FINA 385 Lecture Notes - Lecture 3: Capital Asset Pricing Model, Economic Equilibrium, Capital Market

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28 Jun 2016

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The capital asset pricing model: most of professional investors try to identify mispriced securities. They buy underpriced assets and short sell overpriced ones: to nd a mispriced security an investor needs a model that provides a benchmark price of a given security. Often, these returns are found in a general equilibrium framework. In equilibrium supply should be equal to demand which is possible only at a certain price of a stock share. A1 there are many investors, each with an endowment (wealth) that is small relative to the total endowment of all investors. This assumption is equivalent to perfect competition in microeconomics. It implies that individual investors are price takers. That is, investors trade only once and receive the proceeds from their trades at the end of their investment horizon. An investment horizon is the same for all investors and it could be a few weeks, a few months or even many years.

Related Questions

Suppose that you have estimated the expected returns and betas of the following five stocks using annual data available for the last 10 years:

Stock	Market Size ($M)	Beta	Expected Return (%)
A	360	0.6	8
B	23	0.8	10
C	250	1.2	11
D	10	1.3	12
E	500	1.4	12

The risk-free rate of interest and the expected return on the market are 5% and 10% . You are also told that the market size of the companies in this market is normally distributed with a mean of $400M and a standard deviation of $150M.

a. Explain carefully the extent to which these data are consistent with the Capital Asset Pricing Model and whether there is an optimal investment strategy.

b. What would you advise an investor who would like to hold a portfolio with a beta equal to 1?

c. 'The risk of a company depends upon much than how well the stock market is doing. Beta only captures the co-movement of a company's share price with the market; and hence fails to capture various sources of risk.'

Critically assess the validity of the Capital Asset Pricing Model and its use as a benchmark for project appraisals.

grayraccoon352

Part 1: Twitter has an expected rate of return of 13% and a beta of 1.15. The risk-free rate is 5% and the market expected rate of return is 15%. According to the capital asset pricing model, is Twitter fairly priced, overpriced or underpriced?

Part 2:You have $500,000 available to invest. The risk-free rate as well as your borrowing rate is 8%. The return on the risky portfolio is 16%. If you wish to earn a 20% return, how much you should invest in the risky portfolio?

harlequinclam577

Suppose the rate of return on short-term government securities (perceived to be risk-free) is about 5%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 12%. According to the capital asset pricing model:

What is the expected rate of return on the market portfolio?
What would be the expected rate of return on a stock with beta = 0?
Suppose you consider buying a share of stock at $40. The stock is expected to pay $3 dividends next year and you expect it to sell then for $41. The stock risk has been evaluated at

beta = -0.5. Is the stock overpriced or underpriced?

peachhedgehog189

FINA 385 Lecture Notes - Lecture 3: Capital Asset Pricing Model, Economic Equilibrium, Capital Market

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