Question
Wilson holds a portfolio that invests equally in three stocks (wAwA = wBwB = wCwC = 1/3). Each stock is described in the following table:
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.)
Stock AStock BStock C00.20.40.60.81.01.21.41.61.82.020181614121086420RATE OF RETURN (Percent)RISK (Beta)
A stock is in equilibrium if its expected return ________________ (options: less than, more than, equal to) 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 _______________ (overvalued, undervalued, in equilibrium) , Stock B is _____________ (overvalued, undervalued, inn equilibrium) , and Stock C is in equilibrium and fairly valued.
Stock A A Stock B RATE OF RETURN (Percent) Stock C 0 0.2 0.4 0.6 1.4 1.6 1.8 2.0 0.8 1.0 1.2 RISK (Beta) Stock A A Stock B RATE OF RETURN (Percent) Stock C 0 0.2 0.4 0.6 1.4 1.6 1.8 2.0 0.8 1.0 1.2 RISK (Beta)Step by Step Solution
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