You are examining three different shares. Share A has expected return -0.30%, beta -0.49, and volatility 29.00%. Share B has expected return 9.80%, beta 1.09, and volatility 24.00%. Finally, share C has expected return 8.60%, beta 0.88, and volatility 13.00%. The risk free rate is 2.70%, while the market price of risk is 7.00%. According to the CAPM, which share is undervalued?
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You are examining three different shares. Share A has expected return -0.30%, beta -0.49, and volatility 29.00%. Share B has expected return 9.80%, beta 1.09, and volatility 24.00%. Finally, share C has expected return 8.60%, beta 0.88, and volatility 13.00%. The risk free rate is 2.70%, while the market price of risk is 7.00%. According to the CAPM, which share is undervalued?
Capital asset pricing model is a model which helps to identify the impact of systematic risk on the value of the asset. It uses the systematic risk (Beta) in calculating the fair value of an asset. It calculates the required return from the systematic risk and expected return from the market and risk free rate. We can compare the required return from this model with the expected return to find out whether the security is fairly priced, over/under priced.
Formula for calculating required rate of return with this model:
Required return= Risk free rate + Market price of risk× Beta
If expected return> Required return= Undervalued.
If expected return< Required return= overvalued.
If expected return= Required return= fairly valued.
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