Question

As an analyst you have gathered the following information:

Security	Expected Standard Deviation	Beta
Security 1	25%	1.50
Security 2	15%	1.40
Security 3	20%	1.60

(i)      If the expected market risk premium is 6% and the risk-free rate is 3%, what will be the required rate of return on each of the above securities, and which of the security has the highest required return?

(ii)     With respect to the capital asset pricing model, if expected return for Security 2 is equal to 11.4% and the risk-free rate is 3%, what is will be the expected return for the market?

(iii) With respect to the capital asset pricing model, if the expected market risk premium is 6% which of the above securities provide the highest expected return?

(iv) With respect to the capital asset pricing model, a decline in the expected market return will have the greatest impact on the expected return of which of the above securities?

Answer 1

Solution ;

(1) As per CAPM model Requred return = Risk free return + beta(risk premium)

Security 1 = 3%+1.5(6%)=12%

Security2 =3%+1.4(6%)=11.4%

Security3 =3%+1.6(6%)=12.6%

Security 3 Has highest Requred Return

(2) Given Expected return(E)=11.4% Risk free Rate=3% bete of security 2 = 1.4%

As per CAPM Expected return = RF+ beta (RM-RF) where RM=market Retutn

Substituting the above value in the Formula we get 11.4%=3%+1.4(RM-3%)

Hence RM =9.71%

(3) From 1 We can see that security 3 has highest requred return through that we can assume that

  security3 has highest expected return in long run.

(4) With respect securities above i.e 1,2,3 decline in expected market return will have the greatest

Impact on the expected return of security which has higest beta above i.e security 3 .