Question

a. Suggest an example of an asset with zero beta. Explain whether an asset with zero beta offers an expected return of zero.

b. Milton considers buying the ABC stock. The ABC stock pays a constant dividend of $5 in perpetuity, and the beta of the ABC stock is 1.2. The risk-free rate is 4%, and the expected market return is 12%.

i. Compute the price of the ABC stock based on the CAPM.

ii. Suppose the market price of the ABC stock is $40. According to the CAPM, is the stock over-priced or under-priced? Should he buy the ABC stock? Explain.

Answer 1

a.All risk free assets have zero beta. They provide an expected return equal to risk free rate and not zero

For example: Treasury bills. They have zero risk. Hence, they provide risk free return and no risk premium

b.Required rate of return as per CAPM = Risk free rate + beta*(Market return – risk free return)

= 4% + 1.2*(12%-4%)

= 13.6%

Value of stock = Present value of all future dividends

= 5/13.6%

= $36.76 per share

ii. The stock is overpriced as fair price of stock as per CAPM = $36.76 per share

and hence, he SHOULD NOT buy the share since it is overpriced