Rf + (Rm-Rf)10.80. Equation 1

9.50 = Rf + (Rm-Rf)21.20. Equation 2

Substracting equation 2 from 1 we get

2.50 = 10.40(Rm-Rf)

0.2404 = Rm - Rf

Rm = 0.2404 + Rf

Putting in equation 1

7 = Rf + (0.2404 +Rf - Rf)10.80

Rf = 4.4037 %

Rm = 0.2404 + 4.4037 = 4.6441 %

Since the risk premium is low in comparison to actual 6% for bearing risk at market portfolio.

Expected return is low for bearing the given level of beta so amount should not be invested in these two stocks because of lower premium.