The expected return of the market is 12 percent, and the risk-free rate is 4.5 percent. Stock K has a beta of 1.2 and an expected return of 14.2 percent. Stock L has a beta of 0.85 and an expected return of 10.3 percent. From this information, Stock K is ______ and Stock L is _______.
A) overpriced; overpriced
B) overpriced; underpriced
C) underpriced; underpriced
D) underpriced; overpriced
E) Insufficient information.

Question

Quizplus · Accepted Answer

The expected return of Stock K can be calculated using the Capital Asset Pricing Model (CAPM):
Expected Return of Stock K = Risk-free rate + (Beta of Stock K * (Expected return of the market - Risk-free rate))
Expected Return of Stock K = 4.5% + (1.2 * (12% - 4.5%))
Expected Return of Stock K = 14.1%
Comparing the expected return (14.1%) with the actual expected return (14.2%), we can say that Stock K is slightly overpriced.
Similarly, the expected return of Stock L can also be calculated using CAPM:
Expected Return of Stock L = Risk-free rate + (Beta of Stock L * (Expected return of the market - Risk-free rate))
Expected Return of Stock L = 4.5% + (0.85 * (12% - 4.5%))
Expected Return of Stock L = 10.95%
Comparing the expected return (10.95%) with the actual expected return (10.3%), we can say that Stock L is underpriced. 
Hence, the best choice is D: underpriced; overpriced.

The Expected Return of the Market Is 12 Percent, and the Risk-Free