Question

If a security is underpriced (i.e. intrinsic value > market price), then what is the relationship between its market capitalization rate (k) and its expected rate of return (EHPR)? Briefly explain your answer.

(if you can point out all of the points needed to answer this so I can turn that into 400 words)

[For this theoretical sub-question a word limit of 400 word is required.]

Answer 1

We know from CAPM that a security is underpriced when expected returns is more than required returns or market capitalisation rate. If a security is underpriced it plots above SML.

Proof given below:

Let a constant dividend paying stock have a dividend of D

Intrinsic value now=Dividend/required Return=D/k

Intrinsic value 1 year later=D/k

Let current price of stock be P

Price<Intrinsic Value

P<D/k

=>D/P>k

Expected returns HPR=(D+D/k)/P-1=D/P*(1+1/k)-1

Expected returns>k*(1+1/k)-1

Expected returns>k

Expected returns>Market capitalisation rate