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%

Finance Dec 22, 2020

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

Expert Solution

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

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