The statement is false. This is because the CAPM model helps identify the risk and the corresponding return from the asset investment. Moreover, it assesses assets as well as their security and risk conditions having a return on the investment and enables an individual invest. The provided statement gives false evidence as there is a required risk premium on the security or the investment which bears the systematic risk. Volatile securities do not necessarily require CAPM. Using the model formula as below;
E(rABC) = 0.04 + 1.5 *(0.06) = 0.13
= 13%
E(rXYZ) = 0.04 + 1.0 * (0.06) = 0.10
= 10%
The equation for the security market line is:
E(r) = 0.04 + β * (0.13 – 0.04)
E(r) = 0.04 + β * (0.10 – 0.04)
The SML graph of the two stocks.
ABC forecasted return is 10% while the required return is 13% which implies that it is overpriced.
XYZ forecasted return is 14% while its required return is 10% implying that it is currently underpriced.
The equilibrium rate of return using the Arbitrage Pricing Theory (APT) is derived by taking:
Equilibrium rate of return = Rf + (Bf1 * Returnf1) + (BfR * ReturnFr) + (BFc * ReturnfC)
In the formula;
Rf represents the T-bill.
The beta of factor I is Bf1.
The beta of factor R is BfR.
The beta of factor C is BFc.
The return for factor I is Returnf1
The return for factor R is ReturnFr.
The return for factor C is ReturnfC.
Equilibrium rate = 6%+(1.0*6%)+(0.5*2%)+(0.75*4%)
= 6%+(6%)+(1%)+(3%)
= 16%
Hence the equilibrium rate of return is 16%.
Based on the findings, the higher equilibrium rate of return of 16% puts the analyst at an optimistic situation as the market expects more returns and increase in profits.
The CAPM implies that the individual asset fair risk premium is derived by taking the product of the of the risk premium surrounding the market portfolio and the value of the coefficient of beta.
The Arbitrage pricing theory (APT) assumes that the return from any asset can be estimated through applying the association between the portfolio or the asset with the common risk factor for other asset. Significantly, an investor is able to earn risk free benefits.
Hence, in this scenario, the CAPM needs a mean-variance efficient market portfolio. The model assumes that securities risk premiums get affected by higher returns on the market portfolio. Regardless, the APT permits a model development which does not use the return on the market portfolio as a factor. Hence, the statement is incorrect.
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