Question

(6) As an investment analyst, your own calculations brought up the following E(Rm) Rf Rate Stock A B C Po 0.68 0.54 0.65 E(P1) Beta 0.75 1.2 0.62 1.4 0.82 1.6 12.5% 2.5% Considering a full validity of the CAPM, you need to specify whether the three stocks should be bought sold? Why?

Answer 1

Solution : Using CAPM model we can calculate the expected return of each stock and compare it with the given expected price E(P1)

Expected return = Rf + beta * ( Rm - Rf)

For stock A

Expected return of A = 2.5% + 1.2* ( 12.5%-2.5%) = 2.5% + 12% = 14.5%

Given that P0 = 0.68

Expected return after one year using CAPM return = 0.68* ( 1+ 14.5% ) = 0.68 * 1.145 = 0.782

While given E(P1) = 0.75

So we should sell the stock as calculated price ( 0.782) is higher than expected price of 0.75

For stock B

Expected return = 2.5% + 1.4 * (12.5% -2.5%) = 2.5% + 14% = 16.5 %

Calculated return using CAPM = 0.54* (1+16.5%) = 0.6291

While given E(P1) = 0.62

So we should sell the stock as calculated price is higher than expected price

For stock C

Expected return = 2.5% + 1.6 * ( 12.5% -2.5%) = 2.5% + 16% = 18.5%

Calculated return using CAPM = 0.65 * ( 1+ 18.5% ) = 0.77025

We should by the stock as calculated price (0.77 )l is lower than the expected price i.e. 0.82