Question

Stock Y has a beta of 1.8 and an expected return of 18.2 percent. Stock Z has a beta of .8 and an expected return of 9.6 percent. If the risk-free rate is 5.2 percent and the market risk premium is 6.7 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 :__________. (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

The reward-to-risk ratios for Stocks Y and Z are 7.22 and 5.50 percent, respectively. Since the SML reward-to-risk is 6.70 percent, Stock Y is undervalued and Stock Z is overvalued.

Step-by-step explanation:

Market risk premium is 6.7%

Reward-to-risk ratio of Stock = (Expected return of the Stock - Risk-free rate) / Beta of the Stock

Using equation (1), we therefore have:

Reward-to-risk ratio of Stock Y = (18.2% - 5.2%) / 1.8 = 7.22%

Reward-to-risk ratio Stock Z = (9.6% - 5.2%) / 0.8 = 5.50%

Since the β of the market is one, it implies that SML reward-to-risk is 6.70 perecent.

Therefore, we have:

The reward-to-risk ratios for Stocks Y and Z are 7.22 and 5.50 percent, respectively. Since the SML reward-to-risk is 6.70 percent, Stock Y is undervalued and Stock Z is overvalued.