Practice Week 3:

The Capital Asset Pricing Model

1. A firm wishes to assess the impact of changes in the market return on an asset that has
a beta of 1.20.
a. If the market return increased by 15%, what impact would this change be expected
to have on the asset’s return?
b. If the market return decreased by 8%, what impact would this change be expected
to have on the asset’s return?
c. If the market return did not change, what impact, if any, would be expected on the
asset’s return?
d. Would this asset be considered more or less risky than the market? Explain.

2. Currently under consideration is an investment with a beta, b, of 1.50. At this time, the
risk-free rate of return, Rf, is 7%, and the return on the market portfolio of assets, r(m),
is 10%. You believe that this investment will earn an annual rate of return of 11%.
a. If the return on the market portfolio were to increase by 10%, what would you expect
to happen to the investment’s return? What if the market return were to decline by
10%?
b. Use the capital asset pricing model (CAPM) to find the required return on this
investment.
c. On the basis of your calculation in part b, would you recommend this investment?
Why or why not?
d. Assume that as a result of investors becoming less risk-averse, the market returns
drops by 1% to 9%. What impact would this change have on your responses in parts
b and c?

3. Matt Peters wishes to evaluate the risk and return behaviors associated with various
combinations of assets V and W under three assumed degrees of correlation: perfect
positive, uncorrelated, and perfect negative. The expected returns and standard
deviations calculated for each of the assets are shown in the following table.

Asset Expected Return Standard Deviation

V 8% 5%
W 13 10

a. If the returns of assets V and W are perfectly positively correlated (correlation

coefficient =+1 ), describe the range of (1) expected return and (2) risk associated
with all possible portfolio combinations.
b. If the returns of assets V and W are uncorrelated (correlation coefficient = 0),
describe the approximate range of (1) expected return and (2) risk associated with
all possible portfolio combinations.
c. If the returns of assets V and W are perfectly negatively correlated (correlation
coefficient), describe the range of (1) expected return and (2) risk associated with all
possible portfolio combinations.