02 Jan Given the beta of

Module 3 – Case

THE CAPITAL ASSET PRICING MODEL

Assignment Overview

For each of the scenarios below, explain whether or not it represents a diversifiable or an undiversifiable risk. Please consider the issues from the viewpoint of investors. Explain your reasoning.

There’s a substantial unexpected increase in inflation.

There’s a major recession in the U.S.

A major lawsuit is filed against one large publicly traded corporation.

Use the CAPM to answer the following questions:

Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset “i” is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset “i” is 1.2.

Find the Risk-Free Rate given that the Expected Rate of Return on Asset “j” is 9%, the Expected Return on the Market Portfolio is 10%, and the Beta (b) for Asset “j” is 0.8.

What do you think the Beta (?) of your portfolio would be if you owned half of all the stocks traded on the major exchanges? Explain.

In one page explain what you think is the main ‘message’ of the Capital Asset Pricing Model to corporations and what is the main message of the CAPM to investors?

Assignment Expectations

The Case report should be a two-page report. Please show your work for quantitative questions.

Module 3 – SLP

THE CAPITAL ASSET PRICING MODEL

Using Yahoo! Finance find the value of beta for your reference company. Write a two page paper discussing the following items:

What is the estimated beta coefficient of your company? What does this beta mean in terms of your choice to include this company in your overall portfolio?

Given the beta of your company, the present yield to maturity on U.S. government bonds maturing in one year (currently about 4.5% annually) and an assessment that the market risk premium (that is – the difference between the expected rate of return on the ‘market portfolio’ and the risk-free rate of interest) is 6.5%, use the CAPM equation in order to find out what is the present ‘cost of equity’ of your company? Explain what is the meaning of the ‘cost of equity’.

Choose two other companies, look up their “Beta” and report the names of these companies and their betas. Suppose you invest one third of your money in each of the stocks of these companies. What will the beta of the portfolio be? Given the data in (b), what will the Expected Rate of Return on this portfolio be? Do you feel that the three-stock portfolio is sufficiently diversified or does it still have risk that can be diversified away? Explain.

SLP Assignment Expectations

In a two-page report explain your answers thoroughly with references to the background materials. Make sure to demonstrate a strong understanding of the concept of beta and the risk/return trade off.