Question

Suppose the yield on short-term government securities (perceived to be risk-free) is about 8.26%. Suppose also that the expected return required by the market for a portfolio with a beta of 1.0 is 12.51%. According to the capital asset pricing model:

Required:
(a)	What is the expected return on the market portfolio? (Round your answer to 2 decimal places. Omit the "%" sign in your response.)

Rate of return

%

(b)	What would be the expected return on a zero-beta stock? (Round your answer to 2 decimal places. Omit the "%" sign in your response.)

Rate of return

%

(c)	Suppose you consider buying a share of stock at a price of $37. The stock is expected to pay a dividend of $4 next year and to sell then for $42. The stock risk has been evaluated at β = -0.5. Is the stock overpriced or underpriced?

(Click to select)overpricedunderpriced

Answer 1

a

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 8.26 + 1 * (12.51 - 8.26)

Expected return% = 12.51

b

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 8.26 + 0 * (12.51 - 8.26)

Expected return% = 8.26

c

As per CAPM

expected return = risk-free rate + beta * (expected return on the market - risk-free rate)

Expected return% = 8.26 + -0.5 * (12.51 - 8.26)

Expected return% = 6.14

expected price = (dividend +selling price)/(1+expected return)

=(4+42)/(1+0.0614)=43.3389

As CMP of 37 is lesser than above value stock is underpriced