Question

Wilson holds a portfolio that invests equally in three stocks (WA = WB = wc = 1/3). Each stock is described in the following table: Stock Beta Expected Return 0.5 Standard Deviation 23% 38% 7.5% 12.0% B C 1.0 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 plot each stock's beta and expected return on the graph. (Note: Click on the points on the graph to see their coordinates.) Stock A A Stock B RATE OF RETURN (Percent) Stock C 0 0.2 0.4 0.6 1.4 1.6 1.8 2.0 0.8 1.0 1.2 RISK (Beta) A stock is in equilibrium if its expected return its required 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 A is Stock B is , and Stock C is in equilibrium and fairly valued.

Answer 1

The expected return, as estimated by the analyst has been plotted against the beta of each stock. The stock required rate of return can differ and it will lie on the SML. For stock A = beta = 0.5, Expected return = 7.5% For stock B = beta = 1, expected return = 12% For stock C= beta = 2, expected return = 14% StockC Stock B return rate of I 0.2 0.4 0.6 0.8 1.2 14 16 18 2 Beta

A stock is in equilibrium if its expected rate of return is equal to required rate of return. Stock A expected return = 7.5% Based on CAPM model its, required rate of return = risk free rate + Beta* Market risk premium =4+ 0.5*5 =6.5 Since its expected rate of return is greater than required rate Stock A is undervalued. Stock B expected rate of return = 12% Its required rate of return = =4+ 1*5 =9% Since its expected rate is greater than required rate, Stock B is undervalued We can also say this by looking at the graph the way Stock A and Stock B expected return has been plotted. They are above the SML; hence they are undervalued. If they would have been below the SML, they would have been overvalued.