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Unformatted text preview: = the required return on
security j,
security krf = the riskfree rate of interest, βj = the beta of security j, and
km = the return on the market
index.
index. Example:
Example: Suppose the Treasury bond rate is
Suppose
6%, the average return on the
6%
S&P 500 index is 12%, and Walt
12%
Disney has a beta of 1.2.
1.2 According to the CAPM, what
According
CAPM what
should be the required rate of
return on Disney stock?
return kj = krf + β (km  krrff )
kj = .06 + 1.2 (.12  .06)
kj = .132 = 13.2%
13.2%
According to the CAPM, Disney
According
stock should be priced to give a
13.2% return.
13.2% Required
Required
rate of
rate
return
return SML . 12% Riskfree
rate of
return
(6%) 0 1 Beta Required
Required
rate of
rate
return
return Theoretically, every
Theoretically,
security should lie
on the SML
on SML . 12% Riskfree
rate of
return
(6%) 0 1 Beta Required
Required
rate of
rate
return
return Theoretically, every
Theoretically,
security should lie
on the SML
on SML . 12% If every stock
is on the SML,
is
investors are being fully
investors
compensated for risk.
compensated Riskfree
rate of
return
(6%) 0 1 Beta Required
Required
rate of
rate
return
return If a security is above
the SML, it is
underpriced. SML . 12% Riskfree
rate of
return
(6%) 0 1 Beta Required
Required
rate of
rate
return
return If a security is above
the SML, it is
underpriced. SML . 12% If a security is
If
below the SML, it
is overpriced.
is Riskfree
rate of
return
(6%) 0 1 Beta...
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 Winter '08
 SWEO

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