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The risk-free rate is 4 percent. The expected market rate of return is 11 percent. If...

The risk-free rate is 4 percent. The expected market rate of return is 11 percent. If you expect CAT with a beta of 0.8 to offer a rate of return of 10 percent, you should

A.

hold CAT because it is fairly priced.
B.

buy CAT because it is overpriced.
C.

buy CAT because it is underpriced.
D.

sell stock short CAT because it is underpriced.
E.

sell short CAT because it is overpriced.
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Homework Answers

Answer #1

According to CAPM

According to CAPM, the CAT is expected to return only 9.6%, but it is offering 10%. So, CAT is underpriced. We buy the underpriced stock

Option C is correct. buy CAT because it is underpriced.

Option A is incorrect because CAT is underpriced

Option B is incorrect because CAT is underpriced. We don't buy the overpriced stock.

Option D is incorrect because we buy the underpriced stock, not sell

Option E is incorrect because CAT is underpriced and we buy the stock

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