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28 February, 18:09

Stock Y has a beta of 1.40 and an expected return of 14.8 percent. Stock Z has a beta of. 85 and an expected return of 11.3 percent. If the risk-free rate is 4.85 percent and the market risk premium is 7.35 percent, are these stocks overvalued or undervalued?

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  1. 28 February, 18:38
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    Stock Y has overvalued and Stock Z as undervalued

    Explanation:

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

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

    For Stock Y

    = 4.85% + 1.40 * 7.35%

    = 4.85% + 10.29%

    = 15.14%

    For Stock Z

    = 4.85% + 0.85 * 7.35%

    = 4.85% + 6.2475%

    = 11.0975%

    The (Market rate of return - Risk-free rate of return) is also called market risk premium and the same is applied in the answer

    As we see the expected return of both the stock So, Stock Y has overvalued and Stock Z as undervalued
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