Tut6_2009+Sols - BUS3026W Finance II 2007 - Tutorial 6...

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BUS3026W Finance II 2007 - Tutorial 6 Solutions ______________________________________________________________ Question One Remember that the Forecast return is the return we predict for the share. The CAPM return is the fair return of the share based on our CAPM assumptions. a. For A, according to the CAPM: E (R A ) = r f + β A (R m – r f ) = 5 + 1.5 (21 – 5) = 29% Our forecast return is higher than the CAPM prediction and therefore the share is underpriced. If we plotted it on the SML line it would plot above the line. For B, according to the CAPM: E (R B ) = r f + β B (R m – r f ) = 5 + 0.5 (21 – 5) = 13% Our forecast return is lower than the CAPM prediction and therefore the share is overpriced. If we plotted it on the SML line it would plot below the line. b. In the case of A, those who accurately predicted the mispricing would buy the share therefore increasing demand. As demand increases, the price of the share increases as well thereby reducing the return that can be earned by holding the share. This would gradually push the expected share return back down to that predicted by the CAPM and it would again be fairly priced. At this point the share would again plot on the SML. The reverse is true for B. Those who accurately predicted the
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Tut6_2009+Sols - BUS3026W Finance II 2007 - Tutorial 6...

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