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

Wilson holds a portfolio that invests equally in three stocks (wAA = wBB = wCC = 1/3). Each stock is described in the following table:

Stock	Beta	Standard Deviation	Expected Return
A	0.5	23%	7.5%
B	1.0	38%	12.0%
C	2.0	45%	14.0%

An analyst has used market- and firm-specific information to generate expected return estimates for each stock. The analysts expected return estimates may or may not equal the stocks required returns. Youve also determined that the risk-free rate [rRFRF] is 4%, and the market risk premium [RPMM] is 5%.

Given this information, use the following graph of the security market line (SML) to plot each stocks beta and expected return on the graph.

Tool tip: Mouse over the points in the graph to see their coordinates.

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 stocks prospects and may think that a stock is out of equilibrium (either undervalued or overvalued). Use the analysts expected return estimates to determine if this analyst thinks that each stock in Wilsons portfolio is undervalued, overvalued, or fairly valued.

	Undervalued	Fairly Valued	Overvalued
Stock A
Stock B
Stock C

? 20 18 Stock A 16 14 O A 12 Stock B RATE OF RETURN (Percent) 10 Stock C O N 0 oft 0.2 0.4 0.6 1.4 1.6 1.8 2.0 0.8 1.0 1.2 RISK (Beta)