Question

Let there are two stocks: Stock A and Stock B. The expected returns of Stock A and Stock B are 18% and 10.5% respectively. The beta of Stock A and Stock B are 1.50 and 0.80 respectively. Suppose the risk-free rate of return is 5.5% and the market risk premium is 7.5%. Which of the following statements is most correct?
0	I do not want to answer this Question
1	Stock A is over-priced and Stock B is under-priced.
2	Stock B is over-priced and Stock A is under-priced.
3	Both the Stock A and Stock B are over-priced.
4	Both the Stock A and Stock B are under-priced.

Answer 1

We will use CAPM method to calculate the estimated return of Stock A and Stock B.

CAPM = Risk Free Rate + Market Premium* Beta

Stock A = 5.5% + 7.5%*1.5 = 16.75%

Stock B= 5.5% + 7.5*.80 = 11.5%

Stock A is overpriced because the expected return(ie 18%) is higher than CAPM estimated return (ie 16.75%)

Stock B is under priced because the expected return (ie10.5%) is lower than CAPM estimated return (ie 11.5%)

So the correct answe is 1 Where Stock A is over-priced and Stock B is under-priced.

Authors Bio: Cost and Management Accoutnat, Financial Analyst & Portfolio Manager