Answer:
a. Return predicted by CAPM = 15.32%
b. Alpha of portfolio A = -0.4.32%
c. No, the situation above is not because CAPM is not valid.
Explanation:
Beofre answering the questions, the data given in the question which are merged together are represented as follows:
Portfolio Expected Return (%) Beta
Risk-free 7 0
Market 12.2 1.0
A 11.0 1.6
a. Calculate the return predicted by CAPM for a portfolio with a beta of 1.6. (Round your answer to 2 decimal places.)
This can be calculated using the following formula:
Return predicted by CAPM = Rf + beta * (Rm - Rf) ........... (1)
Where;
Rf = Risk-free Expected Return = 7% = 0.07
Rm = Market Expected Return = 12.2% = 0.122
beta = 1.6
Substituting the values into equation (1), we have:
Return predicted by CAPM = 0.07 + 1.6 * (0.122 - 0.07) = 0.1532, or 15.32%
b. What is the alpha of portfolio A. (Negative value should be indicated by a minus sign. Round your answer to 2 decimal places.)
This can be calculated using the following formula:
Alpha of portfolio A = Portfolio A Expected Return - Return predicted by CAPM ................. (2)
Where;
Portfolio A Expected Return = 11.0%
Return predicted by CAPM = 15.32%
Substituting the values into equation (2), we have:
Alpha of portfolio A = 11.0% - 15.32% = -0.4.32%.
c. If the simple CAPM is valid, is the situation above possible?
No, the situation above is not because CAPM is not valid.
The reason is that when beta is equal to 1.6, the 11.0% expected return of stock A is less than the 12.2% expected market return, but what we should have had instead is an expected return of stock A that higher than the expected market return.
