Question

In relation to the CAPM, indicate for each of the following statements whether it is true or false and explain why. (a) Investors do not differ in their attitudes toward risk. (b) In equilibrium, all risky assets are priced such that their expected return lies on the security market line. (c) If a share's expected return is 4% and the expected return on the market portfolio is 15%, the share's beta must be negative. (d) Two securities with the same expected returns can have different betas. (e) Two securities with the same standard deviations can have different betas. (f) Two securities that have the same correlation coefficients with the market portfolio will have the same betas. (g) The return on a share with a beta of zero is expected to vary directly with the return on the market portfolio. (h) The equation for the security market line when the expected return on the 9 + 6Bj. market is 15% and the risk-free rate is 6% is ri (i) A security lying above the security market line is currently overpriced.

Answer 1

(a) True. It is one of the assumptions of CAPM theory that all the individuals are risk averse which means they do not differ in their attitude towards risk.

(b) True. The equilibrium return is calculated as the risk free rate plus the beta of a given asset multiplied by the overall risk premium of the equity market which lies on the Security Market line.

(c) False. For example, if risk free rate is 4%, then to get expected return of 4%, beta can be zero.

(d) False. According to CAPM, E(R) = r_f + beta*(R_m - r_f​​​​​​), and since R_m and r_f are same for any security in a same market, their beta's must be same for same expected return.

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