Question

Reddi Plc is a car manufacturer. Reddi shares have a beta of 0.9. A security analyst who specialises in studying car manufacturers expects its return to be 13%. Suppose that the risk free rate is 8% and the market-risk premium is 6%. Is the analyst pessimistic or optimistic about this firm relative to the market’s expectations? Support your answer with appropriate calculations.

Answer 1

Based on the given information, the security analyst who specializes in studying car manufacturers expects the return to be = 13%

We will now use the Captial Asset Pricing Model (CAPM) to compute the return based on market expectations.

Expected return = Risk-free rate + Beta of Reddi x Market risk premium

= 8% + 0.9 x 6%

Expected return = 13.4%

Analyst's expected return < Market's expected return

13% < 13.4%

As the analyst expectations of the return are lower, he is pessimistic about this firm relative to the market's expectations.

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