Choice and CAPM Lets say that you are looking to invest in t

Choice and CAPM

Let’s say that you are looking to invest in two stocks A and B. Stock A has a beta of
0.86 and based on your best estimates is expected to have a return of 8%. Stock B has
a beta of 3.37 and is expected to earn 23%. If the risk-free rate is currently 5% and the
expected return on the market is 12%, which stock(s) should you invest in, if any?

Solution

Returns as per CAPM:

Company

Risk free rate

Market Return

Beta

CAPM equation-based return:

CAPM Working

Stocks

Rf

Rm

B

Ri = Rf+B*(Rm-Rf)

Ri = Rf+B*(Rm-Rf)

A

5.00%

12.00%

0.86

11.02%

=5%+0.86*(12%-5%)

B

5.00%

12.00%

3.37

28.59%

=5%+3.37*(12%-5%)

Based on above return based on CAPM equation for A = 11.02% and for B = 28.59%

Whereas reported expected return for A = 8% and for B = 23%

As CAPM based return for both the stocks are higher we should “Invest” in both the shares A and B.