Question

Stock Y has a beta of 1.6 and an expected return of 16.6 percent. Stock Z has a beta of 0.8 and an expected return of 9.4 percent. If the risk-free rate is 5.1 percent and the market risk premium is 6.6 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 ______________- and Stock Z is ___________

Answer 1

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%

SML Reward to Risk = 0.066 = 6.6%

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.