The first step is to calculate the expected rate of return for each security using the capital asset pricing model (CAPM):
E(R) = rf + Bi(RM – rf).
Expected rate of return for A = 0.03 + 0.5(0.09 – 0.03) = 0.03 + 0.03 = 0.06 or 6.0%.
Expected rate of return for B = 0.03 + 1.0(0.09 – 0.03) = 0.03 + 0.06 = 0.09 or 9.0%.
Expected rate of return for C = 0.03 + 1.5(0.09 – 0.03) = 0.03 + 0.09 = 0.12 or 12.0%.
The next step is to compare the forecasted return (FR) for each security with the expected return.
- If the forecasted return is greater than the expected return, then the stock is under-priced and should be included in the portfolio.
- If the FR is less than the expected return, then the security is over-priced and should not be included in the portfolio.
The forecasted returns for stocks A and B are greater than their expected returns. Therefore, both A and B should be included in the portfolio and not stock C.
