Question

Applying the capital-asset pricing model approach, compute the required rate of return for each of the following stocks. Assume a risk-free rate of 0.05 and an expected return for the market portfolio of 0.15.

STOCK

A

B

C

D

BETA

2.0

1.0

-0.5

0

(a) If you could only invest in one of these stocks, justify which stock you would choose.

(b) Suggest which type of stock does stock C belong to. Explain your answer.

Answer 1

Risk-Free Rate = Rf = 0.05 and Return on Market Portfolio = Rm = 0.15

Using CAPM, Expected Return of any stock (say S) = Rs = Rf + Beta of Stock S x (Rm - Rf)

Stock A: Expected Return = 0.05 + 2 x (0.15-0.05) = 0.25 or 25 %

Stock B: Expected Return = 0.05 + 1 x (0.15-0.05) = 0.15 or 15 %

Stock C: Expected Return = 0.05 + (-0.5) x (0.15-0.05) = 0%  

Stock D: Expected Return = 0.05 + 0 x (0.15-0.05) = 0.05 or 5 %

If one were to invest in only one stock, the stock of choice should be Stock A as the same has the highest expected rate of return.

Stock C is a type of stock whose expected returns are negatively related to the returns of the market portfolio. The same is evident in the negative beta value that the stock possesses. Beta is a type of measure of the magnitude of the correlation between market portfolio returns and individual stock returns.