Question 5a

Explain Markowitz Portfolio theory.

Beta coefficient in CAPM model measure what risk? Provide example

Briefly discuss three the criticism of CAPM model.

Question 5b

You are using the arbitrage pricing model to estimate the expected return on Bethlehem Steel,and have derived the following estimates for the factor betas and risk premium:

Factor Beta Market Risk Premium

1 1.2 2.5%

2 0.6 1.5%

3 1.5 1.0%

4 2.2 0.8%

5 0.5 1.2%

i). If the risk-free rate is 5%, estimate the expected return on Bethlehem Steel.

ii). Now assume that the beta in the capital asset pricing model for Bethlehem Steel is 1.1 and that the market risk premium for the market portfolio is 5%. Estimate the expected return using the

CAPM.

iii). Why are the expected returns different between the two models?