Question

Please complete the sentence.
If the excess return of the S&P 500 is 18 and the ratio excess return over beta for the firm CAL is 23, then ________ .
Select one:
It cannot be determined
CAL is fairly priced
CAL is overpriced
CAL is underpriced

Answer 1

If the excess return of the S&P 500 is 18 and the ratio excess return over beta for the firm CAL is 23, then ________.

A. It cannot be determined.

Explanation:

While determining the returns on an asset or portfolio, it is important to consider the alpha as well as beta as metrics of the historical performance of a portfolio. The expected return of the security/investment cannot be determined as beta is unavailable.

Alpha is a measure of the actual performance of the security in relation to the benchmark index like the S&P 500 or any other, while beta is a measure of the volatility of the stock.

The Capital Asset pricing model(CAPM) uses a variety of input factors to calculate the expected return on an asset. They are the risk-free rate, beta, and the expected rate of return on the market.

So as per the CAPM, the expected return on an asset would be:

ERi = Rf + βi(ERm-Rf),

Where:

ERi = Expected return of investment, Rf = Risk-free rate, βi = Beta of the security,
ERm = Expected return of the market,
(ERm – Rf) = The market risk premium, which is the excess of the market return over the risk-free rate.

So, if for instance, one wishes to invest in a security of face value of Rs 100, with a beta of 1.5. Assuming that the benchmark index or risk-free return stands at 5% and the stock is expected to appreciate by 10% per annum, the expected return on the security would work out to be :

ERi = βi(ERm-Rf)

= 5%+ 1.5(10%- 5%)

= 5% + 1.5(5%)

= 12.5%

The expected return may be used to discount future cash flows (dividends). If the discounted value is equal to Rs 100, then the stock can be said to be fairly valued.

If the value is less than Rs. 100, then the security would be overvalued and vice-versa.

* With inputs from print and digital sources where required.