“The Capital Asset Pricing Model (CAPM) implies that investors require
a higher return to hold highly volatile securities.” Is the statement true or
false? Explain using the relevant formula.

b) Here are data on two securities. The T-bill rate is 4% and the market
risk premium is 6%.
Security ABC, XYZ

Forecasted return - 11% (ABC), 15% (XYZ)
Standard deviation of returns - 8% (ABC), 10% (XYZ)
Beta - 1.5 (ABC), 1.0 (XYZ)

Calculate the expected return for each security according to the CAPM
and plot the two securities on the Security Market Line (SML) graph.
Characterise each security as underpriced, overpriced, or properly priced.

c) Suppose that the market can be described by three sources of
systematic risk: industrial production, interest rate and GDP growth. The
risk-free rate is 6%. Consider the following multifactor Arbitrage Pricing
Theory (APT) model of security returns for a particular stock.

Industrial production (I) - 6% (Risk premium), 1.0 (Factor Beta)
Interest rate (R) - 2% (Risk premium), 0.5 (Factor Beta)
GDP growth (GDP) - 4% (Risk premium), 0.75 (Factor Beta)

A security analyst who specialises in studying this stock estimates its
return to be 15%. Calculate the equilibrium rate of return on this stock
using the APT. Determine whether the analyst is pessimistic or optimistic
about this stock relative to the market’s expectation?

d) “Both the CAPM and APT require a mean-variance efficient portfolio.”
Is the statement correct or incorrect? Explain.