Question

You have analyzed the following four securities and have estimated each security?s beta and what you expect each security to return next year. The expected return on the market portfolio is 12%, and the relevant risk-free rate is 5%.

Security	Beta	Expected return (based on your analysis)
A	-0.25	3.25%
B	1.10	12.10%
C	0.75	9.75%
D	2.00	19.50%

Refer to the information above. Based on your analysis, which of the securities is correctly priced?

		A) Security A
		B) Security B
		C) Security C
		D) Security D

Answer 1

As per CAPM assumption,

E(R) = Rf + ß x (Rm – Rf)

Where,

E(R) = Expected return

Rf = Risk free rate = 5 % or 0.05

Rm = Expected return on market = 12 % or 0.12

ß = Beta of portfolio

Computation of E(R) for each security:

Security	Rf	Rm	Rm - Rf	ß	ß x (Rm - Rf)	E(R)	E(R) in %
A	0.05	0.12	0.07	-0.25	-0.0175	0.0325	3.25
B	0.05	0.12	0.07	1.1	0.077	0.1270	12.70
C	0.05	0.12	0.07	0.75	0.0525	0.1025	10.25
D	0.05	0.12	0.07	2	0.14	0.1900	19.00

Expected return of security A is found to be 3.25 % which matches with given value.

Hence option “A) security A” is correct answer.