a) Suppose that you have estimated the expected returns and betas of the following five stocks by
Question:
a) Suppose that you have estimated the expected returns and betas of the following five stocks by using annual data
stock | market capitalisation($m) | beta | expected return (%) |
A | 300 | 0.5 | 7.00 |
B | 30 | 0.9 | 10.60 |
C | 270 | 1.1 | 11.80 |
D | 20 | 1.4 | 14.20 |
E | 50 | 1.7 | 16.60 |
The risk-free rate of interest and the expected return on the market are 3% and 11% per annum respectively. You are also told that the market size of companies in this market is normally distributed with a mean of 250 million and a standard deviation 90 million.
Explain the context to which the data above is consistent with the Capital Asset Pricing Model (CAPM).
b) Referring to the data and results in part (a), discuss whether any arbitrage opportunity exists. What advice would you give to an investor who would like to hold a portfolio with a beta equal to 1?
c) Empirical evidence suggests that small capitalized firms seem to have a higher expected return than what the capital asset pricing model predicts. This evidence is often regarded as an anomaly to the CAPM.
Critically assess whether this information alone casts doubt about the validity of the CAPM and the market efficiency.
Data Analysis and Decision Making
ISBN: 978-0538476126
4th edition
Authors: Christian Albright, Wayne Winston, Christopher Zappe