Problem $7-06$

As an equity analyst, you have developed the following return forecasts and risk estimates for two different stock mutual funds $($Fund T and Fund U$)$:

Forecasted Return CAPM Beta

Fund T $9\mathrm{.}0\%1\mathrm{.}20$

Fund U $13\mathrm{.}00\mathrm{.}70$

Using only the data shown in the preceding table:

If the risk$-$free rate is $3\mathrm{.}5$ percent and the expected market risk premium $($i$.$e$.,$ E$($R M$)$ RFR$)$ is $6\mathrm{.}9$ percent, calculate the expected return for each mutual fund according to the CAPM. Round your answers to two decimal places.

Fund T:

$\%$

Fund U:

$\%$

Choose the correct SML graph. Note that labels with asterisk denote estimated returns.

The correct graph is

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$.$

A$.$

The graph titled Security market Line shows the relationship between the expected rate of return on an asset and its systematic risk, as measured by beta. The horizontal axis labeled Beta ranges from negative $0\mathrm{.}2$ to $2.$ The vertical axis labeled E$($R$)$ ranges from $0$ to $0\mathrm{.}2.$ The graph shows a line which passes through the following points: $(0,0\mathrm{.}035)$ and $(2,0\mathrm{.}173).$ There are $2$ data points labeled Fund T and Funt U$,$ each represented by a small circle and located at $(1\mathrm{.}2,0\mathrm{.}09)$ and $(0\mathrm{.}7,0\mathrm{.}13),$ respectively.

B$.$

The graph titled Security market Line shows the relationship between the expected rate of return on an asset and its systematic risk, as measured by beta. The horizontal axis labeled Beta ranges from negative $0\mathrm{.}2$ to $2.$ The vertical axis labeled E$($R$)$ ranges from $0$ to $0\mathrm{.}2.$ The graph shows a line which passes through the following points: $(0,0\mathrm{.}015)$ and $(2,0\mathrm{.}153).$ There are $2$ data points labeled Fund T and Funt U$,$ each represented by a small circle and located at $(1\mathrm{.}1,0\mathrm{.}09)$ and $(0\mathrm{.}8,0\mathrm{.}11),$ respectively.

C$.$

The graph titled Security market Line shows the relationship between the expected rate of return on an asset and its systematic risk, as measured by beta. The horizontal axis labeled Beta ranges from negative $0\mathrm{.}2$ to $2.$ The vertical axis labeled E$($R$)$ ranges from $0$ to $0\mathrm{.}2.$ The graph shows a line which passes through the following points: $(0,0\mathrm{.}045)$ and $(2,0\mathrm{.}183).$ There are $2$ data points labeled Fund T and Funt U$,$ each represented by a small circle and located at $(0\mathrm{.}8,0\mathrm{.}11)$ and $(1\mathrm{.}1,0\mathrm{.}11),$ respectively.

D$.$

The graph titled Security market Line shows the relationship between the expected rate of return on an asset and its systematic risk, as measured by beta. The horizontal axis labeled Beta ranges from negative $0\mathrm{.}2$ to $2.$ The vertical axis labeled E$($R$)$ ranges from $0$ to $0\mathrm{.}2.$ The graph shows a line which passes through the following points: $(0,0\mathrm{.}045)$ and $(2,0\mathrm{.}183).$ There are $2$ data points labeled Fund T and Funt U$,$ each represented by a small circle and located at $(1\mathrm{.}1,0\mathrm{.}09)$ and $(0\mathrm{.}7,0\mathrm{.}1033),$ respectively.

According to your analysis, are Funds T and U overvalued, undervalued, or properly valued?

Fund Evaluation

T

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U

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