CAPM – SML / CML

Practice Question

Intro to Finance
Capital Asset Pricing Model (CAPM)
SML / CML
MCQs

The ABC company has a beta of 0.8 and an expected return of 9%. The market risk premium is 7% and the risk-free rate is 2 percent. Which of the following statements is correct?

A) This asset is correctly priced according to the CAPM because its return lies on the security market line.
B) This asset is overpriced according to the CAPM because its return lies above the security market line.
C) This asset is underpriced according to the CAPM because its return lies above the security market line.
D) This asset is overpriced.
Answer +
Correct Answer: C) This asset is underpriced according to the CAPM because its return lies above the security market line.
Explanation +

To find the correct statement regarding the ABC company’s asset, we need to apply the Capital Asset Pricing Model (CAPM) formula to determine if the asset is correctly priced, overpriced, or underpriced.

Step-by-Step Solution:
1. Define the Variables:
- Beta (\(\beta\)): 0.8
- Expected Return (\(E(R_i)\)): 9% or 0.09
- Market Risk Premium (\(E(R_m) - R_f\)): 7% or 0.07
- Risk-Free Rate (\(R_f\)): 2% or 0.02

2. Calculate the Required Return using CAPM:
\[ E(R_i) = R_f + \beta \times (E(R_m) - R_f) \]
\[ E(R_i) = 0.02 + 0.8 \times 0.07 = 0.02 + 0.056 = 0.076 \text{ or } 7.6\% \]

3. Compare the Expected Return to the Required Return:
- The calculated required return is 7.6%.
- The given expected return is 9%.
Since the expected return (9%) is higher than the required return (7.6%), this means the asset provides a higher return than what is required for its risk level.

Conclusion:
According to CAPM, this indicates that the asset is underpriced because investors are getting a higher return than what is justified by the risk. An asset is considered underpriced if its return lies above the security market line (SML), offering more return for the same level of risk.