Question

Your personal opinion is that a security has an expected rate of return of 0.11. It has a beta of 1.5. The risk-free rate is 0.05 and the market expected rate of return is 0.09. According to the Capital Asset Pricing Model, this security is A. underpriced. B. overpriced. C. fairly priced. D. Cannot be determined from data provided.

Answer 1

Answer: C. Fairly priced

Explanation:

CAPM model formula is,

$r_{a}$ = $r_{f}$ β  $(r_{m} - r_{f})$

Where,

$r_{a}$ = the expected return on the security A

$r_{f}$ = Risk-Free Rate

$r_{m}$ = Market Expected Rate of Return

β = Beta of the Security

In this question we have the following,

$r_{f}$ =  0.05

$r_{m}$ = 0.09

β = 1.5

We have to calculate the $r_{a}$ (expected return on the security A)

$r_{a}$ = $r_{f}$ + β  $(r_{m} - r_{f})$

$r_{a}$ = 0.05 + 1.5(0.09-0.05)

$r_{a}$  = 0.11

According to the CAPM model, the expected rate of return of security A is 11% and the personal opinion is also equal to 11%

Therefore, the answer is option C. Fairly priced