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

Keith holds a portfolio that is invested equally in three stocks (wDwD = wAwA = wIwI = 1/3). Each stock is described in the following table:

Stock	Beta	Standard Deviation	Expected Return
DET	0.7	25%	8.0%
AIL	1.0	38%	10.0%
INO	1.6	34%	13.5%

An analyst has used market- and firm-specific information to make expected return estimates for each stock. The analysts expected return estimates may or may not equal the stocks required returns.

The risk-free rate [rRFrRF] is 6%, and the market risk premium [RPMRPM] is 4%. Use the following graph with the security market line (SML) to plot each stocks beta and expected return. (Note: Click on the points on the graph to see their coordinates.)

Stock DETStock AILStock INO00.20.40.60.81.01.21.41.61.82.020181614121086420RATE OF RETURN (Percent)RISK (Beta)

A stock is in equilibrium if its required return its expected return. In general, assume that markets and stocks are in equilibrium (or fairly valued), but sometimes investors have different opinions about a stocks prospects and may think that a stock is out of equilibrium (either undervalued or overvalued). Based on the analysts expected return estimates, stock INO is , stock AIL is in equilibrium, and