Question

If the simple CAPM is valid, which of the situations in Problems 13 – 19 below are possible? Explain. Consider each situation independently.

Short answer

The correct answer would be “Not Possible”

Step-by-step solution

Given Information

Given these data, the SML is: E(r) = 10% + β(18% – 10%)

Solution

A portfolio with beta of 1.5 should have an expected return of:

E(r) = 10% + 1.5 x (18% – 10%) = 22%

The expected return for Portfolio A is 16% so the Portfolio A plots below the SML

(i.e., has an alpha of –6%), and hence is an overpriced portfolio.

This is inconsistent with the CAPM hence “Not Possible’.