18-Fundamental Analysis

# 18-Fundamental Analysis - CAPMIIand FundamentalAnalysis...

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CAPM II and  Fundamental Analysis

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Possible or Not Possible? Assume CAPM is correct and prices are in equilibrium 1) If given the beta, risk-free rate, and expected market  return, then verify that expected return for stock equals  r f + β i (E[r m ]-r f ) 2) Relation between the expected returns of two stocks If given betas, stock with higher beta should have higher expected  return If not given the betas, any rank-ordering is possible
Possible or Not Possible? 3) If given enough information to compute Sharpe  ratio of market and stock, verify that market has  the highest Sharpe ratio. 4) If Sharpe ratio is negative for a given stock,  then E[r] must be less than the risk-free rate.

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Example #1 Possible or not possible according to CAPM if all  assets are in equilibrium? Stock A E[r] = -4% σ =.20 Stock B E[r]=10% σ =.05
Example #1 The above scenario is possible according to the  CAPM, since we are not given betas. The beta of stock A could be negative for all we  know.

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Example #2 Possible or not possible according to CAPM if all  assets are in equilibrium? Stock A E[r] = -4% β =1.2 Market E[r]=10% Risk-free rate=4%
Example #2 Not possible according to the CAPM If prices are in equilibrium then expected return  for stock A should be .04+1.2*(.10-.04)=11.2%

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Example #3 Possible or not possible according to CAPM if all  assets are in equilibrium? Market Portfolio E[r]=10% σ =.10 Vastera Stock E[r]=12% σ =.13 Risk-free rate=5% (borrowing and lending)
Sharpe ratios Market : (.10-.05)/.10=0.5 Vastera: (.12-.05)/.13=0.53 The Sharpe ratio of Vastera is greater than that  for the value-weighted portfolio.

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18-Fundamental Analysis - CAPMIIand FundamentalAnalysis...

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