Consider the following questions about CAPM: 1. What is the equilibrium relation
ID: 2820097 • Letter: C
Question
Consider the following questions about CAPM: 1. What is the equilibrium relationship between return and risk that must hold for every risky asset in a perfect market? 2. Define systematic and non-systematic risk. 3. Suppose that the annual returns on two stocks (A and B) are perfectly negatively correlated, and that rA = 0.05, rB = 0.15, A = 0.1, B = 0.4. Assuming that there are no arbitrage opportunities, what must the one-year interest rate be? 4. The expected return on the market portfolio, rm is 13%. The standard deviation of the market return, m, is 0.20. The covariance of a well-diversified portfolio with the market, mp, is 0.03. What is the expected return on the portfolio? Use the answer from part 3
Explanation / Answer
1. In a owrfect market, risk increases with the increase in return for every risky asset.
2. Systematic risk, also known as volatility is an understatement diversifiable risk that is uncertainty inherent to entire market segment.
While unsystematic risk is the one, which can be reduced through diversification i.e by investing in diversified sticks and markets.