Question

Stock Y has a beta of 1.2 and an expected return of 14.5 percent. Stock Z has a beta of .7 and an expected return of 9.3 percent. If the risk-free rate is 5.6 percent and the market risk premium is 6.6 percent, the reward-to-risk percent, respectively. Since ratios for Stocks Y and Z are and 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

Reward to risk ratio is calculated using formula i.e Excess return over risk free rate / Beta of stock ( Stock return - Risk free rate) / beta of stock

Reward to risk for stock Y = (14.5- 5.6)/1.2 = 7.42

Reward to risk for stock Z = (9.3-5.6)/0.7 = 5.29

Market risk premium is 6.6% and we know that market beta is 1 so SML reward to risk ratio is 6.6

Reward to risk ratio of stock Y is high as compared to SML and hence it will be plotted above SML and hence it is undervalued.

Reward to risk ratio of stock Z is low as compared to SML and hence it will be plotted below SML and hence it is overvalued.