(1) Suppose in one year period the risk-free interest rate is 5%, a market portf

Question

(1) Suppose in one year period the risk-free interest rate is 5%, a market portfolio M has the expected return 9% and variance 4%. Assume the covariance between an asset i and M is 8%.

(1a) What is the expected return Eri for asset i predicted by CAPM?

(1b) If an estimated annual return Eri is 11% based on some market data, would you say the asset i is overpriced or underpriced? Why?

(1c) Based on the annual return 11%, what do you think the current price for asset i should be so that the expected price in one year would be $50?

Explanation / Answer

Beta = Covariance (i, m) /Variance(i) = 0.08/0.04 = 2

Predicted return = Rf + (Beta(Rf-Rm) = 5+2(9-5) = 13%

If expected return is 11 which is less than predicted return, we can see that the asset is overpriced. An overpriced asset has a lower than expected return.

3) if the expected price in one year is 50, current price would be 50/(1+r) = 50/(1+0.11) = 50/1.11= 45.05

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