Posted: December 8th, 2015

Capital Asset Pricing Model (CAPM)

In this assignment, you will learn how to calculate risk and return, and how to interpret the results. The focus of this assignment is the Capital Asset Pricing Model (CAPM). After completing the assignment, you will be able to apply the CAPM to any stock or portfolio valuation, understand the concept of the beta of a stock, and understand a portfolio.

Instructions

Answer the following questions and complete the following problems, as applicable:

You may solve the following problems algebraically, or you may use a financial calculator or Excel spreadsheet. If you choose to solve the problems algebraically, be sure to show your computations. If you use a financial calculator, show your input values. If you use an Excel spreadsheet, show your input values and formulas.

Note: In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer.

• Question 1:
  • Proficient-level: “Why is expected return considered forward-looking? What are the challenges for practitioners to utilize expected return?” (Cornett, Adair, & Nofsinger, 2016, p. 258).
  • Distinguished-level: Explain the role of probability distribution in determining expected return.
• Question 2:
  • Proficient-level: “Describe how different allocations between the risk-free security and the market portfolio can achieve any level of market risk desired” (Cornett, Adair, & Nofsinger, 2016. p. 258).
  • Distinguished-level: Provide examples of a portfolio for someone who is very risk averse and for someone who is less risk averse.
• Question 3:
  • Proficient-level: Refer to the table below to complete this question. “Compute the expected return given these three economic states, their likelihoods, and the potential returns” (Cornett, Adair, & Nofsinger, 2016, p. 259).
  • Distinguished-level: Recalculate the expected return under a set of changed economic probabilities.
• Question 4:
  • Proficient-level: “If the risk-free rate is 3 percent and the risk premium is 5 percent, what is the required return?” (Cornett, Adair, & Nofsinger, 2016, p. 259).
  • Distinguished-level: Identify which financial security’s return is typically considered the risk-free rate.
• Question 5:
  • Proficient-level: “The average annual return on the Standard and Poor’s 500 Index from 1986 to 1995 was 15.8 percent. The average annual T-bill yield during the same period was 5.6 percent. What was the market risk premium during these 10 years?” (Cornett, Adair, & Nofsinger, 2016, p. 259).
  • Distinguished-level: Define, in your own words, the term, market risk premium.
• Question 6:
  • Proficient-level: “Hastings Entertainment has a beta of 0.65. If the market return is expected to be 11 percent and the risk-free rate is 4 percent, what is Hastings’ required return?” (Cornett, Adair, & Nofsinger, 2016, p. 259).
    • Use the capital asset pricing model to calculate Hastings’ required return.
  • Distinguished-level: Recalculate the required return with a change to beta, and explain the effect of a 1.0 increase in beta on the subsequent amount of change in the required return.
• Question 7:
  • Proficient-level: Calculate the beta of your portfolio, which comprises the following items: (a) Olympic Steel stock, which has a beta of 2.2 and comprises 40 percent of your portfolio, (b) Rent-a-Center stock, which has a beta of 1.5 and comprises 28 percent of your portfolio, and (c) Lincoln Electric stock, which has a beta of 0.5 and comprises 32 percent of your portfolio (Cornett, Adair, & Nofsinger, 2016).
  • Distinguished-level: Determine whether the portfolio has less risk, equal risk, or more risk compared to the overall market.

Submit your completed assignment as an attachment in the assignment area. You may use either a Word document or an Excel spreadsheet for your work, but not both. Prior to submitting your assignment, review the Estimating Risk and Return Scoring Guide to ensure you have met all of the requirements and as a self-assessment of your work.

Reference

Cornett, M. M., Adair, T. A., & Nofsinger J. (2016). M: Finance (3rd ed.). New York, NY: McGraw-Hill.