A stock is expected to pay an annual dividend of $4 each year into the indefinite...
A stock is expected to pay an annual dividend of $4 each year into the indefinite future. Rates of return on equally risky assets are 4%(0.04). The stock price is $120. Is there a bubble on this stock? How do you know? How big is the bubble? To be consistent with no arbitrage possibilities, what price are people expecting the stock will have next year? Explain. What price is it expected to have in 2 years?
Homework Answers
Current stock price = $4/ 4% = $100
The realistic price as per the risk undertaken and the expected return on the stock is $100 whereas it is priced at $120 which is way bit higher than the expected price. Therefore, it can be concluded that there is a bubble on this stock. The bubble is as big as $20 ( $120 - $100) or simply put 20% is the bubble. Since there are no arbitrage possibilities i.e. the stock is not speculative and the dividend rate is constant , the price of the stock will remain $100 next year and in the next years as well.
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