FINS1613 Lecture Notes - Lecture 10: Capital Asset Pricing Model, Risk Premium, Systematic Risk

46 views4 pages

aquamarinegoat534

2 Sep 2018

School

Department

Course

Professor

For unlimited access to Class Notes, a Class+ subscription is required.

Document Summary

Camp is used to calculate the expected return of an asset j. It is the expected return in the market on investment with equivalent risk to the risk associated with the security: beta: measures the level of systematic risk relative to that of the market. The market has a beta of 1 and the risk-free asset has a beta of 0: market risk premium: the average return market participants demand for bearing the (cid:373)arket(cid:859)s s(cid:455)ste(cid:373)ati(cid:272) risk, market risk premium = e(rm) - rf. The capm can also be applied to portfolios: The sml plots the expected return on a security as a function of its beta. It implies that a se(cid:272)urit(cid:455)(cid:859)s retur(cid:374) li(cid:374)earl(cid:455) depe(cid:374)ds o(cid:374) s(cid:455)ste(cid:373)ati(cid:272) risk. Securities (portfolios) with betas less than 1 are expected to return less than the market. Securities (portfolios) with betas greater than 1 are expected to return more than the market.

Related Questions

Calculating the market risk premium beta and required rate of return. CAPM. Portfolio Risk & Return.

We have a portfolio of three positively correlated but not perfectly correlated stocks.

(Correlation co-efficient between 0-1)

Stock Expected Rate of Return Standard Deviation Beta

X 10% 16% .75

Y 12% 16% 1.25

Z 13% 16% 1.50

What is the market risk premium for the portfolio ?

Required Rate of Return For the Stock = Risk Free rate of Return +

+ ( Market Risk Premium * Beta of stock )

Market Risk Premium = Market Required Rate of Return â Risk Free rate of Return

The returns on stocks X, Y and Z and their beta have been provided. Using the information provided, we will first calculate the market risk premium.

The capital asset pricing model is a model based on the proposition that any stock's required rate of return is equal to the risk free rate of return plus a risk premium that reflects only the risk remaining after diversification.

The required rate of return for a stock is calculated by adding the risk free rate of return to the product of the market risk premium and the stock's beta.

The market risk premium shows the premium that investors require for bearing the risk of average stock and is calculated by deducting the risk free rate from the market's required rate of return.

Now, using stock X or any other stock, we can calculate the market risk premium. We'll use stock X. The expected return on this stock is 10%. The risk free rate is 7& and the stock's beta is .75.

By solving the equation we determine the market risk premium to be 4%.

Next, we will calculate the beta of Fund Q.

Fund Q has 1/3 of its funds invested in each of the three stocks X, Y, and Z.

Thus, the beta of Fund Q will be the sum of one third of the beta of each stock. One third of .75 is .25. One third of 1.25 is .4167 and one third of 1.5 is .5. By adding .25, .4167 and .5, we calculate the beta of Fund Q as 1.1667.

Letâs now calculate the required return of Fund Q. The risk free rate is 7%. The market risk premium is calculated to be 4%. The beta of Fund Q is 1.1667. By adding 7% to the product of 4% and 1.1667, we determine the required return on Fund Q to be 11.67%.

Since the returns on the three stocks included in Fund Q are not positively correlated, the standard deviation of the fund will be less than 16%.

1. If we are able to eliminate all of the unsystematic or diversifiable risk in a portfolio then, what is the result?

a.

a risk-free portfolio
b.
a portfolio that has an expected return of zero
c.

a portfolio that contains only systematic risk

2. A portfolio consists 20% of a risk-free asset and 80% of a stock. The risk-free return is 4%. The stock has an expected return of 15% and a standard deviation of 30%. Whatâs the expected return of the portfolio?

a.
9.5%
b.
15.0%
c.
12.8%

d.
2%

3. The risk-free rate is 5% and the expected return on the market portfolio is 13%. A stock has a beta of 1.5, what is its expected return?

a.
12%
b.
19.5%
c.

