Question

Answer all parts of this question.

a) What is the use of beta (β) in portfolio management?

b) Two stocks have the following returns and Betas Securities Forecasted rate of return Beta A 4% 0.7 B 5% 0.5 If the expected market rate of return is 6% and the risk-free rate is 0.5%, what is the excess return of each security and which would be considered the better buy?

c) What are some key assumptions of the capital asset pricing model (CAPM)?

Different question

a) Describe the ‘intrinsic value’ and the ‘market value’ of shares used in fundamental analysis.

b) Indicate whether an investor should buy, sell or hold a share in the three cases below: i. Intrinsic Value < Market Value ii. Intrinsic Value > Market Value iii. Intrinsic Value = Market Value

c) Seyline plc pays a current (annual) dividend of £3 and is expected to grow at 5% for 3 years and then at 2% thereafter. If the required return for Seyline plc is 10%, what is the intrinsic value of Seyline plc shares?

Answer 1

Answer A

A beta of a stock usually tells about the risk of an investment which cannot be diversified. The amount of risk added to the existing diversified portfolio is what beta estimates. Hence high beta stocks means high risks. Beta greater than 1 are risky assets and less than 1 are less volatile assets. When the market outlook is positive, then the portfolio manager will invest more in high beta stocks and vice versa. Higher beta means higher risks with higher returns.

Answer B

Stock A

forecasted return = 4% , beta = 0.7 , risk free = 0.5%, market rate of return = 6%

required return = rf + beta (rm-rf)

= 0.5 + 0.7 (6-0.5) = 4.35

Forecasted return is less than required return and hence should be avoided .

Stock B

forecasted return = 5% , beta = 0.5 , risk free = 0.5%, market rate of return= 6%

required return = 0.5+0.5(6-0.5) = 3.25 %

forecasted return is higher than required return and hence would give profits. the excess return of 1.75% makes it a better buy.

Answer C

Following are the key assumptions of CAPM

1. Markets are ideal with no transaction fees, taxes, inflation, or short selling restrictions.
2. All investors can borrow and lend unlimited amounts under a risk-free rate.
3. All investors have equal access to all available information.
4. All investors are averse to risk.
5. Beta coefficient is the only measure of risk.
6. All assets are absolutely liquid and infinitely divided.
7. Markets are in equilibrium. All investors are price takers, not price makers.