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

Wilson holds a portfolio that invests equally in three stocks (wAwA = wBwB = wCwC = 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 [rRFrRF] is 4%, and the market risk premium [RPMRPM] 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. (Note: Click on the points on the graph to see their coordinates.)

A stock is in equilibrium if its expected return_______ its required 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 A is______ Stock B is ________and Stock C is in equilibrium and fairly valued.

OPTIONS:

IN EQUILIBRIUM

UNDERVALUED

OVERVALUED