Financial Markets Home Work 1- The risk-free rate rf-4.5%, the market return rm-

Question

Financial Markets Home Work 1- The risk-free rate rf-4.5%, the market return rm-14.5%, the expected return and beta of stock A and B are as following: Stock return 16% 14% 1.2 0.8 Assuming the CAPM is right, (1) draw the relationship between individual stock i's expected return (in theory) and its beta in the figure (SML) (2) Point the stock A and stock B in the figure, and judge that whether they are overpriced or underpriced at the moment. attention: the expected return here is not the one estimated from historical data, the expected return here may base on investors' mind or is estimated Using Possible Outcomes with Probabilities. The expected return estimated from historical data (sample mean) should exactly equal to the expected return estimated using CAPM, you can use your knowledge on regression to prove it] Assuming CAPM is right, fill in the blank of the table below Security Expected return Standard volatility Correlation with the market 2. Pi,m E(R) Stock A 0.13 0.16 0.25 0.15 0.13 0.12 0.9 0.40 1.1 Stock B Stock C Market index Risk-free rate 0.24 0.75 0.10

Explanation / Answer

1)The equation of SML is E(R)=Rf+(Rm-Rf).beta

Stock A: 16.5=4.5+(14.5-4.5)×1.2

Stock B:12.5=4.5+(14.5-4.5)×.8

2)For stock A ,since expected return is lower than the required return ,stock is overpriced.

For stock B, since expected return is more than required return stock is underpriced.

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