Question

Data: Risk-free rate = 2.5%, return on market = 13%, OC stock ẞ = 0.9, and you believe that OC stock will return 11.55% over the next year.

Show the expected return-beta relationship in formulaic terms.

Use the SML [graphically] to demonstrate the relationship between beta and expected return with the data provided below.

Explain alpha and discuss underpriced and over-priced stocks.

Answer 1

Expected Return – Beta relationship in formulaic terms is as follows

E(R) = RFR + β*[E(R­_mkt)­-RFR]

Where:

E(R) = expected return

RFR = risk-free rate (Here 2.5%)

β = Systematic risk (beta) (Here 0.9)

E(R­_mkt)­ = Return on market (Here 13%)

In the case of OC stock

E(R) = 2.5%+0.9*(13% - 2.5%) = 11.95%

Your belief that OC stock would return 11.55% over next year is less than its expected return which implies overpriced stock

SML Graph

Here 11.55% return as believed lies below the SML which implies overpriced share.

Explain alpha and discuss underpriced and over-priced stocks.

Alpha is the actual return earned in excess of expected return for a stock.

Alpha is calculated as follows –

Apha = Actual/ Realized return – { E(R) = RFR + β*[E(R­_mkt)­-RFR]}

Alpha is also referred to as excess return or abnormal rate of return.

Underpriced stocks are those stocks with an expected return greater than its required return from SML and it lies above SML. For e.g. Stock B in the above graph.

Overpriced stocks are those stocks with an expected return less than its required return from SML and it lies below SML. For e.g. Stock A in the above graph.