Practice Problem – CAPM and Beta

Practice Question

Intro to Finance
Capital Asset Pricing Model (CAPM)
Beta
Short Answer

An asset has a beta of 0.75 and a return of 12%. The expected return on the market portfolio is 15% and the risk-free rate is 4%. Please advise whether the asset is correctly priced, underpriced, or overpriced. Justifications are required.

Answer +
Overpriced
Explanation +

Step 1: Use CAPM to calculate expected return

Formula: E(R) = Rf + β (Rm - Rf)
Plug in: E(R) = 0.04 + 0.75 × (0.15 - 0.04) = 0.04 + 0.0825 = 0.1225 or 12.25%

Step 2: Compare with actual return
- Expected return from CAPM: 12.25%
- Actual return: 12%

Step 3: Conclusion
Since the actual return is less than what is predicted by CAPM, the asset provides a lower return for its level of risk. This means it lies below the Security Market Line (SML) and is therefore overpriced.

Final Answer: The asset is overpriced.