Question

If the simple CAPM is valid and all portfolios are priced correctly, which of the situations below is possible? Consider each situation independently, and assume the risk-free rate is 5%.

A)

Portfolio	Expected Return			Beta
A		14	%		1.4
Market		14	%		1.0

B)

Portfolio	Expected Return			Standard Deviation
A		17	%		14	%
Market		12	%		22	%

C)

Portfolio	Expected Return			Beta
A		17	%		1.4
Market		12	%		1.0

D)

Portfolio	Expected Return			Beta
A		21.2	%		1.8
Market		14	%		1.0

Multiple Choice

• Option B

• Option A

• Option D

• Option C

Answer 1

A) Expected return of portfiolio A is 14% , same as market portfolio, which is not possible since it has higher beta, so according to CAPM equation it will have return greater than 14%

B)This is not possible as the portfolio will not lie on the efficient frontier but outside it

C)According to the CAPM equation,

Expected return = Risk free rate + Beta of stock * Market risk premium

= 5 + 1.4 * ( 12 - 5)

= 5 + 9.8 = 14.8

So 17% return not possible

D)According to the CAPM equation,

Expected return = Risk free rate + Beta of stock * Market risk premium

= 5 + 1.8 * ( 14 - 5)

= 5 + 16.2 =21.2

Which is the same as expected return

Hence answer= D)