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Homework answers / question archive / Outline four main assumptions of capital asset pricing model b) The average return of the market is 15% and the risk free rate of return is 10%
Outline four main assumptions of capital asset pricing model
b) The average return of the market is 15% and the risk free rate of return is 10%. The returns and beta factors of three securities are shown in the table below:
Security Expected return Beta factor
A 17.5% 1.3
B 14.5% 0.8
C 15.5% 1.1
D 18.2% 1.7
Required:
i) Compute the required return for each security
ii) State which of the securities are overvalued, undervalued or correctly valued
iii) State which of the securities to be retained or disposed
A required return = 10% + 1.3*(15 - 10)% = 16.5%
B required return = 10% + 0.8*5% = 14%
C required return = 10% + 1.1*5% = 15.5%
D required return = 10% + 1.7*5% = 18.5%
ii) when expected return is less than required return, the security is overvalued
overvalued = D
Úndervalued = A,B
correctly valued = C
iii) retain A,B and C
dispose D
