Assume that the short-term risk-freerate is 3%, the market index S&P500 is expected to pay returns of 15% with the standard deviation equal to 20%. Asset A pays on average 5%, has standard deviation equal to 20% and is NOTcorrelated with the S&P500. Asset B pays on average 8%, also has standard deviation equal to 20% and has correlationof 0.5 with the S&P500. Determine whether asset A and B are overvalued or undervalued, and explain why.
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
Assume that the short-term risk-freerate is 3%, the market index S&P500 is expected to pay returns of 15% with the standard deviation equal to 20%. Asset A pays on average 5%, has standard deviation equal to 20% and is NOTcorrelated with the S&P500. Asset B pays on average 8%, also has standard deviation equal to 20% and has correlationof 0.5 with the S&P500. Determine whether asset A and B are overvalued or undervalued, and explain why.
(Hint: Beta of asset i (??)=???????, where ??,??are standard deviations of asset i and market portfolio, ???is the correlation between asset i and the market portfolio)
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