There are currently two stocks A and B available for Peter Clark to choose for portfolio construction.
Question:
There are currently two stocks A and B available for Peter Clark to choose for portfolio construction. The past returns of the two stocks are shown below
Stock A 1% 2% 3% 4% 5%
Stock B 4% 5% 6% 7% 8%
Stock A has a beta of 0.6 and Stock B has a beta of 1.3. The T-bill rate is 3% and market expected rate of return is 10%. If we refer to the arithmetic average of past stock return as stock’s expected rate of return, identify whether the two stocks are undervalued or overvalued under the CAPM. What are the alphas of the two stocks? How should Peter trade the two stocks? Should he buy or short sell each one?
Useful formulas:
Required rate of return: E(rP) = rf + βP × [E(rM ) – rf ]; = Expected rate of return – required rate of return (CAPM return)
Expert Answer:
Using the CAPM model we can calculate the expected return for each stock using the following ... View the full answer
