Question

Risk-free rate is 5.65%.

Beta of the Share A is 1.28.

Expected market premium is 6.29%.

The coefficient for size effect is 0.78.

Expected return on a portfolio of Small firms is 13.78%.

Expected return on a portfolio of Big firms is 12.31%.

The coefficient for book to market is 0.95.

Expected return on a portfolio consisting of high book to market ratio is 13.14%.

Expected return on a portfolio consisting of low book to market ratio is 8.42%.

Calculate the required rate of return of Share A using the following models:

1. CAPM:   

2. Fama French et al:  

Answer 1

1. CAPM model, required rate of return=risk free rate+(beta*market risk premium)=5.65%+(1.28*6.29%)=13.70%

2. Fama French model, required rate of return=risk free rate+(beta*market risk premium)+((coefficient for size effect*(Expected return on a portfolio of Small firms-Expected return on a portfolio of Big firms))+((coefficient for book to market*(Expected return on a portfolio consisting of high book to market ratio-Expected return on a portfolio consisting of low book to market ratio))

=5.65%+(1.28*6.29%)+(0.78*(13.78%-12.31%))+(0.95*(13.14%-8.42%))

=19.33%