Question

Consider the following information:

Portfolio	Expected Return		Beta
Risk-free	8	%	0
Market	10.2		1.0
A	8.2		0.7

a. Calculate the expected return of portfolio A with a beta of 0.7. (Round your answer to 2 decimal places.)

b. What is the alpha of portfolio A. (Negative value should be indicated by a minus sign. Round your answer to 2 decimal places.)

c. If the simple CAPM is valid, is the above situation possible?

• Yes

• No

Answer 1

Given that,

Risk free rate Rf = 8%

Expected market return Rm = 10.2%

a). Beta of portfolio A is 0.7

Expected return on stock using CAPM is Rf + Beta*(Rm - Rf)

expected return of portfolio A with a beta of 0.7 = 8 + 0.7*(10.2-8) = 9.54%

b). when actual return = 8%,

Alpha of portfolio is Actual return - expected return = 8 - 9.54 = -1.54%

c). No, this situation is not possible since portfolio is plotted below SML and is overpriced. Which is not possible when CAPM holds true.