Question

If the risk-free rate is 3.4% and the market risk premium is 4.95%, find out if the below investments are overvalued or undervalued given their beta coefficient and required rate of return observed using the capital asset pricing equation. Stock Beta A 1.1 observed Required Return A 8% stock B 1.3 observed Required Return B 12% stock C 1.2 observed Required Return c 9% stock D 1.9 observed Required Return D 15% stock E 0.7 observed Required Return E 7% Given the information above, draw the security market line and show where the assets (i.e., Stock A, B, C, D, and E) fit on the graph.

Answer 1

Risk free rate		3.40%
Market Risk premium		4.95%
	Formula - Captial Asset Pricing Equation Risk Free Rate + (Beta*Market Risk Premium)
Stock	Beta	Observed Required Return	Required return as per CAPM
A	1.1	8%	8.8%
B	1.3	12%	9.8%
C	1.2	9%	9.3%
D	1.9	15%	12.8%
E	0.7	7%	6.9%

Stock B and D are overvalued because their observed required returns are higher than the justified required returns. Stock A and C are undervalued because their observed required returns are lower than required returns that should prevail given their systematic risk. Only Stock E is fairly-valued because it appears on the security market line.

146- 10y + 87+ 677 477 24+ . OS I 1.5 2 2.5 3.