Question

Assume that the CAPM is a good description of stock price returns. The market expected return is 7% with 10% volatility and the risk-free rate is 3%. New news arrives that does not change any of these numbers but it does change the expected return of the following stocks

	Expected Return	Volatility	Beta
Green Leaf	12%	20%	1.50
NatSam	10%	40%	1.80
HanBel	9%	30%	0.75
Rebecca Automobile	6%	35%	1.20

a. At current market prices, which stocks represent buying opportunities?

b. On which stocks should you put a sell order in?

What are the Alpha % for each stock

Answer 1

a) Required Rate of Green Leaf =Risk Free Rate + Beta*(Market Return-Risk Free Rate) =3%+1.50*(7%-3%)=9%
Since Expected return is greater than required rate of return it provides buying opportunities

Required Rate of Natsam =Risk Free Rate + Beta*(Market Return-Risk Free Rate) =3%+1.80*(7%-3%)=10.2%
Since Expected return is less than required rate of return it doesnot provide buying opportunities

Required Rate of Hanbel =Risk Free Rate + Beta*(Market Return-Risk Free Rate) =3%+0.75*(7%-3%)=6%
Since Expected return is greater than required rate of return it provides buying opportunities

Required Rate of Rebecca Automobile =Risk Free Rate + Beta*(Market Return-Risk Free Rate) =3%+1.20*(7%-3%)=7.8%
Since Expected return is less than required rate of return it doesnot provide buying opportunities


b) On Natsam and Rebecca there should be sell order.
Alpha of Green Leaf =12%-9% =3%
Alpha of Natsam =10%-10.20%=-0.2%
Alpha of Hanbel =9%-6% =3%
Alpha of Rebecca Automobile =6%-7.8% =-1.8%