Question

Stock Y has a beta of 1.2 and an expected return of 11.1 percent. Stock Z has a beta of .80 and an expected return of 7.85 percent. If the risk-free rate is 2.4 percent and the market risk premium is 7.2 percent, the reward-to-risk ratios for stocks Y and Z are 7.25 and ??????? percent, respectively. Since the SML reward-to-risk is 7.20 percent, Stock Y is undervalued and Stock Z is overvalued (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 = (Expected return of stock - Risk free rate of return)/Beta of stock

Reward to Risk ratio of stock Y = (11.1 - 2.4)/1.2

= 7.25 %

Reward to Risk ratio of stock Z = (7.85 - 2.4)/0.80

6.8125%

SML reward to Risk ratio is always market Risk premium which is 7.20%

Stock Y has higher reard to Risk ratio than SML, so it is underpriced or undervalued.

Stock Z has lower reward to Risk ratio than SML, so it is overpriced or overvalued.