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CAPM Excercise - SCQF

The document presents exercises related to the Capital Asset Pricing Model (CAPM), including calculations of market price of risk, expected returns on various assets, and the derivation of a single index model. It also discusses the assumptions of CAPM, the significance of Beta in pricing securities, and the parameters needed for evaluating a portfolio under different theories. Additionally, it outlines the limitations of CAPM and its implications in investment decisions.

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41 views2 pages

CAPM Excercise - SCQF

The document presents exercises related to the Capital Asset Pricing Model (CAPM), including calculations of market price of risk, expected returns on various assets, and the derivation of a single index model. It also discusses the assumptions of CAPM, the significance of Beta in pricing securities, and the parameters needed for evaluating a portfolio under different theories. Additionally, it outlines the limitations of CAPM and its implications in investment decisions.

Uploaded by

aqf23pooja
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CAPM --Exercise

1. An investor has the choice of the following assets that earn rates of
return as follows in each of the four possible states of the world:

State Probability Asset 1 Asset 2 Asset 3


1 0.2 5% 5% 6%
2 0.3 5% 12% 5%
3 0.1 5% 3% 4%
4 0.4 5% 1% 7%

Market capitalisation 10,000 17,546 82,454

Determine the market price of risk assuming CAPM holds

2. A market consists of three securities A, B and C with capitalisations of


£22bn, £33bn and £22bn respectively. Annual returns on the three
shares (RA, RB and RC) have the following characteristics:
Asset Standard deviation
A 40%
B 20%
C 10%
The expected rate of return on the market portfolio is 22.86% p.a.
The correlation between the returns on each pair of distinct securities is
0.5.
The risk-free rate of return is 3.077% p.a. No adjustments to an investor’s
portfolio are possible within the year.
(i) Prove that the expected returns on A, B and C are 40%, 20% and 10%
respectively if the CAPM is assumed to hold.
(ii) Derive a single index model (with the index equal to RM, the random
return on the market portfolio) with the same expected returns and
variances as in the CAPM. You are required to calculate the values of all
parameters in the model.
(iii) Prove that this single index model is not completely consistent with the
CAPM model.
(iv) Outline the limitations of CAPM.

1
3. (i) State the assumptions, additional to those used in modern
portfolio theory, that allow the capital asset pricing model
(CAPM) to be consistent with an equilibrium model of prices
in the whole market.

(ii) Explain why in the CAPM all investors should hold all risky
assets in proportion to the market capitalisation of those assets.

In an investment market there are three risky assets available.


The table below shows the returns each of the assets will earn in
the three possible states of the world and the current market
capitalisation of the assets. Assume a risk free rate of return of
4% is available.
States Probability Asset 1 Asset 2 Asset 3
1 0.4 5% 6% 7%
2 0.1 8% 2% 1%
3 0.5 3% 5% 4%
Market Capitalisation 30,000 50,000 30,000
(iii) Calculate the market price of risk under the CAPM.

4. (i) (a) Define Beta in the Capital Asset Pricing Model (CAPM)
(b) Explain why Beta is used in pricing securities.
In a market where the CAPM holds the following parameters are
known:
Risk-free rate of interest = 6%
Expected market rate of return = 12%
Standard deviation of an efficient portfolio’s returns = 0.50
Standard deviation of the market returns = 0.7
(ii) Calculate the expected return on the portfolio.
(iii) An investor is evaluating the risk and expected return of a
portfolio of N securities.
Explain how many parameters need to be estimated if:
(a) the evaluation is made using mean-variance portfolio theory
without any assumed cross-sectional structure in the variances of
the securities.
(b) the CAPM is assumed to hold.
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