Question

Which one of the following stocks is correctly priced if the risk-free rate of return is 2.7 percent and the market risk premium is 7.2 percent?

Stock Beta Expected Return
A 0.71 7.90%
B 1.43 12.41%
C 1.24 11.16%
D 1.38 11.56%
E 0.95 9.54%
Stock D
Stock C
Stock B
Stock E
Stock A

Answer 1

Using the Capital Asset Pricing Model (CAPM), it is determined that Stock E is correctly priced as its calculated expected return of 9.54% matches the given expected return.

Step-by-step explanation:

We can determine which stock is correctly priced by using the Capital Asset Pricing Model (CAPM), which estimates the expected return of an asset based on its risk compared to the market. The CAPM formula is:

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

Given the risk-free rate of 2.7% and the market risk premium of 7.2%, we can calculate the expected return for each stock based on its beta:

• Stock A: 2.7% + (0.71 × 7.2%) = 7.822%
• Stock B: 2.7% + (1.43 × 7.2%) = 13.056%
• Stock C: 2.7% + (1.24 × 7.2%) = 11.628%
• Stock D: 2.7% + (1.38 × 7.2%) = 12.636%
• Stock E: 2.7% + (0.95 × 7.2%) = 9.54%

Comparing the calculated expected returns with the given expected returns, we can see that Stock E has an expected return that matches the given expected return and therefore is correctly priced according to CAPM.