Question

Suppose the yield on short-term government securities (perceived to be risk-free) is about 4%. Suppose also that the expected return required by the market for a portfolio with a beta of 1 is 6.0%. According to the capital asset pricing model:

a. What is the expected return on the market portfolio? (Round your answer to 1 decimal place.)

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

Suppose you consider buying a share of stock at a price of $55. The stock is expected to pay a dividend of $6 next year and to sell then for $57. The stock risk has been evaluated at β = –0.5.

c-1. Using the SML, calculate the fair rate of return for a stock with a β = –0.5. (Round your answer to 1 decimal place.)

c-2. Calculate the expected rate of return, using the expected price and dividend for next year. (Round your answer to 2 decimal places.)

c-3. Is the stock overpriced or underpriced?

• Underpriced

• Overpriced

Answer 1

(a)Expected return on market portfolio=

Return required by market for a portfolio of beta 1

=6%

(b)Expected return on zero beta stock = Risk free rate

=4%

(C-1)

Using SML,

Fair rate of return =

Risk free rate + (Market return- Risk free return )* Beta

=4+(6-4)*(-0.5)

=3%

(C-2) Expected return

= ((Expected price - Current price + Dividend )/Current price )*100

=((57-55+6)/55)*100

=14.55%

(C-3) As expected return is greater than fair return or required return ,Hence Stock should be bought and hence Stock is Under valued .