Question

need help on this one will give review

You strongly believe in the CAPM and have recently identified a stock that you estimate to have a Beta of 1.5. At the same time you observe that the one year US Treasury bill yield is 0.8% and know that the average annual return to the SPY ETF has been 7% per year. Given that this stock has consistently earned about 10% per year then which of the following statements are likely true? Select one or more: a. I feel this stock to be undervalued 0 b. I need to assume stàtionarity of returns in order to make a decision with this model c. I feel this stock to be overvalued d. I should long this stock e. I should short this stock f. I need to assume the SPY is a decent proxy for the entire market in order to have necessary inputs

Answer 1

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Correct Answer: Option B, C, E and F

Working

First Calculating expected return using CAPM,

CAPM(Capital Asset Pricing Model ),

E(R) = Risk-free rate + Beta (Market return - Risk free rate)

Let the expected return be E(R)

Parameters provided in the question

• Beta = 1.5
• Risk-free rate = 0.8 % as Treasury bills are backed by the Fed and can be taken as a substitute to the risk-free rate.
• Market Return = 7% as SPY ETF are decent proxy to the entire market return

Substituting the values,

E(R) = 0.8 + 1.5 (7 - 0.8)

E(R) = 0.8 + 1.5 (6.2)

E(R) = 0.8 + 9.3

E(R) = 10.10%

Therefore the expected return is 10.10 %

Now, Since the stock has earned a rate of interest(10%) less than the expected return as calculated above( 10.1%), it is an overvalued stock. Since the stock is overvalued it must be shorted to earn profits as stock price may fall due to market efficiency.

Henceforth, the final correct options are :

b. Stationarity of returns is present in beta claudication and since we are using CAPM the same is assumed.

c. Stock is overvalued as discussed above.

e. Overvalued stocks must be shorted to earn profits.

f. SPY has been considered to be a good proxy to market return and used accordingly in the CAPM equation.

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