AN INVESTMENT ADVISOR IS ANALYZING THE RANGE OF POTENTIAL EXPECTED...

8.

An investment advisor is analyzing the range of potential expected returns of a new fund designed to repli-

cate the directional moves of the BSE Sensex Index but with twice the volatility of the index. The Sensex has

an expected annual return of 12.3% and volatility of 19.0%, and the risk free rate is 2.5% per year. Assuming

the correlation between the fund’s returns and that of the index is 1, what is the expected return of the fund

using the capital asset pricing model?

a.

18.5%

b.

19.0%

c.

22.1%

d.

24.6%

Correct Answer: c

Rationale:

If the CAPM holds, then R

i

= R

f

+

β

i

x (R

m

– R

f

), which is maximized at the greatest possible beta value

which implies a correlation of 1 between the fund’s return and the index return. Since the volatility of the fund is twice

that of the index, a correlation of 1 implies a maximum beta

β

i

of 2. Therefore: R

i

(max) = 2.5% + 2 x (12.3% - 2.5%) = 22.1%.

Section:

Foundations of Risk Management

Reference:

Edwin J. Elton, Martin J. Gruber, Stephen J. Brown and William N. Goetzmann, Modern Portfolio Theory

and Investment Analysis, 9th Edition

(Hoboken, NJ: John Wiley & Sons, 2014). Chapter 13, “The Standard Capital

Asset Pricing Model.”

Learning Objective:

Apply the CAPM in calculating the expected return on an asset.