Question

The risk-free rate of return is 4%, and the market return is 10%. The betas of Stocks A, B, C, D, and E are 0.85, 0.75, 1.20, 1.35, and 0.5 respectively. The expected rates of return for Stocks A, B, C, D, and E are 7%, 9%, 9.5%, 12.1%, and 14% respectively. Which of the above stocks would an investor be indifferent towards buying or selling?

Answer 1

Stock D as their expected return matches the Capital Assets Price Models

Step-by-step explanation:

We have to calcualte the CAPM for each stock and look which matches with the expected rate of return:

`Ke= r_f + \beta (r_m-r_f)`

risk free = 0.04

market rate = 0.1

premium market = (market rate - risk free) 0.06

Stock A

beta(non diversifiable risk) = 0.85

`Ke= 0.04 + 0.85 (0.06)`

Ke 0.09100 = 9.1%

Expected return: 7% it would prefer to sale

Stock B

beta(non diversifiable risk) = 0.75

`Ke= 0.04 + 0.75 (0.06)`

Ke 0.08500 = 8.5%

Expected return: 9% it would prefer to purchase as it offer more

Stock C

beta(non diversifiable risk) = 1.2

`Ke= 0.04 + 1.2 (0.06)`

Ke 0.11200 = 11.20%

Expected return: 9.5% it would prefer to sale

Stock D

beta(non diversifiable risk) = 1.35

`Ke= 0.04 + 1.35 (0.06)`

Ke 0.12100 = 12.1%

Expected return: 12.1% Indifferent as it is mathces the CAMP the stock is neither overperforming nor underperforming

Stock E

beta(non diversifiable risk) = 0.5

`Ke= 0.04 + 0.5 (0.06)`

Ke 0.07000 = 7%

Return = 14% It would prefer to purchase as it offer more