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
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
This is the end of the preview.
Sign up
to
access the rest of the document.
 Summer '09
 DrToerien
 Capital Asset Pricing Model, 5%, Modern portfolio theory, 11%, mispricing

Click to edit the document details