CAPITAL ASSET PRICING MODEL (CAPM)

Capital Asset Pricing Model (CAPM) is a model based on the proportion that any stock’s
required rate of return is equal to the risk-free rate of return plus a risk premium that reflects
only the risk remaining after diversification.

Expected Portfolio Returns-The weighted average of the expected returns of the individual
assets in the portfolio, with the weights being the percentage of the total portfolio invested in
each asset.

Sample Problem No. 1

Stock (1) Expected Return Amount Invested Percent of Total Product (2) x (4)
(2) (3) (4) (5)
Microsoft 7.75% 25,000,000
IBM 7.25% 25,000,000
GE 8.75% 25,000,000
Exxon Mobil 7.75% 25,000,000
7.88% 100,000,000

Portfolio- Generally smaller than the average of the stock’s standard deviation because
diversification lowers the portfolio’s risk.

The Beta Coefficient, b- A metric that shows the extent to which a given stock’s return move
up and down with the stock market.

The equation

Ri=RF+ [bi x (rm –RF)]

ri= required return on asset i

Rf = risk-free rate of return

bi= beta coefficient

rm= market return

Seatwork- CAPM

Problem 1

Assuming that Apple was included in the listed stocks, how much is the expected return on a
portfolio?

Stock (1) Expected Return (2) Amount Invested (3)

Microsoft 7.75% 25,000,000
IBM 7.25% 25,000,000
GE 8.75% 25,000,000
Exxon Mobil 7.75% 25,000,000
Apple 15.50% 25,000,000

Problem 2

Portfolio P consists of two (2) stocks: 50% is invested in Stock A, and 50% is invested in Stock
B. Stock A has a standard deviation of 25% and a beta of 1.2, and a Stock B has a standard
deviation of 35% and a beta of 0.80. The correlation between these stocks is 0.4.

a. What is the beta of Portfolio P?

b. Which stock is riskier to a diversified investor?

Problem 3

The risk free rate is 3%, and the market risk premium is 4%. Stock A has a beta of 1.2, and
Stock B has a beta of 0.8.

a. What is the required rate of return on each stock?

b. Investors become more risk-averse, so the market risk premium rises from 4% to 6%.
Assuming that the risk-free rate remains constant, what effect will this have on the
required rates of return on the two?