You have come across an asset that pays no dividends but has an expected price o

Question

You have come across an asset that pays no dividends but has an expected price of $100 an year from now. The correlation of this asset with the market portfolio is believed to be 0.5. The standard deviation of the return is believed to be 30%. The riskfree rate of return is 4%, and the expected return on the market portfolio is 14% with a standard deviation of 20%. a. If the price of this asset is $80 today, according to CAPM should you be buying or short selling this asset (or just selling it if you actually own it). b. If all participants in the market followed your strategy what would happen to the price of this asset, and respectively its return? c. According to the CAPM at what price should investors attempt to neither buy nor sell shares of this asset.

Explanation / Answer

According to CAPM equation:

Expected return on Stock = Risk free rate + Beta *(Expected market return - Risk free rate )

Risk free rate = 4%

Expected market return = 14%

Beta = Standard Deviation (Stock) *Correlation (Asset & market) / Standard Deviation (Market)

= (30% * 0.5) /20%

= 0.75

Hence ,

Expected return on Stock = 4% + 0.75*(14%-4%)

= 4% + 7.5%

= 11.50%

A. Current Price of Stock for expected return of 11.50% = $100 / (1+11.50%)

= $89.69

Actual Price of the asset = $80

We can see that asset is underpriced so we should buy it .

B. If all participants in the market followed this strategy, the price of the asset shall increase due to higher demand.

C. According to the CAPM at $89.69 price investors should attempt to neither buy nor sell shares of this asset.

Related Questions

Navigate

• Browse (All)
• Browse Y
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.