Question

Stock B has a beta of 1.5. The S&P 500 is expected to yield 10% (market's return). Treasuries yield 5% (risk free rate). They expected return is 14%. They should______.

a. buy because the expected return is above required

b. buy because the required return is above the expected.

c. not buy because the expected return is above the required.

d. not buy because the required return is above the expected.

Answer 1

Given that,

Market's return Rm = 10%

risk free rate Rf = 5%

beta of stock B = 1.5

So, required return on stock can be calculated using CAPM model

Required return on stock B Rb = Rf + beta*(Rm - Rf) = 5 + 1.5*(10-5) = 12.50%

But expected return on stock B, E(b) is 14%

When expected return on the stock is higher than required return, it is plotted above the security market line and thus the stock is current undervalued. So, this stock should be purchased.

So, The should buy the stock because the expected return is higher than the required return.

Option A is correct.