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problem 1) Part A

(a) Describe how CAPM provides a framework for measuring systematic risk of the individual security in a well diversified portfolio, using concept of security market line.

(b) Mr. Douglas has asked for your advice in selecting a portfolio of assets. The given data has been supplied:

Expected return

Year               Asset A             Asset B             Asset C
2004               12%                   16%                  12%
2005               14%                   14%                  14%
2006               16%                   12%                   16%

No probabilities have been supplied. You have been told that you can create two portfolios:

• One consisting of assets A and B

• One consisting of assets A and C

Both by investing equal proportions (50%) in each of the two component assets.

Required:

(i) What is the expected return for each asset over the 3 year period?

(ii) What is the variance for each asset’s return?

(iii) What is the expected return for each of the two portfolios?

(iv) What is the variance for each portfolio?

(v) Which portfolio do you recommend? Why?

(c) Mr. James is owner of a small enterprise; he has decided to buy the machine. He can afford to pay Rs. 10, 000 per month. He visited the bank and found that going rate is 1.5% per month for 48 months. How much can he borrow?

(d) A company has issued debentures of Rs 500, 000 to be repaid after 7 years. How much must the company invest at the end of each year in a sinking fund earning 12% in order to be able to repay debentures?

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