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10. The Capital Asset Pricing Model and the security market line Wilson holds a portfolio that invests equally in three stocks (WA - WB - Wc - 1/3). Each stock is described in the following table: Stock Beta Standard Deviation 23% Expected Return 7.5% A 0.5 B 1.0 38% 12.0% 14.0% C 2.0 45% An analyst has used market- and firm-specific information to generate expected return estimates for each stock. The analyst's expected return estimates may or may not equal the stocks' required retums. You've also determined that the risk-free rate (ru) is 4%, and the market tisk premium (RPM) is 5%. Given this information, use the following graph of the security market line (SML) to plot each stock's beta and expected return on the graph. (Note: click on the points on the graph to see their coordinates.) 20 16 Stock 12 Stock B RATE OF RETURN Percent) Stock 2 03 04 wa 14 10 2.0 0.6 10 12 RISK (Beta) A stock is in equilibrium if its required return equals its expected return. In general, assume that markets and stocks are in equilibrium (or fairly valued), but sometimes investors have different opinions about a stock's prospects and may think that a stock is out of equilibrium (either undervalued or overvalued). Use the analyst's expected return estimates to determine if this analyst thinks that each stock in Wilson's portfolio is undervalued, overvalued, or fairty valued. Undervalued Fairly Valued Overvalued Stock A O O Stock B O Stock

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