17%

4. For what value of the correlation coefficient for the returns of a pair of stocks will the benefits of diversification the largest?

a.

1.0
b.

-1.0
c.

0.0
d.

0.5

5. Which of the following is an example of systematic risk?
a.
IBM posts lower than expected earnings.
b.
The overall stock market becomes more risky due to super fasting trading algorithms.
c.

Intel announces record earnings.

6. According to the CAPM (capital asset pricing model), the security market line is a straight line. The intercept of this line should be equal to

a.
zero
b.
the expected risk premium on the market portfolio
c.
the expected return on the market portfolio
d.
the risk-free rate

7. A portfolio has 40% invested in Asset 1, 50% invested in Asset 2 and 10% invested in Asset 3. Asset 1 has a beta of 1.2, Asset 2 has a beta of 0.8 and Asset 3 has a beta of 1.8, whatâs the beta of the portfolio?

a.
0.80
b.
1.06
c.
1.27

8. Suppose you can borrow and lend at the risk free-rate of 3%. Which of the following four risky portfolios has the best return relative to risk. (Hint: Calculate Sharpe Ratios the ratio of risk premium to standard deviation for each portfolio)

a.
portfolio with a standard deviation of 15% and an expected return of 12%
b.
portfolio with a standard deviation of 12% and an expected return of 9%
c.
portfolio with a standard deviation of 25% and an expected return of 18%
d.
portfolio with a standard deviation of 19% and an expected return of 15%

9. Which statements are TRUE regarding risk and return?

Statement I:
Diversification is the process of removing systematic risk from a portfolio.
Statement II:
In general, the greater the risk, the greater the return required by an investor.
Statement III:
Investors should focus on real returns if they are concerned about the purchasing power of their wealth.

a.
Statements II and III only
b.
Statement I only
c.
Statements I and III only
d.
Statements I and II only

10. The beta of the risk-free asset is:
a.

1.0
b.

0.5
c.

0.0
d.

-1.0

What is an appropriate required rate of return (hurdle rate) for Food Products and Instruments? How did you get it? (Hints: you may want to use the capital asset pricing model (CAPM) to estimate the cost of equity)

Chestnut Foods Estimation of WACC for Chestnut Foods (year-end 2013) Chestnut Foods Hurdle Rate as of December 2013: 7.0% Chestnut uses a hurdle rate that reflects prevailing rates of return in financial markets using a weighted average of both debt and equity securities. The current mix of debt and equity in Chestnutâs capital structure on a market-value basis is 20% debt and 80% equity. The prevailing yield on debt of similar credit risk is estimated at 3.5%. Based on a marginal corporate tax rate of 37%, the after-tax cost of debt is 2.2%. The cost of equity for Chestnut is estimated at 8.2% based on the CAPM with a beta of 0.9, a market risk premium of 6.0%, and a risk-free rate of 2.8%.* Based on these estimates, the WACC is 7.0%. * An alternative model that uses a market risk premium of 9% and a risk-free rate of 0.1% gives a similar cost-of-equity estimate. PLEASE CLARIFY HOW TO GET D/E RATIOS. `WACC Food Processing market risk premium 9% risk-free rate 0.1% debt ratio 60% equity ratio 40% tax rate 37% cost of debt 2.20% cost of equity 4.8% WACC 3.22%

Instruments market risk premium 9% risk-free rate 0.1% debt ratio 40% equity ratio 60% tax rate 37% cost of debt 2.20% cost of equity 9.4% WACC 6.52%

scarletmink280

FINS1613 Lecture Notes - Lecture 10: Capital Asset Pricing Model, Risk Premium, Systematic Risk

Document Summary

Get access

Related Documents

FINS1613 Lecture Notes - Lecture 7: Risk-Free Interest Rate, Risk Premium, Capital Asset Pricing Model

FINS1613 Lecture Notes - Lecture 4: Dividend, Dividend Yield, Risk Premium

FINS1613 Lecture Notes - Lecture 3: Dividend Discount Model, Risk Premium, Preferred Stock

Related Questions