7. The Capital Asset Pricing Model and the security market line Keith holds a portfolio that is invested equally in three stocks (WD = WA = WI = 1/3). Each stock is described in the following table: Stock Beta Standard Deviation Expected Return 8.0% DET 0.7 25% 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 analyst's expected return estimates may or may not equal the stocks' required returns. The risk-free rate (IRF) is 6%, and the market risk premium (RPM) is 4%. Use the following graph with the security market line (SML) to plot each stock's beta and expected return. (Note: Click on the points on the graph to see their coordinates.) ? 20 18 Stock DET 16 14 12 Stock AIL RATE OF RETURN (Percent) 10 Stock INO 4 2 0 0.2 0.4 0.6 1.4 1.6 1.8 2.0 0.8 1.0 1.2 RISK (Beta) A stock is in equilibrium if its required return equals its expected return. In general, assume that markets and stock 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 Keith's portfolio is undervalued, overvalued, or fairly valued. Undervalued Fairly Valued Overvalued Stock DET Stock AIL Stock INO