Question

Assume the market rate of return is 10.1 percent and the risk-free rate of return is 3.2 percent. Lexant stock has 2 percent less systematic risk than the market and has an actual return of 10.2 percent. This stock:

A. is underpriced.

B. is correctly priced.

C. will plot below the security market line.

D. will plot on the security market line.

E. will plot to the right of the overall market on a security market line graph.

Answer 1

The systematic risk of the market (beta) is 1. Therefore the beta of Lexant = 1 - 2%, which is 0.95

expected return on Lexant stock = risk free rate + (beta)*(market return - risk free rate)

expected return on Lexant stock = 3.2% + (0.98)*(10.1% - 3.2%)

expected return on Lexant stock = 9.96%

However the actual return is 10.2%. That means it is undervalued, because investors expect a higher return given the level of systematic risk

the answer is A