Question

Assume that the CAPM is a good description of stock price returns. The market expected return is 7% with 10% volatility and the risk-free rate is 3%. New news arrives that does not change any of these numbers but it does change the expected return of the following stocks:

Expected Return Volatility Beta
Green Leaf 12% 20% 1.5
NatSam 10% 40% 1.8
HanBel 9% 30% 0.75
Rebecca Automobile 6% 35% 1.2
At current market prices, which stocks represent buying opportunities?

Answer 1

Green Leaf and NatSam represent buying opportunities based on their higher expected returns than the market.

Step-by-step explanation:

According to the CAPM, the expected return on a stock is determined by its beta. The beta measures the stock's sensitivity to market movements. A stock with a beta greater than 1 is expected to have higher returns than the market, while a stock with a beta less than 1 is expected to have lower returns.

In this case, the stocks with higher expected returns than the market are Green Leaf (12%) and NatSam (10%). These stocks have betas of 1.5 and 1.8, respectively. Therefore, these stocks represent buying opportunities.

On the other hand, HanBel (9%) and Rebecca Automobile (6%) have lower expected returns than the market. HanBel has a beta of 0.75, indicating lower sensitivity to market movements, while Rebecca Automobile has a beta of 1.2. These stocks may not be attractive buying opportunities based on their expected returns.