Assignment 08 - Risk and Rates of Return Due on Tomorrow at 11:59 PM EST Wilson
ID: 2786031 • Letter: A
Question
Assignment 08 - Risk and Rates of Return Due on Tomorrow at 11:59 PM EST Wilson holds a portfolio that invests equally in three stocks (WA WB WC1/3). Each stock is described in the following table: Stock Beta Standard Deviation Expected Return A 0.5 B 1.0 C 2.0 23% 38% 45% 7.5% 12.0% 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 [rRF] is 4%, and the market risk premium [RPm] is 5%.Explanation / Answer
A stock is in equilibrium if its expected return is equal to its required return.
Based on analyst estimates ,
Stock A = 4% + 0.5* ( 5%) = 6.5% (Over valued) 7.5%
Stock B =4% + 1 (5%) = 9% (Over valued) 12%
Stock C = 4% + 2*(5%) = 14% (Fairly valued) 14%
When expected return using CAPM is higher than the required return then the security is undervalued and when expected return using CAPM is less than the required return then the security is overvalued.