The Capital Asset Pricing Model and the security market line Wilson holds a port

Question

The Capital Asset Pricing Model and the security market line Wilson holds a portfolio that invests equally in three stocks (w_A = w_B = w_C = 1/3). Each stock is described in the following table: An analyst has used market- and firm-specific information to make expected return estimates for each stock. The analyst's expected return estimates may or may not equal the stocks' required returns. The risk-free rate [r_RF] is 4%, and the market risk premium [RP_M] is 5%. Use the following graph of the security market line (SML) to plot each stock's beta and expected return on the graph. Tool tip: Mouse over the points on the graph to see their coordinates. 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). Use the analyst's expected return estimates to determine if this analyst thinks that each stock in Wilson's portfolio is undervalued, overvalued, or fairly valued.

Explanation / Answer

Ans.

Calculation of required return (R)

As per CAPM model

R= Risk Free Return + (Market Risk Premium) Beta

If the expected return of the security is less than the return required by CAPM this security would be over valued and therefore should be sold or an investor should maintain a short position.

If the expected return is greater than the return required based on the CAPM, this security would be under valued and therefore an investor would then go long the security because the stock expects to return an amount greater than required based on the risk

Stock A

R= 4% + (5%x0.5)

= 4% +2.5%

= 6.5%

Expected Return= 7.5%

Conclusion: Stock A is under valued

Stock B

R= 4%+ (5%x1)

=4%+5%

=9%

Expected Return=12%

Conclusion: Stock B is under valued

Stock C

R= 4% + (5%x2)

=4% + 10%

=14%

Expected Return=14%

Conclusion: Stock C is fairly valued

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