10. The expected returns and betas of two stock A & B are shown in the table bel

Question

10. The expected returns and betas of two stock A & B are shown in the table below. The expected market return as represented by the S&P 500 is 10% and the risk free rate is 5%. Circle true or false for the statements below.

Stock

Expected Return

Beta

A

11%

1.2

B

14%

1.5

a. The fair value of return of stock A is 11%-------True or False

b. Stock B can be bought at a bargain--------True or False

c. Stock A is over-priced------True or False

d. Stock A is better because it’s less risky-----True or False

e. The fair-value return of stock B is 12.5%-----True or False

Stock

Expected Return

Beta

A

11%

1.2

B

14%

1.5

Explanation / Answer

Solution:

1. False because the expected return equals the required return on stock

Using CAPM,

Required return = Rf + beta*(Rm - Rf) = 5% + 1.2*(10% - 5%) = 11%

2. True

Stock B can be bought at a bargain because there is difference between its expected return and required return.

3. False

It is not overpriced. It is correctly priced because expected return = required return.

4. False

Since it is less risky but the return is also lower. Therefore, it is not better.

5. True

Using CAPM,

Required return = Rf + beta*(Rm - Rf) = 5% + 1.5*(10% - 5%) = 12.5%

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