Question

Stock Y has a beta of 1.2 and an expected return of 15.3 percent. Stock Z has a beta of 0.8 and an expected return of 10.7 percent. If the risk-free rate is 6 percent and the market risk premium is 7 percent, the reward-to-risk 7.75 and ratios for stocks Y and Z are 5.88 percent, respectively. Since the SML reward-to-risk is 7.0 percent, Stock Y is undervalued 16 overvalued (Do not round intermediate calculations and Stock Z is points and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) еВook Print References

Answer 1

Reward-to-risk ratio Y = (15.3%-6%)/1.2 = 7.75%

Reward-to-risk ratio Z = (10.7%-6%)/0.8 = 5.88%

Since the SML reward-to-risk is 7.00%

Stock Y is undervalued and Stock Z is overvalued.

(As the reward-to-risk for stock Y is very high, this indicates that the stock is plotted below the SML and it is undervalued. The reward-to-risk for stock Z is very low, this indicates that the stock is plotted above the SML and it is overvalued.)