You Have Been Asked to Use a CAPM Analysis to Choose

question 42

Multiple Choice

You have been asked to use a CAPM analysis to choose between stocks R and s, with your choice being the one whose expected rate of return exceeds its required rate of by the widest margin.The risk-free rate is 6%, and the required return on an average stock (or "the market") is 10%.Your security analyst tells you that Stock S's expected rate of return is $\hat { \mathrm { r } }$ = 11%, while Stock R's expected rate of return in $\hat { \mathrm { r } }$
= 13%.The CAPM is assumed to be a valid method for selecting stocks, but the expected return for any given investor (such as you) can differ from the required rate of return for a given stock.The following past rates of return are to be used to calculate the two stocks' beta
coefficients, which are then to be used to determine the stocks' required rates of return.
$\begin{array}{llll}\underline{\text { Year} } &\underline{\text { Stock R }}& \underline{\text { Stock S}} &\underline{\text { Market} }\\1 & -15 \% & 0 \% & -5 \% \\2 & 5 & 5 & 5 \\3 & 25 & 10 & 15\end{array}$

-Refer to CAPM Analysis.Set up the SML equation and use it to calculate both stocks' required rates of return, and compare those required returns with the expected returns given above.You should invest in the stock whose expected return exceeds its required return by the widest margin.What is the widest margin, or greatest excess return $( \hat { \mathrm { r } } - \mathrm { r } )$ ?

• A)0.0%
• B)0.5%
• C)1.0%
• D)2.0%
• E)3.0%

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Definitions:

Communications Gap

A situation where there is a difference or conflict between the message sent and the message received, often leading to misunderstanding.

Knowledge Gap

The difference between what is known and what needs to be known to effectively understand or perform an activity.

Pricing Strategies

Various approaches businesses use to set prices for their products or services to maximize profitability and meet market demand.

Perishable

Describes products or services that have a limited life span or expiry date, after which they are no longer usable or valuable.