Question

a. Suggest an example of an asset with zero beta. Explain whether an asset with zero beta offers an expected return of zero.

b. Milton considers buying the ABC stock. The ABC stock pays a constant dividend of $5 in perpetuity, and the beta of the ABC stock is 1.2. The risk-free rate is 4%, and the expected market return is 12%.

i. Compute the price of the ABC stock based on the CAPM.

ii. Suppose the market price of the ABC stock is $40. According to the CAPM, is the stock over-priced or under-priced? Should he buy the ABC stock? Explain.

Answer 1

Solution A:-

Example of Zero Beta Assets is Treasury Bill Government Bonds. A zero beta portfolio is a portfolio which constructs to have zero systematic Risk or in other words a beta of zero.

Zero Beta Portfolio have same expected Return as same as Risk Free Return. Such Portfolio have zero correlation with market Movements and given that its expected return is equals to Risk free Return.

B-

First we need to calculate Required Rate of return as per Capital Assets Pricing Model (CAPM)-

Required Rate of Return = Risk Free Return + Beta * (Market Return - Risk free return)

Required Rate of Return = 4% + 1.20 * (12% - 4%)

Required Rate of Return = 13.6%

(i) To Calculate Price of Stock-

Price =

Price =

Fair Price = $36.76

(ii) Given Actual Price = $40, Fair Price = $36.76.

The Price is Over-priced. As he Should sell the ABC stock. If Actual Price is greater than Fair price then Stock is treated as over-priced.

If Value of Investment is traded at Intrinsic value, then it is treated as fairly valued. when the assets or investments traded away from intrinsic value it should be over-priced or under-priced. Over-priced stock are expected to go lower and under-priced stocks are expected to go higher.

So, this stock is over-priced. Hence to sell this stock at this time. When this stock became lower then buy the same stock. Thanks. Please rate.

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