Question

Stock A has an expected return of 11 percent, a beta of 0.9, and a standard deviation of 15 percent Stock B also has a beta of 0.9, but its expected returm is 9 percent and its standard deviation is 13 percent. Portfolio AB has $900,000 invested in Stock A and $300,000 invested in Stock B. The correlation between the two stocks' returns is zero. Which of the following statements is CORRECT? Select one O a.I am not sure b. The stocks are not in equilibrium based on the CAPM, If A is valued correctly, then B is overvalued C.The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is undervalued O d. Portfolio AB's expected return is 11.0%. e.Portolio AB's beta is less than 1.2

Answer 1

As per CAPM, the required return on stock is equal to Risk free Rate + Beta*Market Risk Premium

Hence, stocks with same beta should have same expected return

Hence, If stock A is valued correctly, B in undervalued (since expected return is lower)

Portfolio beta is equal to weighted average beta

= 0.9

Expected return of portfolio will be between 11%*3/4 + 9%*1/4 = 10.5%

Hence, the correct statement is

C.