Question

1. Suppose the yield on short-term government securities (perceived to be risk-free) is about 3%. Suppose also that the expected return required by the market for a portfolio with a beta of 1 is 13.5%. According to the capital asset pricing model:

a. What is the expected return on the market portfolio?

b. What would be the expected return on a zero-beta stock?

c. Suppose you consider buying a share of stock at a price of $41. The stock is expected to pay a dividend of $2 next year and to sell then for $43. The stock risk has been evaluated at beta = -.5. Is the stock overpriced or underpriced?

Answer 1

a

As per CAPM

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

Expected return% = 3 + 1 * (13.5 - 3)

Expected return% = 13.5

b

As per CAPM

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

Expected return% = 3 + 0 * (13.5 - 3)

Expected return% = 3

c

As per CAPM

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

Expected return% = 3 + -0.5 * (13.5 - 3)

Expected return% = -2.25

intrinsic price = (future price+dividend)/(1+discount rate) = (43+2)/(1-0.0225)=46.035

Stock is underpriced as CMP is less than intrinsic price