Question

(2) Stock Y has a beta of 1.30 and an expected return of 15.3%. Stock Z has a beta of 0.70 and an expected return of 9.3%. If the risk-free rate is 5.5% and the market risk premium is 6.8%, are these stocks correctly priced? (

3) You have one million USD and want to create a portfolio equally as risky as the market. Given this information, fill in the rest of the following table: Asset Investment Beta Stock A $195,000 beta 0.90 Stock B $340,000 beta 1.15 Stock C ? 1.29 Risk-free asset ?

(4) Suppose you observe the following situation: Security Beta Expected Return Pete Corp. 1.15 12.90% Repete Co. 0.84 10.20% Assume the two securities are correctly priced. Based on CAPM, what is the expected return on the market? What is the risk-free rate?

Answer 1

(2)

Capital asset Pricing Model (CAPM) return is considered to be the minimum possible return which company must give. It can also be termed as Fair return.

It can be compated to actual or expected returns to determine whether stock is correctly valued , over valued or undervalued.

CAPM Return = Risk free return + Beta of stock ( Market risk premium)

Given :-

Risk free rate =5.5 %

Market risk Premium = 6.8%

Particulars	Beta	Expected Return
Stock Y	1.30	15.3%
Stock Z	0.70	9.3%

CAPM of Stock Y =  5.5 +1.30 ( 6.8)

= 5.5 + 8.84

= 14.34 %

CAPM of Stock Z =  5.5 +0.70 ( 6.8)

= 5.5 + 4.76

= 10.26 %

Particulars	CAPM Return	Expected Return	Valuation
Stock Y	14.34%	15.3%	Under Valued
Stock Z	10.26%	9.3%	Over Valued

Thesze stocks are not correctly priced. In case opf Stock Y the fair return is lesser than the expectation, due to which stock is under valued and in stock Z fair return is higher than expected returns making it over valued.

The correct valuation is when CAPM return = Exoected return