The risk-free rate is 4%.The expected market rate of return is 11%.If you expect stock X with a beta of .8 to offer a rate of return of 12 percent,then you should _________.
A) buy stock X because it is overpriced
B) buy stock X because it is underpriced
C) sell short stock X because it is overpriced
D) sell short stock X because it is underpriced

Question

Quizplus · Accepted Answer

According to the Capital Asset Pricing Model (CAPM), the expected rate of return for a stock is equal to the risk-free rate plus the stock's beta (systematic risk) multiplied by the expected market rate of return minus the risk-free rate.

Using the formula, the expected rate of return for stock X is:
4% + 0.8(11% - 4%) = 10.2%

Since the expected rate of return for stock X is greater than the required rate of return (10.2% vs. 12%), stock X is considered underpriced and a good investment opportunity. Therefore, the correct choice is B- buy stock X because it is underpriced.

The Risk-Free Rate Is 4