Question

Assuming a risk-free rate of 8 percent and a market return of 12 percent, would a wise investor acquire a security with a beta of 1.5 if its expected return were 14 percent?

Answer 1

Using the Capital Asset Pricing Model (CAPM), the expected return on a security with a beta of 1.5 is calculated to be 14%, matching the security's expected return. Therefore, it would be considered a fair investment based on this model. However, personal investment objectives and risk tolerance should still guide the final decision.

Step-by-step explanation:

The student's question pertains to whether an investor should acquire a security with a beta of 1.5 when the expected return is 14%, given a risk-free rate of 8% and a market return of 12%. To answer this, the Capital Asset Pricing Model (CAPM) is used, which calculates the expected return of an asset based on its beta and the market's expected return. The formula for CAPM is:

Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)

Using the provided data, we apply the CAPM formula:

Expected Return = 8% + 1.5 * (12% - 8%)Expected Return = 8% + 1.5 * 4%Expected Return = 8% + 6%Expected Return = 14%

Since the security's expected return of 14% matches the expected return calculated by the CAPM, the security is correctly priced according to the model. Therefore, acquiring this security falls in line with the risk-return tradeoff expected for its level of risk, as described by its beta value.

However, it is important to note that investment decisions should take into account an individual's risk tolerance, investment objectives, and other available investments that may offer better risk-return profiles.