Answer;
Reward-to-risk ratio of Y = 7.2%
Reward-to-risk ratio of Z = 5%
Explanation:
Stock Y
reward-to-risk ratio of Y = (12.4%-5.2%)/1= 7.2%
reward-to-risk ratio of Z = (8.2%-5.2%)/0.6= 5%
SML reward-to-risk = 6.4%/1= 6.4%
Therefore the reward-to-risk ratio for Stock Y is very high, meaning the stock plots above the SML, and the stock is undervalued. Hence, Its price must increase until its reward-to-risk ratio is equal to the market reward-to-risk ratio.
The reward-to-risk ratio for Stock Z is very low, which simply means the stock plots below the SML, and the stock is overvalued. Hence Its price must decrease until its reward-to-risk ratio is equal to the market reward-to-risk ratio.
Therefore If the risk-free rate is 5.2 percent and the market risk premium is 6.4percent, the reward-to-risk ratios for stocks Y and Z are 7.2 and 5 percent, respectively. Since the SML reward-to-risk is 6.4 percent, Stock Y is undervalued and Stock Z is overvalued.
