Question

Risk free rate of return would be taken ofreturn of treasury bills because they are deemed to be risk free Assets and they are to be incorporated while calculation of Capital Asset pricing model expected rate of return. Expected rate of return of investor A= Rf+Beta (Rm-Rf) = 3+1.5(15-3) = 3+18 = 21% Expected rate of return of investor B = 3+1(15-3) = 15% It can be seen that investor A has generated return of 20.98% where as investor B has generated a return of 16.45%. So,it can be said that investor A has underperformed the expectation of the market and investor B has outperformed thethe expectation of the market.

Answer 1

In the above question while calculating return for investor A or B using CAPM, the risk free rate of return(Rf=3%) and market rate of return(Rm=15) are same, the only difference was in Beta and beta is always considered as risk factor of any industry. So by CAPM we calculate return by consudering risk free rate of return , market rate of return and Risk associated with that security in the relevant industry.

As expected return for investor A was 21% and he has generated 20.98%, so yes it can be said that investor has underperformed and as expected return for investor B was 15% and he has generated 16.45%, so yes it can be said that investor has outperformed.

Decision rule:When expected return exceed actual return = Underperformance

Actual return exceed expected return = Outperformance