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 14.0%. According to the capital asset pricing model:

Suppose you consider buying a share of stock at a price of $45. The stock is expected to pay a dividend of $4 next year and to sell then for $47. The stock risk has been evaluated at = 0.5.

Using the SML, calculate the fair rate of return for a stock with a = 0.5. (Negative value should be indicated by a minus sign. Enter your answer as a percentage rounded to 2 decimal places.)

Calculate your expected rate of return for the stock with a = 0.5, using the expected price and dividend for next year. (Enter your answer as a percentage rounded to 2 decimal places.)

Is the stock overpriced or underpriced?

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 14.0%. According to the capital asset pricing model:

Explanation / Answer

c-3. Because the expected return exceeds the

fair return, the stock must be under-

priced.

a. The expected return on the market portfolio Risk-free rate+ Beta(Expected return-risk-free rate) ie.0.06+ 1(0.14-0.06)=0.14 ie.14% b. The expected return on a zero-beta stock is the risk-free rate ie. 6% c-1. Return expected on the stock=( Expected Dividend+ Profit on sale)/ Current market price ie. (4+(47-45))/45= 0.133333 ie. 13.33% Fair return =13.33% * 0.5(beta) 0.0667 ie. 6.67% c-2. Expected return is 13.33%

c-3. Because the expected return exceeds the

fair return, the stock must be under-

priced.

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