The Capital Asset Pricing Model, almost always referred to as the CAPM, is a centre-piece of modern financial economics. It was first proposed by William F. Sharpe, who was awarded the 1990 Nobel Prize for economics.

Required:

(a) What is CAPM and what purposes does it serve in finance in general, and in investments in particular? Discuss. (2 marks)

(b) Outline and explain the main assumptions of CAPM. What limitations do these place on its practical application? Explain.

(c) If only some investors perform security analysis while all others hold the market portfolio (M), would the CML still be the efficient CAL for investors who do not engage in security analysis? Explain.

(d) Suppose the risk-free is 5 %, the average investor has a risk aversion co-efficient of A = 2, and the standard deviation of the market portfolio is 20 %. What is the equilibrium value of the market risk premium? What is the expected return on the market? If the average degree of risk aversion were 3, what would be the market risk premium, and expected return?

(e) Historical data for the S & P 500 Index show an average excess return over Treasury bills of about 8.5 % with standard deviation of about 20 %. To the extent that these averages approximate investor expectations for the sample period, what must have been the co-efficient of risk aversion of the average investor? If the co-efficient of risk aversion were 3.5, what risk premium would have been consistent with the markets historical standard deviation?

The risk premium of the market portfolio is 9 %, the risk free rate is 5 % and the beta estimate for AELZ is = 1.3. What is the risk premium? What is the expected rate of return?

The risk premium on the market portfolio is estimated at 8 % with a standard deviation of 22 %. What is the risk premium on a portfolio invested 25 % in AELZ with a beta of 1.15 and 75 % in BAT with a beta of 1.25?

The return on the market is expected to be 14 %, a stock has a beta of 12, and the T-bill rate is 6 %. What expected rate of return would the SML predict?

A company is considering a new water bottling plant. Business plan forecasts an internal rate of return of 14 % on the investment. The beta of similar projects is 1.3. the risk free rate is 4 % and the market risk premium is estimated at 8 %. What is the hurdle for the project? What does this mean for the project: should it or should it not be undertaken?

Equity holders investment in the firm is K100 million, and the beta of the equity is 0.6. if the T-bill rate 6 %, and the market risk premium is 8 %. What would be a fair annual profit?

Stock XYZ has an expected return of 12 %, and risk of and = 1.0. Stock ABC is expected to return 13 % with a beta of 1.5. The markets expected return is 11 % and risk free rate is 5 %. Which stock is a better buy? What is the alpha of each stock? Plot the SML and the two stocks and show the alphas of each on the graph?

The risk free rate is 8 % and the expected return on the market portfolio is 16 %. A firm is considering a project with an estimated beta of 1.3. What is the required rate of return on the project? If the IRR is of the project is 19 %, what is the project alpha?