Tutorial 1.2 Memo 1. This statement is true. The security market line (SML) is the graphical representation of CAPM. It displays the relationship between the systematic risk (beta) and the expected return of a financial asset. In this graph, beta and the expected return are displayed on the x-axis and the y-axis respectively. The slope of SML stands for the market risk premium. Hence, when the slope of SML is positive, an increase in beta results in the increase in expected rate of return. 2. Stock A has a beta of 1.2 and Stock B has a beta of 0.6. Which of the following statements is true? Answer: C 3. Consider a stock with a beta of 1.5. Which of the following statements is true? Answer: D 4. Which of the following statements is true about the market risk premium? Answer: A 5. Answer: C 6. Answer: A 7. Re = Rf + β(Rm-Rf) Re = 3 + 2(8-3) Re = 13% 8. Re = Rf + β(Rm-Rf) 14 = Rf + 1.5(10-Rf) 14 = Rf + 15 – 1.5Rf 14 = 15 – 0.5Rf -1 = -0.5Rf Rf = 2 9. Re = Rf + β(Rm-Rf) Re = 6 + 0.66(12-6) Re = 9.96% 10. Required rate of return = 4.75 + 0.95(11.25 – 4.75) = 4.75 + 6.175 =10.925% HPR = 23/20 – 1 × 100 = (1.15 – 1) – 100 Estimated rate of return (HPR) = 15% Required rate of return < Estimated rate of return. 10.925% < 15%. Therefore, the share is undervalued Yes, you will purchase the share because it is undervalued
