Question

Wilson holds a portfolio that invests equally in three stocks (WAWBWc following table: 1/3). Each stock is described in the Stock Beta Standard Deviation Expected Return A 0.5 23% 38% 45% 7.5% 12.0% 14.0% C 2.0 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 [Rr] is 4%, and the market risk premium RPn] 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. Tool tip: Mouse over the points on the graph to see their coordinates RATE OF RETURN (Percent 20 18 Stack A Stock B 14 12 10 Stock C 0.0 0.2 0.4 0.6 0.8 1.0 1.2 14 1.6 1.8 2.0 RISK (Betal A stock is in equilibrium if its expected return 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 equilibrium and fairly valued its required return. In general, assume that markets , Stock B is , and Stock C is in

Answer 1

A stock is in equilibrium if its expected return is same as its required return.

For Stock A:

Required return= Risk free rate+Beta(Risk Premium)

RA = 4%+0.5(5%) = 6.5%

Since required return is less than expected return

stock A is undervalued.

For Stock B:

Required return= Risk free rate+Beta(Risk Premium)

RB = 4%+1.0(5%) = 9%

Since required return is less than expected return

stock B is undervalued.