Question

Keith holds a portfolio that is invested equally in three stocks (wp = WA = WI = 1/3). Each stock is described in the following table: Expected Return Standard Deviation 25% 8.0% Stock DET AIL INO Beta 0.7 1.0 1.6 38% 10.0% 34% 13.5% An analyst has used market and firm-specific information to make expected return estimates for each stock. The analyst's expected return estimates may or may not equal the stocks' required returns. The risk-free rate (TRF) is 6%, and the market risk premium (RPM) is 4%. Use the following graph with the security market line (SML) to plot each stock's beta and expected return. (Note: Click on the points on the graph to see their coordinates.) Stock DET Stock AIL RATE OF RETURN (Percent) Stock INO 0 0.2 0.4 0.6 1.4 1.8 1.8 2.0 0.8 1.0 1.2 RISK (Beta) A stock is in equilibrium if its required return its expected return. In general, assume that markets and stocks are in equilibrium (or fairly valued), but sometimes investors have different opinions about a stock's prospects and may think that a stock is out of equilibrium (either undervalued or overvalued). Based on the analyst's expected return estimates, stock INO is stock AIL is in equilibrium, and stock DET is

Answer 1

Below is the SML with the plot of the 3 stocks:

15.00% = 13.00% 2 11.00% Expected return AIL 9.00% 7.00% 5.00% 0 0.2 0.4 1 1.2 1.4 0.6 0.8 Beta SML DET + AIL INO

Asset	Beta	Return
Risk Free (Rf)	0	6.00%
Market Portfolio (Rm)	1	10.00%
DET	0.70	8.00%
AIL	1.00	10.00%
INO	1.30	13.50%

• Market beta = 1
• Riskfree beta = 0
• 
  Risk premium = Rmarket – Rrisk free 4% = Rmarket - 6% Rmarket = 10%
  
• Using the CAPM equation we can calculate the required rate of each stock:
  • 
    DET = Rrisk free + BDET(Rmarket – Rrisk free) TDET = 6% +0.7(4%) TDET = 8.8% TAIL = Rrisk free + BAIL(Rmarket – Rrisk free) TAIL = 6% + 1(4%) TAIL = 10% TINO = Rrisk free + Bino(Rmarket – Rrisk free) TINO = 6% +1.6(4%) TINO = 11.20%
    
• Now comparing the required return to the expected returns, we can say that the stocks that lie above the SML are undervalued and those which lie below it are overvalued. Those lying on it are fairly valued.
  • This is so because the stocks that lie above the SML have expected return > required return it are
  • The stocks that lie below the SML have expected return < required return it are
  • The stocks that lie on the SML have expected return = required return it are

Now coming to answering the questions:

• Stock is in equilibrium when the required return is equal to the expected return
• INO is undervalued
• DET is overvalued