Question

A particular asset has a beta of 1.2 and an expected return of 10%. The expected return on the market portfolio is 13% and the risk-free rate is 5%. The asset is:

Select one:

a. under-priced

b. appropriately priced

c. overpriced

d. There is not enough information to answer the question

Answer 1

Here, to say whether a stock is underpriced, fairly priced or over priced, we have to look at the results that we will get by CAPM model.

Lets put the given value in CAPM (Capital Asset Pricing Model) to get the insights about the stock.

CAPM Model : Expected stock returns = Risk-free rate + (Expected market returns - Risk-free return) * Beta of the stock.

From the given question, we have following things.

risk free rate = 5%,

Expected market returns = 13%

beta of the stock = 1.2

therefore, Expected stock returns = 5% + (13% - 5%) * 1.2 = 14.6%

Now, in the question it is given that expected returns on the stock was 10%, but from the CAPM calculations we have calculated it as 14.6%.

The calculated CAPM value(14.6%) is greater than the expected one(10%), which implies that the stock we are talking about is overpriced.