Suppose the rate of return on short-term government securities (perceived to be

Question

Suppose the rate of return on short-term government securities (perceived to be risk-free) is about 7%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 14%. According to the capital asset pricing model: What is the expected rate of return on the market portfolio? (Round your answer to 2 decimal places. Omit the "%" sign in your response.) What would be the expected rate of return on a stock with beta = 0? (Round your answer to 2 decimal places. Omit the "%" sign in your response.) Suppose you consider buying a share of stock at $51. The stock is expected to pay $2 dividends next year and you expect it to sell then for $53. The stock risk has been evaluated at beta = -.5. Is the stock overpriced or underpriced? Underpriced Overpriced

Explanation / Answer

a. Expected Rate of Return on the Market Portfolio= Rf + Beta (Rm-Rf)

= 7 + 1(14-7) = 14 %

b. Expected Rate of Return on Stock= Rf + Beta (Rm-Rf)

= 7 + 0(14-7) = 7%

c. Using SML , the fair return on the stock is :

E (r) = 7 + (-0.5) * (14-7) = 7 - 3.5 = 3.5 %

The expected rate of return , using the expected price of the stock and dividend paid

E(r) = ((Expected Price + Dividend)/Buying price) - 1

= ((53+2)/51)-1 = 1.0784-1 = 7.84 %

Since the expected retrn ecxceeds the fair return, we can come to conclution that the stock is underpriced.

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