Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2, but its expected return is 10% and its standard deviation is 15%. Portfolio AB has $300,000 invested in Stock A and $100,000 invested in Stock B. The correlation between the two stocks' returns is zero (that is, rA,B = 0). Which of the following statements is CORRECTσ
A) the stocks are not in equilibrium based on the capm; if a is valued correctly, then b is overvalued.
B) the stocks are not in equilibrium based on the capm; if a is valued correctly, then b is undervalued.
C) portfolio ab's expected return is 11.0%.
D) portfolio ab's beta is less than 1.2.
E) portfolio ab's standard deviation is 17.5%.

Question

Quizplus · Accepted Answer

Stock A's expected return is higher than Stock B's, but both have the same beta. According to CAPM, stocks with the same beta should have the same expected return if they are in equilibrium. Therefore, if Stock A is correctly valued, Stock B is overvalued.

Stock a Has an Expected Return of 12%, a Beta