Question

Question 2

You plan to invest part of your savings and are examining the following data:

	Expected Return	Beta
Yield to maturity on 10-year government bonds	2%
Stock A	20%	1.3
Stock B	9%	1.1
Stock C	7%	0.5
Portfolio D	10%	1.0

(a) If only Portfolio D is correctly priced, are stocks A, B and C correctly priced? If not, what investment action would you recommend for each stock to take advantage of the price anomaly?

(b) Company X has just paid a dividend of $0.20 per share. The company expects dividends to grow at 5% per annum for the foreseeable future. It is trading at $10 in the market. You feel that, given the risk of this company, your required return on this stock is 8%. Is the market assigning a lower or higher risk to this stock compared to its fair value? Appraise this observation in relation to the SML
.

Answer 1

(a)

If a stock is correctcly priced then, its-

Expected return = Required return as per CAPM

As per CAPM , the required return in the stock , Ke = Rf+ Beta* market risk premium

Rf = Risk free return

here 10-year government bonds is the risk free asset as Govt bonds has zero risk.

Hence risk free return = 2%

if D is correctly priced then its Expected return = Required return as per CAPM

=>10% = 2%+ 1.0*Market risk premium

=> Market risk premium = 8%.

CAPM return is also know as the MINIMUM REQUIRED RETURN.

Stock	Rf	Beta	Market risk premium	Required return or CAPM return	Expected return	Whether Correctly priced		Decision	Reason	In simple term
A	2%	1.3	8%	12.40%	20%	NO	Underpriced	Buy	Expected return from the stock is More than the Minimum required return	Stock will give more return than the minimum required return
B	2%	1.1	8%	10.80%	9%	NO	Overpriced	sell	Expected return from the stock is less than the Minimum required return	Stock will give less return than the minimum required return
C	2%	0.5	8%	6.00%	7%	NO	Underpriced	Buy	Expected return from the stock is More than the Minimum required return	Stock will give more return than the minimum required return
D	2%	1	8%	10.00%	10%	YES	Correctly priced	Hold/Buy	Expected return= Minimimum return

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(b)

Fair price of the share (P0) =

D0 = recently paid dividend= $0.20

g = growth rate = 5% or 0.05

Ke or required return in the stock = 8% or 0.08.

hence

Fair price of the share (P0) =

the fair price of the stock = $7

but its trading at $10 per share in the market, hence the share is Over priced.

All the Corrctly priced share will be on the SML line or security market line.

Over priced share will be under the SML line and have lower risk assigned.

SML line is a representation of CAPM model.

Now if P0 = $10, then the market assigned required return or market assigned Ke will be

=> Market assigned Ke = 0.071 or 7.1%

the market has assigned lower Ke or return of 7.10%.

As we know that the more the risk the more the return and the less the risk the less the return.

hence the market has assigned Lower risk and hence assumed lower required. return