Question

Question 2

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

a)

An asset with zero beta means that irrespective of the market risk and movements in market , the correlation with the market will be zero. An example of such as asset is risk free asset like treasury bonds and cash. Using CAPM, the expected return on asset = Risk free rate + Beta * MRP

As Beta is zero, Expected return on asset = Risk free rate, so the expected return will not be zero as it will be equal to risk free rate. However, risk free rate like treasury bill rate can fall to zero and in such circumstances, the expected return can be zero.

b)

Risk free rate = 4%

beta = 1.2

Expected market return = 12%

Market risk premium, MRP = 12% - 4% =8%

Expected return on ABC stock, ke = 4% + 1.2* 8% = 13.6%

Constant dividend ,D = $ 5

i)

Price of ABC stock, IV = D/ke = 5/13.6% = $ 36.76

ii)

As Market Price ($40) > Intrinsic Value (IV), the stock is overpriced in the market. As such, he should not buy the stock in the market.