The stock of BP, a flood insurance provider, has a marketed beta of .8. The risk free rate is 3%. You estimate that the market risk premium is 5%. Compute the expected return for BP stock. Assume that BP’s true expected return is 8%. What is BP’s stock’s alpha assuming that CAPM is the correct asset pricing model? Is BP stock fairly priced, underpriced, or overpriced? Please explain your answer
The stock of BP, a flood insurance provider, has a marketed beta of .8. The risk free rate is 3%. You estimate that the market risk premium is 5%. Compute the expected return for BP stock. Assume that BP’s true expected return is 8%. What is BP’s stock’s alpha assuming that CAPM is the correct asset pricing model? Is BP stock fairly priced, underpriced, or overpriced? Please explain your answer
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Question
The stock of BP, a flood insurance provider, has a marketed beta of .8. The risk free rate is 3%. You estimate that the market risk premium is 5%. Compute the expected return for BP stock. Assume that BP’s true expected return is 8%. What is BP’s stock’s alpha assuming that CAPM is the correct asset pricing model? Is BP stock fairly priced, underpriced, or overpriced? Please explain your answer
Expert Solution
Step 1
As per CAPM, cost of equity = risk-free rate + Beta*(market risk premium)
risk-free rate = 3%
Beta = 0.8
market risk premium = 5%
cost of equity (BP) = 3% + 0.8*5% = 7%
expected return (BP) = 8%
Alpha = True expected return - required return calculated from CAPM = 8% - 7% = 1%
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