Answer:
Stock Y is undervalued and Stock Z is overvalued
Explanation:
The Required return on Stock Y = Risk free Rate + BetaY * Market Premium = 5.1% + 1.6%* 6.6% = 15.66%
Expected Return on Y = 16.6%
Here, the Expected return > Required return, the stock is undervalued
Reward to risk Ratio = (Expected return - Risk free rate) / Beta. For Y, Reward to risk = (0.166 - 0.051)/1.6 = 0.115/1.6 = 0.0719 = 7.19%
Required return on Stock Z = Risk free Rate + BetaZ * Market Premium = 5.1 + 0.8 * 6.6 = 10.38%
Expected Return on Z = 9.4%
Here, the Expected return < Required return, the stock is overvalued.
Reward to risk Ratio = (Expected return - Risk free rate) / Beta. For Z, Reward to risk = (0.094 - 0.051)/0.8 = 0.043/0.8= 0.0538 = 5.38%
<em>SML Reward to Risk = 0.066 = 6.6%</em>
Reward to Risk for Y > than SML Reward to Risk, then stock Y is undervalued.
Reward to RIsk for Z > than SML Reward to Risk, then stock Z is overvalued.
