Question

The risk-free rate is 4.2 percent and the expected return on the market is 12.3 percent. Stock A has a beta of 1.2 and an expected return of 13.1 percent. Stock B has a beta of 0.87 and an expected return of 11.4 percent. Are these stocks correctly priced?

Answer 1

Answer:

Thus, both the stocks are not priced properly.

Stock A is priced less by 13.92 - 13.1 = 0.82%

Stock B is priced over by 11.4 - 11.247 = 0.153%

Explanation:

Using Capital Asset Pricing Model we have,

Expected return on stock = Rf + Beta(Rm - Rf)

Where Rf = Risk free rate of return

Rm = Expected return on market

Beta = Risk volatility of stock in relation to market

For Stock A

We have expected return = 13.1%

Actual expected return as computed = 4.2 + 1.2(12.3 - 4.2)

= 4.2 + 9.72 = 13.92%

For Stock B

We have expected return = 11.4%

Actual expected return as computed = 4.2 + 0.87 (12.3 - 4.2)

= 4.2 + 7.047 = 11.247%

Thus, both the stocks are not priced properly.

Stock A is priced less by 13.92 - 13.1 = 0.82%

Stock B is priced over by 11.4 - 11.247 = 0.153%