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You have analyzed the following four securities and have estimated each securityʹs beta and what you expect each security to return next year. The expected return on the market portfolio is 12%, and the relevant risk-free rate is 5%. Security Beta Expected return (based on your analysis) A -0.25 3.25% B 1.10 12.10% C 0.75 9.75% D 2.00 19.50% Refer to the information above. Based on your analysis, which of the securities is correctly priced? A) Security A B) Security B C) Security C D) Security D

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Answer: A) Security A

Explanation:

Using CAPM, the expected return of a security is;

Expected return = Risk free rate + beta ( Market return - Risk free rate)

Security A

= 5% + -0.25 ( 12% - 5%)

= 3.25%

Security B

= 5% + 1.1 ( 12% - 5%)

= 12.7%

Security C

= 5% + 0.75 ( 12% - 5%)

= 10.25%

Security D

= 5% + 2.00 ( 12% - 5%)

= 19%

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