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5% -2% 6%

## a. What are the betas of the two stocks?

b. What is the expected rate of return on each stock if the market return is equally likely to be 5% or
25%?
c. If the T-bill rate is 6% and the market return is equally likely to be 5% or 25%, draw the SML for
this economy.

Answer: a. Call the aggressive stock A and the defensive stock D. Beta is the sensitivity of the
stock’s return to the market return, i.e., the change in the stock return per unit change in the market return.
Therefore, we compute each stock’s beta by calculating the difference in its return across the two
scenarios divided by the difference in the market return:
.02  .38 .06  .12
A   2.00 D   0.30
.05  .25 .05  .25
b. With the two scenarios equally likely, the expected return is an average of the two possible
outcomes:
E(rA ) = 0.5  (–.02 + .38) = .18 = 18%
E(rD ) = 0.5  (.06 + .12) = .09 = 9%

c. The SML is determined by the market expected return of [0.5 × (.25 + .05)] = 15%, with βM =
1, and rf = 6% (which has βf = 0). See the following graph:

## Expected Return - Beta Relationship

40
35 SML
30
Expected Return

25
20
A
15 A
D M
10

0
0 0.5 1 1.5 2 2.5 3
Beta
The equation for the security market line is:
ri = 6% + β × (15% – 6%)

For defensive stock, the required rate of return calculated from CAPM model is ri = 6%
+ 0.3 × (15% – 6%) = 7.8%, but the expected rate of return calculated from (b) is 9%,
so defensive stock is undervalued.

For aggressive stock, the required rate of return calculated from CAPM model is ri =
6% + 2 × (15% – 6%) = 24%, but the expected rate of return calculated from (b) is
18%, so aggressive stock is overvalued.