Question

1. The risk-free rate as measured by the current T-Bill rates and during the recent past has been 3.64%, while the market return on the S&P 500 was 11.12% last year. The beta on two securities we are considering adding to our portfolio are 1.12 for ABC and 0.85 for XYZ respectively.

3. If both stocks are expected to return at their required rates, as an investor who requires a minimum of 11% in any given investment I make in the coming years, which one of the two securities should I add to my portfolio according to the Capital Asset Pricing Model (CAPM)?

4. If I were to use a risk-adjusted return, where I divide the calculated return by the beta of each of the investments, what would the risk-adjusted rate of return be for each of these two securities? And would my answer be any different?

Answer 1

Return as per CAPM = Risk free rate + beta*Market risk premium

or Expected return = Risk free rate + Beta*(Market Return – Risk free return)

Hence, return of ABC = 3.64% + 1.12*(11.12%-3.64%)

= 12.0176%

XYZ = 3.64% + 0.85*(11.12%-3.64%)

= 9.998%

c.Minimum Required Return = 11%

ABC should be added to the portfolio since expected return is greater than 11%

d.Risk Adjusted Return:

ABC = 12.0176%/1.12 = 10.73%

XYZ = 9.998%/0.85 = 11.76%

XYZ should be added to the portfolio since risk adjusted return is greater than 11% for XYZ