CAPM calculation

According to CAPM (Shapiro, 2003), if an asset is correctly priced, it should be positioned on the SML. However, in reality, the expected returns may differ from what it should be according to CAPM. Using the information given, the required returns are calculated using the formula below:

Required returns = Risk free rate + (Share’s beta x market Risk premium)

Stock A: CAPM = 4% + 1.5 (6%) = 13%

Stock B: CAPM = 4% + 0.5 (6%) = 7%

On the basis of the above calculations, investors would require a return of 13% to justify buying Stock A and 7% for Stock B. Using the derived CAPM, this is plotted on to the SML chart to analyse if the expected returns given reflect the correct price.

Shares should be bought if the security is plotted above the SML as it is undervalued and investors can expect greater takings. Vice versa, the stock should be sold if it is plotted below the line as it means it is overvalued and the returns are not enough to compensate for the risk.

Applying the above calculations and information given, Stock A is undervalued (required return is 13% against 19%), while Stock B is also undervalued (7% against 8%), therefore both stock should be bought.

CAPM is an equilibrium model. This then pushes the market to move towards equilibrium, meaning that all assets would be correctly priced and the expected and required return would be equal. The market is efficient when no investor can recognise any mispriced assets (Zivot, 2006).