Question

An analyst expects a risk-free return of 4.5%, a market return of 14.5% and the returns for stocks A and B, shown below.

Stock	Beta	Analyst Expected Return
A	1.2	16%
B	0.8	14%

If the analyst is correct in their expected return, what does it tell you about the value of the stock, and why?

Answer 1

CAPM return= risk free return+beta(risk premium)

risk premium would be calculated after deduction of risk free rate of return from market rate of return.= (14.5-4.5)= 10%

Stock A= 4.5+1.2(10)

=16.5%

Stock B= 4.5+.8(10)

= 12.5%

analyst is not correct in estimation of the expected return because the Capital Asset pricing model return reflect differently because analyst is predicting a higher rate of return for the stock, but according to the model, the stock is there to yield a lower rate of return.

it tells that higher beta stock is always having a higher expectation of Return and a lower beta stock would always be having a lower expectation of Return.