Question

1. There are two mutual funds, A and B with the following information, Security The Market Ri Gi 0.20 Pim (i) (iv) (vi) (vii) 0.08 (ii) (v) (vii) The Riskfree Bond 0.03 (iii) Mutual Fund A 0.07 I 0.12 Mutual Fund B where o is the standard deviation, and pim is the correlation with the market portfolio. Assume that the CAPM holds, with fund A being efficient. (a) What are the answers to (i)-(v) above without doing any computation? (b) From given information, compute (vi) and (vii) in the table above. (c) If you are using the CAPM as a benchmark, which fund should you buy? [hint: what is the return implied by the CAPM] 0.09 0.30 1.2

Answer 1

Answer:-

a) The answers for (i) to (v) are zero
The correlation and beta for the market are zero. The standard deviation, correlation and beta for risk free rate are zero.

b) Compute (vi) and (vii)

Given the CAPM holds for the Fund A
0.07 = RFR + Beta ( Market return - RFR)
0.07 = 0.03 + Beta ( 0.08 - 0.03)

Beta x (0.05) = 0.07 - 0.03
Beta = 0.04 / 0.05
Beta = 0.8

c) Using CAPM which fund should one buy?

CAPM for find A

Return A = RFR + Beta A ( Market Return - RFR)
Return A = 0.03 + 0.8 ( 0.07 - 0.03)
Return A = 0.03 + 0.8 x 0.04
Return A = 0.03 + 0.032
Return A = 0.062

CAPM for find B

Return B = RFR + Beta B ( Market Return - RFR)
Return B = 0.03 + 1.2 ( 0.09 - 0.03)
Return B = 0.03 + 1.2 x 0.06
Return B = 0.03 + 0.072
Return B = 0.102

The CAPM return is greater than the expected return the stock is overvalued.

For Fund B the CAPM return is 0.102 which is greater than expected return of 0.09 so its overvalued and one should not buy this fund
For Fund A the CAPM return is 0.062 which is less than the expected return of 0.07 so it us undervalued and one can buy the fund A