Suppose the yield on short-term government securities perceived to be risk-free

Question

Suppose the yield on short-term government securities perceived to be risk-free is about 6%. Suppose also that the expected return required by the market for a portfolio with a beta of 1 is 16.0%. According to the capital asset pricing model: a. What is the expected return on the market portfolio? (Round your answer to 1 decimal place.) Expected rate of return b. What would be the expected return on a zero-beta stock? Expected rate of return Suppose you consider buying a share of stock at a price of $65. The stock is expected to pay a dividend of $8 next year and to sell then for $68. The stock risk has been evaluated at p- 0.5 c-1. Using the SML, calculate the fair rate of return for a stock with a ? =-0.5. (Round your answer to 1 decimal place.) Fair rate of return c-2. Calculate the expected rate of return, using the expected price and dividend for next year. (Round your answer to 2 decimal places.) Expected rate of return c-3. Is the stock overpriced or underpriced? Underpriced O Overpriced

Explanation / Answer

a). As the market portfolio has a beta of 1, Hence, the expected return of market = 16%

b). zero-beta stock means that the stock has no systematic risk, hence the return would be equal to the risk free rate. Thus, E(r) = 6%.

c-1). Usine the SML,

E(r) = Rf + beta[E(rm) - Rf]

= 6% + (-0.5)[16% - 6%]

= 6% - 5% = 1%

c-2). According to HPR,

E(r) = (P1 + D1 - P0)/P0

= ($68 + $8 - $65)/$65 = 16.92%

c-3). As the fair return is less than the expected return, the stock ought to be under-priced.

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