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11 October, 08:46

The risk-free rate is 4.2 percent and the expected return on the market is 12.3 percent. Stock A has a beta of 1.2 and an expected return of 13.1 percent. Stock B has a beta of 0.87 and an expected return of 11.4 percent. Are these stocks correctly priced?

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  1. 11 October, 08:57
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    Thus, both the stocks are not priced properly.

    Stock A is priced less by 13.92 - 13.1 = 0.82%

    Stock B is priced over by 11.4 - 11.247 = 0.153%

    Explanation:

    Using Capital Asset Pricing Model we have,

    Expected return on stock = Rf + Beta (Rm - Rf)

    Where Rf = Risk free rate of return

    Rm = Expected return on market

    Beta = Risk volatility of stock in relation to market

    For Stock A

    We have expected return = 13.1%

    Actual expected return as computed = 4.2 + 1.2 (12.3 - 4.2)

    = 4.2 + 9.72 = 13.92%

    For Stock B

    We have expected return = 11.4%

    Actual expected return as computed = 4.2 + 0.87 (12.3 - 4.2)

    = 4.2 + 7.047 = 11.247%

    Thus, both the stocks are not priced properly.

    Stock A is priced less by 13.92 - 13.1 = 0.82%

    Stock B is priced over by 11.4 - 11.247 = 0.153%
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