THE ECONOMICS OF FINANCIAL MARKETS R. E. BAILEY Exercises for Chapter 6 The capital asset pricing model 1. The following information is provided for a stock market: μ j β j Asset 1 6.6% 0.4 Asset 2 9.8% 1.2 Asset 3 12.2% 1.8 Notation: μ j = expected rate of return on asset j ; β j = beta-coefﬁcient for asset j , j = 1 , 2 , 3 . (a) In the context of the Capital Asset Pricing Model (CAPM), deﬁne the ‘beta-coefﬁcient’, β j , corresponding to asset j . Discuss how assets’ beta-coefﬁcients should be interpreted and explain how their values can be obtained in practice. (b) Assuming that a risk-free asset is available, explain and interpret the Security Market Line (SML) in the context of the CAPM. Construct the SML from the given information and interpret the values of its coefﬁcients. (c) Now suppose a risk-free asset is not available, although the other assumptions of the CAPM remain valid. How should the SML be constructed and interpreted in this case?
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