Question

You are analysing four different stocks. The expected market return is 10% with a standard deviation of 20%. The risk free-rate is 2%. Assume the Capital Asset Pricing Model (CAPM) holds and you base your conclusion completely on CAPM. Indicate in the table below which of the following securities is underpriced, overpriced or correctly priced.

Security	Expected Return	Standard Deviation	Beta	Price?
Omega	16%	25%	1.5
Psi	5%	3%	0.5
Chi	10%	17%	1.2
Phi	6%	4%	0.3

Answer 1

As per CAPM,
As per CAPM,

Rf = Risk free Return = 2%

Rm = Market return = 10%

i). Beta of Omega = 1.5

Required Return of Omega = 2% + 1.5 (10% - 2%)

Required Return of Omega = 14%

Expected Return of Omega = 16%

As, Required Return < Expected Return, Stock is Underpriced.

ii). Beta of Psi= 0.5

Required Return of Omega = 2% + 0.5 (10% - 2%)

Required Return of Omega = 6%

Expected Return of Omega = 5%

As, Required Return > Expected Return, Stock is Overpriced.

iii). Beta of Omega = 1.2

Required Return of Omega = 2% + 1.2(10% - 2%)

Required Return of Omega = 11.6%

Expected Return of Omega = 10%

As, Required Return > Expected Return, Stock is Overpriced.

iv). Beta of Omega = 0.3

Required Return of Omega = 2% + 0.3(10% - 2%)

Required Return of Omega = 4.4%

Expected Return of Omega = 6%

As, Required Return < Expected Return, Stock is Underpriced.

Security	Expected Return	Standard Deviation	Beta	Price?
Omega	16%	25%	1.5	Underpriced
Psi	5%	3%	0.5	Overpriced
Chi	10%	17%	1.2	Overpriced.
Phi	6%	4%	0.3	Underpriced