$10.$ The Capital Asset Pricing Model and the security market line

Wilson holds a portfolio that invests equally in three stocks $($wA

$=$ wB

$=$ wC

$=1/3).$ Each stock is described in the following table:

Stock

Beta

Standard Deviation

Expected Return

A $0\mathrm{.}523\%7\mathrm{.}5\%$

B $1\mathrm{.}038\%12\mathrm{.}0\%$

C $2\mathrm{.}045\%14\mathrm{.}0\%$

An analyst has used market$-$ and firm$-$specific information to generate expected return estimates for each stock. The analyst$$s expected return estimates may or may not equal the stocks$$ required returns. You$$ve also determined that the risk$-$free rate $[$rRF

$]$ is $4\%,$ and the market risk premium $[$RPM

$]$ is $5\%.$

Given this information, use the following graph of the security market line $($SML$)$ to plot each stock$$s beta and expected return on the graph. $($Note: Click on the points on the graph to see their coordinates.$)$

Stock A

Stock B

Stock C

$0$

$0\mathrm{.}2$

$0\mathrm{.}4$

$0\mathrm{.}6$

$0\mathrm{.}8$

$1\mathrm{.}0$

$1\mathrm{.}2$

$1\mathrm{.}4$

$1\mathrm{.}6$

$1\mathrm{.}8$

$2\mathrm{.}0$

$20$

$18$

$16$

$14$

$12$

$10$

$8$

$6$

$4$

$2$

$0$

RATE OF RETURN $($Percent$)$

RISK $($Beta$)$

A stock is in equilibrium if its required return equals its expected return. In general, assume that markets and stocks are in equilibrium $($or fairly valued$),$ but sometimes investors have different opinions about a stock$$s prospects and may think that a stock is out of equilibrium $($either undervalued or overvalued$).$ Use the analyst$$s expected return estimates to determine if this analyst thinks that each stock in Wilson$$s portfolio is undervalued, overvalued, or fairly valued.

Undervalued

Fairly Valued

Overvalued

Stock A

Stock B

Stock C