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You expect the risk-free rate to be 3 per cent and the market return to be 8 per cent. You also have the following information about three stocks.   CurrentExpectedExpectedShareBetaPricePriceDividendX1.5$11$9$0.5Y1.0$17$21$0.2Z0.8$30$31$0.3    Using the CAPM, what is your investment strategy about stocks X, Y, and Z?Group of answer choicesSell X, Y and ZSell X and Z, buy YSell Y and Z, buy XBuy X, Y and Z

Question

You expect the risk-free rate to be 3 per cent and the market return to be 8 per cent. You also have the following information about three stocks.   CurrentExpectedExpectedShareBetaPricePriceDividendX1.5111190.5Y1.00.5Y1.01721210.2Z0.8303031$0.3    Using the CAPM, what is your investment strategy about stocks X, Y, and Z?Group of answer choicesSell X, Y and ZSell X and Z, buy YSell Y and Z, buy XBuy X, Y and Z

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Solution

To determine the investment strategy using the Capital Asset Pricing Model (CAPM), we first need to calculate the expected return for each stock. The formula for CAPM is:

Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)

Let's calculate the expected return for each stock:

  1. Stock X: Expected Return = 3% + 1.5 * (8% - 3%) = 10.5%

  2. Stock Y: Expected Return = 3% + 1.0 * (8% - 3%) = 8%

  3. Stock Z: Expected Return = 3% + 0.8 * (8% - 3%) = 7%

Next, we calculate the expected total return for each stock, which includes the expected price appreciation and the dividend yield. The formula for total return is:

Total Return = (Expected Price - Current Price + Dividend) / Current Price

  1. Stock X: Total Return = (9−9 - 11 + 0.5)/0.5) / 11 = -13.64%

  2. Stock Y: Total Return = (21−21 - 17 + 0.2)/0.2) / 17 = 24.71%

  3. Stock Z: Total Return = (31−31 - 30 + 0.3)/0.3) / 30 = 4.33%

Comparing the expected return from CAPM with the total return:

  • Stock X: The expected return (10.5%) is higher than the total return (-13.64%). This suggests that the stock is overpriced, and the strategy would be to sell.

  • Stock Y: The expected return (8%) is lower than the total return (24.71%). This suggests that the stock is underpriced, and the strategy would be to buy.

  • Stock Z: The expected return (7%) is higher than the total return (4.33%). This suggests that the stock is overpriced, and the strategy would be to sell.

So, the investment strategy would be to sell stocks X and Z, and buy stock Y.

This problem has been solved

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