Answer the questions below.
a.Write the equation for the capital-asset pricing model. b.Describe, in words, what the CAPM is trying to explain, and describe each element of the equation in part a. Use the capital-asset pricing model to predict the returns next year of the following stocks, if you expect the return to holding stocks to be 12 percent on average, and the interest rate on three-month T-bills will be 2 percent. Show your calculations. c.A stock with a beta of ?0.3 d.A stock with a beta of 0.7 e.A stock with a beta of 1.6
What will be an ideal response?
| a. | Rit = rt + ?i (Rt?rt) + ?it | |
| b. | The capital asset pricing model (CAPM) relates a stock's return (relative to the risk-free rate) to the market return (relative to the risk-free rate): | |
| The realized return to holding stock i at date t | |
rt: | The interest rate on a risk-free bond | |
Rt?rt: | The market's excess return | |
Rt: | The average return to all stocks in the market | |
| The part of the return that is unexplained by the market's return | |
| Returns on different stocks react differently to changes in the market's excess return, so the coefficient ?i differs across stocks. | ||
| c. | E(Rit + 1) = E(rt + 1) + ?i (Rt + 1?rt + 1) = 2% + (?0.3 × 10%) = ?1% | |
| d. | E(Rit + 1) = E(rt + 1) + ?i (Rt + 1?rt + 1) = 2% + (0.7 × 10%) = 9% | |
| e. | E(Rit + 1) = E(rt + 1) + ?i (Rt + 1?rt + 1) = 2% + (1.6 × 10%) = 18% | |
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