The risk-free rate is 4%. The expected market rate of return is 12%. If you expect stock X with a beta of 1.0 to offer a rate of return of 10%, you should
A) buy stock X because it is overpriced.
B) sell short stock X because it is overpriced.
C) sell short stock X because it is underpriced.
D) buy stock X because it is underpriced.
E) None of the options, as the stock is fairly priced.

Question

Quizplus · Accepted Answer

Using the Capital Asset Pricing Model (CAPM), the expected return of a stock can be calculated as: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate). For stock X, this would be: 4% + 1.0 * (12% - 4%) = 12%. Since the expected return of 10% is less than the CAPM return of 12%, stock X is overpriced, and the correct action would be to sell short.

The Risk-Free Rate Is 4