Question

1/3). Each stock is described in the Wilson holds a portfolio that invests equally in three stocks (WA = WB Wc following table: Stock Beta Standard Deviation Expected Return A 0.5 23% 7.5% B 1.0 38% 12.0% C 2.0 45% 14.0% An analyst has used market and firm-specific information to generate expected return estimates for each stock. The analyst's expected return estimates may or may not equal the stocks' required returns. You've also determined that the risk-free rate (TRF) is 4%, and the market risk premium (RPM) is 5%. Given this information, use the following graph of the security market line (SML) to lot each stock's beta and expected return on the graph. Tool tip: mouse over the points on the graph to see their coordinates. RATE OF RETURN (Percent) Stock A Stock B Stock C 0.0 0.2 0.4 0.6 0.8 1.0 20 RISK (Beta) Clear A

Answer 1

Using CAPM model to calculate expected return of stock A

Given : risk free rate = 4%

Market risk premium = 5%

Beta = 0.5

Expected return = Risk free rate + beta (market risk premium)

= 4% + 0.5 × 5%

= 4% + 2.5%

= 6.5%

Since the expected return of stock is more than expected return calculated by CAPM , the stock is undervalued, and it will fall above the sml line

For Stock B

Given: Risk free rate = 4%

Market risk premium =5%

Beta = 1

Expected return = risk free rate + beta (market risk premium)

= 4% + 1 × 5%

= 4% + 5%

= 9%

Since the expected return of the stock is more than the expected return calculated by CAPM, the stock is undervalued,

and it will fall above the sml line.

For Stock C,

Given: Risk free rate = 4%

Market risk premium = 5%

Beta = 2

Expected return = risk free rate + beta × (market risk premium)

= 4% + 2 × 5%

= 4% + 10%

= 14%

Since the expected return of the stock is equal to the expected return calculated by CAPM, the stock is fairly valued , and it will fall on the sml line.