Question

CAPM and Security Pricing Stock A has an expected return of 28% and a beta of 2.3. Stock B has an expected return of 28% and a beta of 2.3 when the risk free rate is 6%. Which of the following statements are correct?

I. Stock A is underpriced relative to Stock B

II. Stock B is underpriced relative to Stock A

III. This situation is inconsistent with the CAPM

IV. This situation is consistent with the CAPM

Multiple Choice:

• II and IV only

• I and III only

• II and III only

• I and IV only

Answer 1

Stock A return Re=28% beta =2.3

Stock B return Re =28% beta=2.3

As per CAPM expected return Re is given by the relation

Re = Rf+ β (Rm-Rf)

In this case for both A & B, Re and β are equal. Rf applicable is also the same.

Thus from CAPM perspective, both A & B should be equally priced

Thus if we were to look at the options provided, the option 1 or 2 of either A or B being under or over priced is an inconsistent scenario as per CAPM.

Thus if we combine option II and III, this is the correct combination as B being underpriced w.r.t A is an inconsistent scenario as per CAPM.