What is the excesses return

Question

The estimated alpha and beta of Fund DEF . are 2.3 and 3.1 respectively. If the expected market risk premium is 12% what would we expect the excess return of Fund DEF ?

A)39.5%

B)30.7%

C)5.4%

D)64.8%

Answer 1

To answer this question, we need to first start with the formula for the CAPM:

E[R_i] = R_f + ß_i[E[R_m - R_f]] + α_i where...

R_f = Risk-free Rate

E[R_i] = Expected Return of Asset i

ß_i = Asset's Beta, which is the part of the asset's excess return explained by systematic risk.

E[R_m - R_f] = Market Risk Premium

α_i = Asset's alpha, which is the part of the asset's excess return NOT explained by systematic risk.

The excess return can be characterized by subtracting R_f from both sides of the CAPM formula:

E[R_i] - R_f = α_i + ß_i[E[R_m - R_f]]

Remember, if the CAPM is correct, α_i should be zero. From here, we can plug in the values given in the problem:

E[R_i] - R_f = 2.3 + 3.1[12] = 39.5%

Thus, the excess return is 39.5%.