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

Expected return of Portfolio = 16%

Beta = 0.9

Risk free rate = 10%

Market expected rate = 18%

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

Finding the required rate of return for Portfolio A

Here, the required expected return for Portfolio A is:

E (r) = r _f+β [E(r_M– r_f)]

E(r) = 10% + (0.9% x 8%) = 17.2%

This is still higher than 16%. Portfolio A is overpriced, with alpha equal to: –1.2%

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