Financial Managment

MGMT 31000 – Financial Management

MGMT 310 - Financial Management

1

Buy Low, Sell High (p 435)
• An asset is said to be overvalued if its price is too high given its expected return and risk. Suppose you observe the following situation:
Security

Beta

Expected Return

SWMS Co.

1.3

14%

Insec Co.

0.8

10%

• The risk-free rate is currently 6 percent. Is one of the two securities overvalued relative to the other?

MGMT 310 - Financial Management

2

Buy Low, Sell High (p 435) - Solution
• To answer, we compute the reward-to-risk ratio for both. For SWMS, this ratio is (14%−6%)/1.3 =
6.15%. For Insec, this ratio is 5 percent. What we conclude is that Insec offers an insufficient expected return for its level of risk, at least relative to SWMS. Because its expected return is too low, its price is too high. In other words, Insec is overvalued relative to SWMS, and we would expect to see its price fall relative to SWMS’s. Notice that we could also say SWMS is undervalued relative to
Insec.
MGMT 310 - Financial Management

3

Systematic risk vs. Unsystematic risk (p
447)
• Consider the following information about Stocks I and II:

• The market risk premium is 7 percent, and the riskfree rate is 4 percent. Which stock has the most systematic risk? Which one has the most unsystematic risk? Which stock is “riskier”? Explain.
MGMT 310 - Financial Management

4

Systematic risk vs. Unsystematic risk (p
447) - Solution
• The amount of systematic risk is measured by the  of an asset.
• E(RI) = .25(.02) + .50(.21) + .25(.06) = .1250, or 12.50%
• Using the CAPM to find the  of Stock I, we find:
.1250 = .04 + .07I  I = 1.21

• The total risk of the asset is measured by its standard deviation.
• I2 = .25(.02 – .1250)2 + .50(.21 – .1250)2 + .25(.06 –
.1250)2 = .00743
• I = (.00743)1/2 = .0862, or 8.62%

MGMT 310 - Financial Management

5

Systematic risk vs. Unsystematic risk (p
447)