Problem 1: Here are data on two companies. The T-Bill rate is 4% and the market

Question

Problem 1:

Here are data on two companies. The T-Bill rate is 4% and the market risk premium is 6%

Company - Victoria Store - Houston Store

Forecasted return 12 % 11 %

Standard Deviation of Returns 8 % 10 %

Beta:   1.5 1.0

a.Estimate the expected return for each company according to

CAPM

b.Characterize each company as underpriced, overpriced, or properly priced according to CAPM

c.Another company, Sugar Land store, has a beta of 2.0.

Assuming efficient market hypothesis

(CAPM holds), estimate the expected rate of return for a portfolio consisting of 1/3 Victoriastock, 1/3 Houston stock, and 1/3 Sugar Land store

.

Explanation / Answer

Here are data on two companies. The T-Bill rate is 4% and the market risk premium is 6%

Company - Victoria Store - Houston Store

Forecasted return 12 % 11 %

Standard Deviation of Returns 8 % 10 %

Beta:   1.5 1.0

a.Estimate the expected return for each company according to CAPM

Company - Victoria Store

As per CAPM

Expected return = Risk Free rate + Market Risk Premium*Beta

Expected return = 4 + 6*1.5

Expected return = 13%

Company - Houston Store

As per CAPM

Expected return = Risk Free rate + Market Risk Premium*Beta

Expected return = 4 + 6*1.0

Expected return = 10%

b.Characterize each company as underpriced, overpriced, or properly priced according to CAPM

Company - Victoria Store is overpriced

Company - Houston Store is Underpriced

c.Another company, Sugar Land store, has a beta of 2.0.

Assuming efficient market hypothesis

(CAPM holds), estimate the expected rate of return for a portfolio consisting of 1/3 Victoriastock, 1/3 Houston stock, and 1/3 Sugar Land store

Company - Sugar Land store

As per CAPM

Expected return = Risk Free rate + Market Risk Premium*Beta

Expected return = 4 + 6*2.0

Expected return = 16%

Expected rate of return for a portfolio = Weight of Victoriastock * Expected return of Victoriastock + Weight of Houston stock * Expected return of Houston stock + Weight of Sugar Land store * Expected return of Sugar Land store

Expected rate of return for a portfolio = 1/3*13 + 1/3*10 + 1/3*16

Expected rate of return for a portfolio = 13%

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