Question

#24 Stock A has a beta of 1.2 and an expected return of 12%. Stock B has a beta of 0.7 and an expected return of 8%. If the risk-free rate is 2% and the market risk premium is 8%, what is true about the two stocks? A. Stock A is underpriced and stock

B is overpriced B. Both stocks are underpriced

C. Stock A is overpriced and stock

B is underpriced

D. Both stocks are correctly priced

E. Both stocks are overpriced

Answer 1

Solution:-

To calculate Expected Fair Return of Stock A-

As per Capital Assets Pricing Model-

Fair Return = Risk Free Return + Beta * Market Risk Premium

Fair Return = 0.02 + 1.20 * 0.08

Fair Return = 11.60%

Actual Expected Return = 12%

Since the actual return (12%) exceeds the CAPM Return hence, Stock is Under-priced.

To calculate Expected Fair Return of Stock B-

As per Capital Assets Pricing Model-

Fair Return = Risk Free Return + Beta * Market Risk Premium

Fair Return = 0.02 + 0.70 * 0.08

Fair Return = 7.60%

Actual Expected Return = 8%

Since the actual return (8%) exceeds the CAPM Return hence, Stock is Under-priced.

Hence, The Correct Answer is point B i.e. Both Stock are Under priced.

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