CAPM and Security Pricing Stock A has an expected return of 28% and a beta of 2.3. Stock B has an expected return of 28% and a beta of 2.3 when the risk free rate is 6%. Which of the following statements are correct? |
I. Stock A is underpriced relative to Stock B |
II. Stock B is underpriced relative to Stock A |
III. This situation is inconsistent with the CAPM |
IV. This situation is consistent with the CAPM |
Multiple Choice:
II and IV only
I and III only
II and III only
I and IV only
Stock A return Re=28% beta =2.3
Stock B return Re =28% beta=2.3
As per CAPM expected return Re is given by the relation
Re = Rf+ β (Rm-Rf)
In this case for both A & B, Re and β are equal. Rf applicable is also the same.
Thus from CAPM perspective, both A & B should be equally priced
Thus if we were to look at the options provided, the option 1 or 2 of either A or B being under or over priced is an inconsistent scenario as per CAPM.
Thus if we combine option II and III, this is the correct combination as B being underpriced w.r.t A is an inconsistent scenario as per CAPM.
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