Question

A particular asset has a beta of .90 and an expected return of 10%. Given that the expected return on the market portfolio is 13% and the risk-free rate is 5%, is the stock appropriately priced

Answer 1

As per CAPM,

Expected return is:

E(r) = R_f + β (R_m -R_f)

R_f = Risk-free rate of return = 0.05

R_m= Market rate of return = 0.13

β = Beta of stock = 0.90

E(r) = 0.05 + 0.9 x (0.13 - 0.05)

   = 0.05 + (0.9 x 0.08)

   = 0.05 + 0.072 = 0.122 or 12.2 %

For the stock, required return is 12.2 % , which is higher than estimated return of 10 %. The estimated return can be plotted below SML and hence has a lower return for the given systematic risk. Hence the stock is overvalued and not appropriately priced.

answered by: anonymous