the risk free rate is 5%. the expected Market return is 11%. if you expect stock
ID: 2807804 • Letter: T
Question
the risk free rate is 5%. the expected Market return is 11%. if you expect stock x with a beta of 2.1 to offer a rate of return of 15% you should. ....
a. buyt stock x because it is over priced
b. sell short stock x because it is overpriced
c. sell short stock x because it is under priced
d. buy stock x because it is underpriced
your opinion is that csco has an expected rate of return of .13 and beta of 1.3. the risk free rate is .04 and the market expected rate of return is .115. according to the CAPM, this security is......
a. underpriced
b. overpriced
c. fairly priced
d. can't be determined from data provided
Explanation / Answer
(A)
Risk Free Rate = 5 %, Market Return = 11%, Stock Beta = 2.1
Therefore, by CAPM fair market stock return = Risk Free Rate + Stock Beta x (Market Return - Risk Free Rate)
= 5 + 2.1 x (11 - 5)
= 17.6 %
The Investor expected return (or investor's minimum return) is 15% which is lower than the fair value return of 17.6% thereby making the stock undervalued. The investor should buy the stock x as it is underpriced.
Hence correct answer is option (d).
(B) Stock Beta =1.3, Risk Free Rate = 4% and Market Return = 11.5%
Therefore, Fair Return as per CAPM = Risk Free Rate + Stock Beta x (Market Return - Risk Free Rate) = 4 + 1.3 x (11.5 - 4) = 13.75 %
Expected Stock Return =13% which is less than the fair return (by CAPM) of 13.75% , thereby making the stock underpriced.
Hence correct answer is option (a).
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