Question

1. Security ABC has a price of $35 and a beta of 1.5. The risk-free rate is 5% and the market risk premium is 6%.

According to the CAPM, what return do investors expect on the security?
Investors expect the security not to pay any dividend next year. At what price do investors expect the security to trade next year?
At what price do investors expect the security to trade next year, if the expected dividend next year is $2 instead of zero?
Under the CAPM, expected returns depend only on the exposure to systematic (market) risk. Illustrate the concept of systematic risk through examples and explain the logic of this result.

Please maximally detailed answer! The answer to all questions in detail!

Answer 1

CAPM = Risk free rate + Beta * Market risk premium = 5+1.5*6 = 14% According to CAPM the expected return is 14%

If the investor's required rate of return is 14%, and Investor expect the security to not pay any dividends, then the next year price should be, Current price *(1+expected rate of return) 35*(1.14) = 39.90 If the dividend expected is $2, and the expected return is 14%, then the price at the year end Let X be the price at the year end (X-35+2)/35 = 0.14 Solving the value of x We get, X = 37.9

The required return calculated from CAPM compensates the investor for taking only the systematic risk. There are two types of risk, systematic risk and non-systematic risk. Systematic risk is the risk which is common for all kinds of stocks like Interest rate, political disturbance, war, natural disturbances like fire earthquake, change in certain policy, tax rate. These kinds of risk are going to impact all the sectors directly or indirectly. These types of risk cannot be mitigated by diversification of asset portfolio. The unsystematic risk are those risk which affect a particular stock or Industry. For example due to Internal disturbances in the middle east countries the prices of crude oil remains volatile, however you can mitigate the risk of your portfolio by reducing your exposure to oil sector or investing in assets which are negatively correlated with oil prices. Hence, the assumption while calculating the required return with CAPM is the portfolio is diversified and CAPM model is only going to compensate for the systematic risk or risk which cannot be diversified away.