FPSC CSS EXAM 2024 – Business Administration – Question no. 3 with Solution
Currently under consideration is an investment with a beta, b, of 1.50. At this time, the risk- free rate of return, RF is 7%, and the return on the market portfolio of assets, rm, is 10%. You believe that this investment will earn an annual rate of return of 11%.
а. If the return on the market portfolio were to increase by 10%, what would you
expect to happen to the investment’s return? What if the market return were to decline by 10% ? b. Use the capital asset pricing model (CAPM) to find the
required return on this investment. c. On the basis of your calculation in part b, would you recommend this investment?
Why or why not?
d. Assume that as a result of investors becoming less risk-averse, the market return
drops by 1% to 9%. What impact would this change have on your responses in parts hand c?
Solution
Analysis of Investment with CAPM
a. Impact of Market Return Change on Investment Return:
- Increase in Market Return: If the market return (ram) increases by 10%, we would expect the investment’s return to also increase, but likely by less than 10%. This is because beta (b) of 1.5 indicates the investment is 1.5 times more volatile than the market. So, its return will amplify market movements, but not perfectly.
- Decrease in Market Return: If the market return (ram) declines by 10%, we would expect the investment’s return to also decrease, but likely by more than 10% due to its higher beta.
b. Required Return using CAPM:
We can use the Capital Asset Pricing Model (CAPM) to find the required return (re) on the investment:
re = RF + b * (rm - RF)
where:
- re = required return on the investment
- RF = risk-free rate of return (7%)
- b = beta of the investment (1.50)
- rm = return on the market portfolio (10%)
Plugging in the values:
re = 7% + 1.50 * (10% – 7%) re = 7% + 4.5% re = 11.5%
c. Investment Recommendation based on CAPM:
Based on CAPM, the required return on the investment is 11.5%. Since you believe the investment will earn an annual rate of return of 11%, it meets the minimum required return based on CAPM. However, this is just one factor to consider. Here’s why further analysis might be needed:
- Market Efficiency: CAPM assumes a semi-strong efficient market where all publicly available information is reflected in stock prices. In reality, the market might not be perfectly efficient, and there could be opportunities for excess return beyond CAPM’s prediction.
- Other Investment Details: Consider factors like investment horizon, risk tolerance, and diversification within your portfolio before making a decision.
d. Impact of Market Return Change on b and c:
If the market return (ram) drops to 9%:
- Required Return (b): The required return using CAPM would be slightly lower due to the smaller market risk premium. However, the impact wouldn’t be significant.
- Recommendation (c): The recommendation might change depending on the new required return calculation. If the required return remains close to 11%, the investment might still be acceptable. However, a significant decrease in required return could make the investment less attractive.