Question

Consider two stocks, A and B. Stock A has an expected return of 10% and a beta of 1.2. Stock B has an expected return of 14% and a beta of 1.8. The expected market rate of return is 9% and the risk-free rate is 5%. Security __________ would be considered the better buy because _________.A; it offers an expected excess return of .2%A; it offers an expected excess return of 2.2%B; it offers an expected excess return of 1.8%B; it offers an expected return of 2.4%

Answer 1

Answer:

B; it offers an expected excess return of 1.8%

Explanation:

In this question, we apply the Capital Asset Pricing Model (CAPM) formula which is shown below

Expected rate of return = Risk-free rate of return + Beta × (Market rate of return - Risk-free rate of return)

For Stock A

The expected rate of return would be

= 5% + 1.2 × (9% - 5%)

= 5% + 1.2 × 4%

= 5% + 4.8%

= 9.8%

And, the expected return is 10%

So, the excess would be

= 10% - 9.8%

= 0.2%

For Stock B

The expected rate of return would be

= 5% + 1.8 × (9% - 5%)

= 5% + 1.8 × 4%

= 5% + 7.2%

= 12.2%

And, the expected return is 14%

So, the excess would be

= 14% - 12.2%

= 1.8%