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Currently, the risk-free interest rate (RF) is 3% and the required market return (rm) is 10%....

Currently, the risk-free interest rate (RF) is 3% and the required market return (rm) is 10%. You consider to buy a stock with a beta (β) of 1.5 and you expect to earn 11% annual rate of return from this stock.

(1) Use the Capital Asset Pricing Model (CAPM) to find the required return on this stock

(2) Base on your answer from part (1), would you buy this stock? Why or why not?

(3) Draw the Security Market Line (SML) using the data above, and determine intercept and slope of the SML

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Answer #1

1) According to CAPM the required return is calculated as follows:

2) So the required rate is13.5% but the actual expected rate is 11% so you should not buy the stock as the return is lower.

3)SML is plotted as follows:

The intercept is the risl free rate of 3% and the slope is the difference between the market return and the risk free return, which is 10% - 3% = 7%

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