Question

Accordingto the CAPM, a stock is twice as risky as the market portfolio Theexpected return of the market portfolio is 12 and the risk free rate is 6 Thestock’s price is currently 10 An analyst predicts that the price will be 11 in oneyear According to the analyst, where does this stock plot relative to the SML? Ifthe analyst’s forecast is correct, then by what percentage would the stock’s pricehave to change today in order for it to plot on the SML?

Answer 1

a.

Beta of stock = 2 [twice risky as compared to market]

Rf = 6%, Rm = 12%

Required return = Rf + beta (Rm - Rf) 

                              = 6% + 2*(12%-6%) 

                              = 18%

 

Expected return = P1/P0 - 1 

                              = 11/10 - 1 

                              = 10%

 

Expected return < Required return, so stock is overvalued, will plot below SML

Answer a : Plot below SML

 

b.

Now 

Price after a year = 11, required return = 18%

So price today should be = 11/(1++0.18) = 9.32

So price has to change today = 9.32/10 - 1 

                                                     = - 6.78%

 

Price has to be decreased by 6.78%

Answer b  : decrease of 6.78%

Answer a : Plot below SML

Answer b  : decrease of 6.78%