Question

The risk-free rate for the next year is 3%, and the market risk premium is expected to be 6%. The beta of XYZ stock is 1.5. If you believe that XYZ’s stock will actually return 14% over the next year, then according to the CAPM you should:

a.

buy the stock because it is under priced.

b.

sell the stock because it is overpriced.

c.

sell the stock because it is under priced.

d.

be indifferent between buying and selling the stock.

Answer 1

As per the question

Rf is the risk free rate of return = 3%

Market risk premium= Rm-Rf= 6%

Beta of the stock= 1.5

As per CAPM the required return from the stock should be =Rf+Beta*(Rm-Rf)

Rm-Rf is the premium that one will get by investing in the market rater than investing in Rf

Beta shows the relation between market and stock price

so Required return from XYZ stock= 3%+1.5*(6%)= 12%

But we are expecting that the stock will actually return is 14%

So the stock will give us more than the required return i.e 12% so one should buy the stock. As pricing is dependent on the CAPM return so it would have been undervalued. If expected retun from stock increases then its price of the stock will increase. so its price has to be decided based on 14% and the present price is decided based on CAPM return of 12% so it is undervalued.

So answer is a Buy the stock it is undervalued