Question

Stock Y has a beta of 1.2 and an expected return of 15.3 percent. Stock Z has a beta of .8 and an expected return of 10.7 percent. If the risk-free rate is 6 percent and the market risk premium is 7 percent, the reward-to-risk ratios for stocks Y and Z are  and  percent, respectively. Since the SML reward-to-risk is  percent, Stock Y is Undervalued of Overvalued (pick one) and Stock Z is  Undervalued of Overvalued (pick one). (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Expected rate of return:

Stock Y= Risk free return + beta(market return- risk free return)

= 0.06+1.2(0.07-0.06) = 0.072 or 7.2%

Stock Z = Risk free return + beta(market return- risk free return)

= 0.06 + 0.8(0.07-0.06) = 0.068 or 6.8%

Case 1: we can see that the expected return of stock Y is 15.3% but the CAPM gives a value of 7.2% which means the stock is undervalued in the market.

Case 2: similarly, the expected returns of stock Z in the market is 10.7% but the results shows that it is actually undervalued.