Question

Stock X has an expected return of 10.7% and a beta of 0.9. Stock Y has an expected return of 17.9% and a beta of 2.4. Stock Z has an expected return of 13.5% and a beta of 1.5. The market risk premium is 7% and the risk-free rate is 3%. Which of the following statements is true?

A. Stock X is underpriced, Stock Y is overpriced, Stock Z is overpriced.
B. Stock X is fairly priced, Stock Y is underpriced, Stock Z is underpriced.
C. Stock X is over priced, Stock Y is overpriced, Stock Z is underpriced.
D. Stock X is fairily priced, Stock Y is fairly priced, Stock Z is overpriced.
E. Stock X is underpriced, Stock Y is overpriced, Stock Z is fairly priced.

Answer 1

The correct statement is:

E. Stock X is fairly priced, Stock Y is overpriced, Stock Z is fairly priced.

Step-by-step explanation:

This is determined by comparing the expected returns of the stocks with their respective required returns based on the Capital Asset Pricing Model (CAPM).

Calculating the required returns using the CAPM formula, we find that:

- Stock X has an expected return of 10.7%, which is higher than the required return of 9.3%. Therefore, Stock X is fairly priced.

- Stock Y has an expected return of 17.9%, which is lower than the required return of 19.8%. Therefore, Stock Y is overpriced.

- Stock Z has an expected return of 13.5%, which is equal to the required return of 13.5%. Therefore, Stock Z is fairly priced.

Based on these comparisons, we can conclude that Stock X and Stock Z are fairly priced, while Stock Y is overpriced.