The risk-free rate is 7 percent.The expected market rate of return is 15 percent.If you expect a stock with a beta of 1.3 to offer a rate of return of 12 percent,you should
A)buy the stock because it is overpriced.
B)sell short the stock because it is overpriced.
C)sell the stock short because it is underpriced.
D)buy the stock because it is underpriced.
E)none of the above,as the stock is fairly priced.

Question

Quizplus · Accepted Answer

According to the Capital Asset Pricing Model (CAPM), the expected rate of return on a stock can be calculated using the formula:

Expected return = Risk-free rate + Beta x (Market rate of return - Risk-free rate)

In this case, the expected return on the stock with a beta of 1.3 is:

Expected return = 7% + 1.3 x (15% - 7%)
Expected return = 15.6%

Since the expected return of the stock is lower than the required rate of return (15.6% < 12%), this means that the stock is overpriced and is not worth buying at its current price.

Therefore, the best choice is to sell short the stock because it is overpriced (choice B).

The Risk-Free Rate Is 7 Percent