Keith holds a portfolio that is invested equally in three stocks (wD = wA = w-1/

Question

Keith holds a portfolio that is invested equally in three stocks (wD = wA = w-1/3). Each stock is described in the following table 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 [Rr] 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 Stock DET Stock AIL 12 Stock INO 10 0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 RISK (Beta) Clear All

Explanation / Answer

Required return =Rf + [Beta*Market risk premium]

If required return is less than expected return ,Your stock is undervalued or you will buy the stock.

if required return is more than expected return ,Your stock is overvalued or you will sell the stock.

stock Required return Required return Expected return valuation DET [6+ (.7*4] = 6 + 2.8 8.8 8 overvalued AIL [6 + (1*4)] = 6 + 4 10 10 Fairly valued INO [6 + (1.6*4)] = 6 +6.4 12.40 13.5 undervalued

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