Question

6. Assume CAPM holds: Are the following true or false? a. Stocks with a beta of zero offer an expected rate of return of zero. b. The CAPM implies that investors require a higher return to hold highly volatile securities. c. You can construct a portfolio with beta of 75 by investing.75 of the investment budget in T-bills and the remainder in the market portfolio.

Answer 1

As per CAPM, Expected Return on Stock = Risk Free Return+Beta(Expected Return on Market-Risk Free Return)

Beta of Market is 1 and Beta of T-Bills is 0.

Based on above,

a) If Beta is 0, Expected Return will be equal to Risk Free Return & NOT 0. Therefore, False

b) Higher Volatility means Higher Beta and Higher Beta means Higher Expected Return. Therefore, True

c) To get a Beta of 0.75, 0.75 should be invested in Market Portfolio and remainder in T-Bills, as T-Bills have a Beta of 0 and Market has a Beta of 1, Average Beta of Portfolio will be 0.75. Therefore, False

Answer 2

Its false, as the Cost of Equity based on CAPM = Rf+Beta(Rm-Rf).

Answer 3

ANSWERS 

a.  False .   ( Expected return will be equal to risk-free rate if beta is zero)

b.  True. (If highly volatile, beta will br high and expected return will also br high).

c. False. (In the given situation , beta of portfolio will be = 0*0.75 + 1*0.25 = 0.25)