Question

8. The Capital Asset Pricing Model and the security market line

Wilson holds a portfolio that invests equally in three stocks (wAwA = wBwB = wCwC = 1/3). Each stock is described in the following table:

Stock	Beta	Standard Deviation	Expected Return
A	0.5	23%	7.5%
B	1.0	38%	12.0%
C	2.0	45%	14.0%

An analyst has used market- and firm-specific information to generate expected return estimates for each stock. The analyst’s expected return estimates may or may not equal the stocks’ required returns. You’ve also determined that the risk-free rate [rRFrRF] is 4%, and the market risk premium [RPMRPM] is 5%.

Given this information, use the following graph of the security market line (SML) to plot each stock’s beta and expected return on the graph. (Note: Click on the points on the graph to see their coordinates.)

A stock is in equilibrium if its expected return_______ its required return. In general, assume that markets and stocks are in equilibrium (or fairly valued), but sometimes investors have different opinions about a stock’s prospects and may think that a stock is out of equilibrium (either undervalued or overvalued). Based on the analyst’s expected return estimates, Stock A is______ Stock B is ________and Stock C is in equilibrium and fairly valued.

OPTIONS:

IN EQUILIBRIUM

UNDERVALUED

OVERVALUED

Answer 1

Answer:

A stock is in equilibrium if its required return equals its expected return. In general, assume that markets and stocks are in equilibrium (or fairly valued), but sometimes investors have different opinions about a stock's prospects and may think that a stock is out of equilibrium (either undervalued or overvalued).

based on the stock expected reurn estimates Stock A is   Under Valued     stock B is Undervalued   Stock C is    in equilibrium and fairly valued

In Case Fair Return > Actual Expected Return = Stock is Over Valued

Fair Return < Actual Expected Return = Stock is Under Valued

Fair Return = Actual Expected Return = Stock is Fairly Valued

Working notes for the above answer is as under

Stock-A

R_A =R_f +Ba (RP_M)

=4% +0.5(5%)

Fair Return =6.5%

Expected Return = 7.5%

So Stock A is Under Valued

Stock-B

R_A =R_f +Ba (RP_M)

=4% +1(5%)

Fair Return =9%

Expected Reurn is 12%

So Stock B is under valued

Stock-C

R_A =R_f +Ba (RP_M)

=4% +2(5%)

Fair Return =14%

Expected Return = 14%

So Stock C is Fairly Valued

If there is any doubt please ask in comments