Which of the following stocks is (are) incorrectly priced if the risk-free rate is 4% and the market risk premium is 6%?
A) A only
B) B only
C) C only
D) A and C only
E) A, B, and C

Question

Which of the following stocks is (are) incorrectly priced if the risk-free rate is 4% and the market risk premium is 6%? 
A) A only 
B) B only 
C) C only 
D) A and C only 
E) A, B, and C

Quizplus · Accepted Answer

To determine if a stock is correctly priced, we can use the Capital Asset Pricing Model (CAPM):
Expected return = Risk-free rate + Beta * (Market risk premium)
where Beta measures the stock's systematic risk relative to the market. If the actual expected return is lower than the calculated expected return, the stock is overpriced. Conversely, if the actual expected return is higher than the calculated expected return, the stock is underpriced.
Let's calculate the expected return for each stock:
A: Expected return = 4% + 0.5 * 6% = 7%
Actual expected return = 5%, so stock A is overpriced.
B: Expected return = 4% + 1.2 * 6% = 11.2%
Actual expected return = 11%, so stock B is underpriced.
C: Expected return = 4% + 0.9 * 6% = 9.4%
Actual expected return = 10%, so stock C is correctly priced.
Therefore, stocks A and C are incorrectly priced, so the answer is D.

Which of the Following Stocks Is (Are) Incorrectly Priced If