Question

Additional Problems with Answers Problem 4 Annie is curious to know whether the following 5 stocks (in the next slide) are appropriately valued in the market. Accordingly, she creates a table (shown below) listing the betas of each stock along with their expected return values that have been calculated using a probability distribution. She also lists the current risk-free rate and the expected rate of return on the broad market index. Help her out and state your steps.

Answer 1

Given : Stock Beta Expected Return 26.00% 16.00% 14.00% 16.15% 20.00% 3.50% 15.00% 1 2 3 - 4 5 Rf Rm 1.8 0.9 1.2 1.4 1 Solution:- (Rm-Rf) Step 1: We know that as per CAPM (capital asset pricing model) theory, Ri Rf + Bi X Where, Security return (CAPM Return) Risk free rate Beta of Security Rm Market return Rf Bil Step 2: Hence, using above formula we shall calculate CAPM return for each stock Stock Beta 1 2 3 4 5 Expected Return 26.00% 16.00% 14.00% 16.15% 20.00% 1.8 0.9 1.2 1.1 1.4 CAPM return 24.20% 13.85% 17.30% 16.15% 19.60% - Hence, only Stock 4 is appropiately valued as Expected return = CAPM Return