Question

Stock Y has a beta of 1.30 and an expected return of 14.6 percent. Stock Z has a beta of 0.75 and an expected return of 11.3 percent.

Required:
If the risk-free rate is 5.00 percent and the market risk premium is 7.50 percent, are these stocks correctly priced? in other words is stock Y undervalued, overvalued, or correctly price, is stock X undervalued, overvalued ,or correctly priced?

Answer 1

Using CAPM, Stock Y appears slightly overvalued with its actual expected return being lower than the CAPM expected return. Stock Z seems undervalued as its actual expected return is higher than that of CAPM's expected. The calculations rely on beta, risk-free rate, and market risk premium to determine expected returns.

Step-by-step explanation:

To determine if stocks Y and Z are correctly priced, we can use the Capital Asset Pricing Model (CAPM), which expresses the expected return of a security as a function of the risk-free rate, the security's beta, and the market risk premium.

The formula for CAPM is:

Expected Return = Risk-Free Rate + Beta x (Market Risk Premium)

Given that

Risk-free rate = 5.00%

Market risk premium = 7.50%

Beta of stock Y = 1.30

Expected return of stock Y = 14.6%

Beta of stock Z = 0.75

Expected return of stock Z = 11.3%

We can calculate the expected return using CAPM:

For Stock Y:

Expected Return = 5.00% + 1.30 x 7.50% = 14.75%

For Stock Z:

Expected Return = 5.00% + 0.75 x 7.50% = 10.625%

Comparing these expected returns with the actual expected returns provided:

Stock Y actual expected return = 14.6% (CAPM = 14.75%)

Stock Z actual expected return = 11.3% (CAPM = 10.625%)

Stock Y's actual expected return is slightly lower than the CAPM expected return, indicating that it might be slightly overvalued.

On the other hand, Stock Z's actual expected return is higher than the CAPM expected return, which could indicate that it is undervalued.