The risk-free rate is 5%. The expected market rate of return is 11%. If you expect stock X with a beta of 2.1 to offer a rate of return of 15%, 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 on stock X can be calculated as: Expected Return = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate) = 5% + 2.1 * (11% - 5%) = 17.6%. Since the expected return of 15% is less than the CAPM return of 17.6%, stock X is overpriced, and the correct action would be to sell short.

The Risk-Free Rate Is 5