10 B, #3 Keith holds a portfolio that is invested equally in three stocks (WD= W

Question

10 B, #3

Keith holds a portfolio that is invested equally in three stocks (WD= WA following table WI = 1/3). Each stock is described in the Stock Beta Standard Deviation Expected Return DET 0.7 AIL 1.0 INO 1.6 25% 38% 34% 8.0% 10.0% 13.5% 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, is 6%, and the market risk premium [Rpm] is 4%. Use the following graph with the security market line (SML) to plot each stock's beta and expected return Tool tip: Mouse over the points on the graph to see their coordinates. RATE OF RETURN (Percent) 20 18 16 14 12 10 Stock DET Stock AIL Stock INO 0.0 0.2 0.4 0.6 0.8 1.0 1.2 14 1.6 1.8 2.0 RISK (Betal

Explanation / Answer

We know

equation of SML: Required return=risk free+ beta* market risk premium

here, market risk premium=4%

risk free rate=6%

So, return on DET should be 6+0.7*4=8.8% whereas expected return is 8% hence, it is overvalued

So, return on AIL should be 6+1*4=10% whereas expected return is 10% hence, it is fairly valued

So, return on INO should be 6+1.6*4=12.4% whereas expected return is 13.5% hence, it is undervalued

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