CAPM and Expected Return. If the risk-free rate is 6% and the expected rate of return on the market portfolio is 13%, is a security with a beta of 1.25 and an expected rate of return of 16% overpriced or underpriced

under priced

Explanation:

In this question, we apply the Capital Asset Pricing Model (CAPM) formula which is shown below

Required rate of return = Risk-free rate of return + Beta * (Market rate of return - Risk-free rate of return)

= 6% + 1.25 * (13% - 6%)

= 6% + 1.25 * 7%

= 6% + 8.75%

= 14.75%

The Market rate of return - Risk-free rate of return) is also known as the market risk premium and the same is applied.

As we see that the expected return i. e 16% is more than the required rate of return so the return is under priced