You are examining three different shares. Share A has expected return 8.00%, beta 0.74, and volatility 31.00%. Share B has expected return 5.40%, beta 0.45, and volatility 13.00%. Finally, share C has expected return 7.20%, beta 0.56, and volatility 27.00%. The risk free rate is 2.70%, while the market price of risk is 7.60%. According to the CAPM, which share is undervalued?
You are examining three different shares. Share A has expected return 8.00%, beta 0.74, and volatility 31.00%. Share B has expected return 5.40%, beta 0.45, and volatility 13.00%. Finally, share C has expected return 7.20%, beta 0.56, and volatility 27.00%. The risk free rate is 2.70%, while the market price of risk is 7.60%. According to the
CAPM is a method which is used for pricing of securities and calculating the required return from the security from the risk free return, the expected return from the market and beta of the security. By calculating the required return and comparing with the expected return/actual return, we can identify whether the security is overvalued, undervalued or fairly valued.
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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