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Exercise Capm
Exercise Capm
Question 1
Two investments are available in the market consisting of security A and security B. The
parameters for these securities are given below:
Security 𝝆𝒊,𝑴 Volatility
A 0.9 6%
B 0.7 10%
where 𝜌𝑖,𝑀 is the correlation coefficient between the return of security 𝑖 where 𝑖 = 𝐴, 𝐵
and the market portfolio’s return. In addition, we also have the information that the risk-free
rate of return is 4%, whilst the market portfolio’s expected return and volatility is 11% and 8%
respectively.
ii) Calculate the beta of security A and B, and hence find the expected return of security A and
B.
ANSWER:
beta of security A =0.675
beta of security B = 0.875
expected return of security A = 0.08725 and B = 0.10125
iii) Sketch the capital market line and identify the position of the market portfolio.
iv) Create a portfolio consisting of riskless asset and a market portfolio which has the
same volatility as security A. Show your calculation. Hence, calculate the expected
return of this portfolio.
ANSWER: 𝐸𝑝 = 0.0925
Question 2
An investor has the following choice of assets together with its associated rate of return
based on three possible states of the world:
The probability of State 1, State 2 or State 3 to occur is 0.3, 0.5 and 0.2 respectively.
i) Determine the market price of risk assuming capital asset pricing model holds. Define all
terms used.
ANSWER: 3.2369
JULY 2022
Question 1
Consider the following assets are the only available in the market where the Capital Asset
Pricing Model holds. There are three risky assets and one risk-free asset.
Question 2
a) Information on all securities available in the market consisting of two major industries is
given below:
Security Type Variance Market 𝜌𝑋,𝑌
Capitalization
X Telecommunication 49%% 70,000
0.55
Y Energy 64%% 30,000
where 𝜌𝑋,𝑌 is the correlation coefficient between security X and Y. You are also given
additional information that the risk-free rate of return is 5%, which is 60% lower than the
market portfolio’s expected return.
i) Consider a portfolio comprising of one-third holdings of riskless assets and the rest
is a market portfolio. Calculate the expected return and the variance of this portfolio.
𝐸𝑀 = 0.125, 𝐸𝑃 = 10%, 𝑉𝑃 = 18.98044444%%, 𝑉𝑀 = 0.42706%
ii) Determine the market price of risk assuming capital asset pricing model holds.
(1.147669)
iii) List three assumptions of the capital asset pricing model (CAPM).
b) The expected return of a unit investment in a market portfolio is 10%, and the variance
of this return is 64%%. The following investment portfolios are available in the market:
Portfolio 𝛽𝑖 Variance
1 1.05 100%%
2 0.45 25%%
3 0.75 36%%
i) Determine if any of the portfolios listed above is an efficient portfolio given a risk-
free rate of return of 4% per annum. Show all your calculations.
𝐸1 => 0.103 (𝑓𝑟𝑜𝑚 𝑠𝑚𝑙) < 0.115 (𝑓𝑟𝑜𝑚 𝑐𝑚𝑙)
𝐸2 => 0.067(𝑓𝑟𝑜𝑚 𝑠𝑚𝑙) < 0.0775 (𝑓𝑟𝑜𝑚 𝑐𝑚𝑙)
𝐸3 => 0.085 (𝑓𝑟𝑜𝑚 𝑠𝑚𝑙) = 0.085 (𝑓𝑟𝑜𝑚 𝑐𝑚𝑙) − 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝑝𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
ii) Sketch the security market line and identify the position of all assets.
iii) Calculate the correlation coefficient between each asset and that of the market
portfolio.
𝜌1,𝑀 = 0.84, 𝜌2,𝑀 = 0.72, 𝜌3,𝑀 = 1.0